The government has attributed the weakening of the rupee against the dollar in recent weeks to the reduced inflow into and occasional outflow of foreign portfolio investment from India’s equity markets. This reduced foreign institutional investor (FII) interest has been explained by developments outside the country. Problems abroad, it is suggested, is forcing these institutions to sell their equity in India to meet commitments or cover losses at home. Hence, the exit.
There are two reasons why this argument is not convincing. First, since India’s equity markets have been performing poorly in recent times, FIIs may have also chosen to exit to cut losses and move to more profitable locations. Second, even if FII inflows are down, aggregate net capital inflows to India have remained high, because of foreign direct investment and foreign debt. After the global crisis, these flows fell to a small $7.8 billion in 2008-09, but quickly bounced back to $51.8 billion in 2009-10 and $57.3 billion in 2010-11. Thus recent flows have been substantial, even if much below the exceptional peak in 2007-08. In any case they have been more than required to finance the country’s current account deficits, resulting in an increase in foreign exchange reserves in most years. There is no reason to believe, therefore, that the inadequacy of capital flows could alone explain rupee’s depreciation.
If developments on the balance of payments have to explain rupee depreciation, then the problem must be traced to the current account. There are two factors involved here. The first is that the merchandise trade deficit, or the excess of goods imports over goods exports has remained in the range of 8-9 per cent of GDP in recent years, excepting for crisis year 2008-09 when it rose sharply to 10.4 per cent (see accompanying Chart). Given the growth of GDP, this points to high absolute growth in the merchandise trade deficit as well. The second is that during this period India’s receipts from what are termed “invisibles” have shrunk relative to the trade deficit. Most important among invisibles as contributors to India’s foreign exchange receipts are exports of software and IT-enabled business services, on the one hand, and remittances or “personal transfers” from Indians working abroad. Earlier, these flows were adequate to finance much of the trade deficit, even after outflows on account of dividends and interest (which are also in the invisibles category). But since 2007-08, the ratio of net invisible receipts to the merchandise trade deficit has fallen from 83 per cent to 65 per cent in 2010-11. In sum, while India’s trade deficit has risen more or less in proportion to GDP, invisible earnings have not kept pace, resulting in a doubling of the current account deficit to GDP ratio from 1.4 per cent in 2007-08 to 2.9 per cent in 2009-10 and 2010-11.
It is no doubt true that a rising current account deficit per se need not weaken the currency of a country, if access to capital inflows is adequate to finance the gap. That has indeed been true of India. But the difficulty is that India has by and large been a chronically deficit country on the current account, resulting in the fact that continuous inflows have been needed to finance that deficit. In sum, India has continuously “borrowed” to meet the excess of its annual foreign exchange expenditures over its revenues. It is indeed true that in India’s case actual capital inflows have been more than needed to finance the current account deficit in most years, resulting in the accumulation of large reserves.
But for that reason these reserves are in the nature of “borrowed” reserves and therefore can be repatriated abroad at will, besides involving future payments commitments.
It is in this background that we should assess the effects of a slowdown in capital flows, especially through the FII route. That slowdown can be interpreted as evidence that India is losing its earlier favoured status in FII investment plans and may begin to experience a net capital outflow and a consequent reduction in foreign exchange reserves. The problem is that this trend reinforces itself. Net sales by FIIs generate uncertainties in India’s thin and shallow stock markets, leading to a fall in stock indices that could accelerate the exit. This does exert downward pressure on the rupee. When this occurred recently, for a short period the RBI chose to let things be and not intervene in the foreign exchange market to shore up the rupee. The result was a slide in he value of the rupee that was aggravated by speculative holding of dollars by exporters and dealers, in the expectation of substantial depreciation. In the end the RBI had to intervene to stabilise the currency.
The point to note is that underlying all of this are two tendencies. One is the rising deficit on India’s merchandise trade account. More recently, that deficit stood at $86 billion during the first two quarters (April-September) of financial year 2011-12, as compared with $69 billion in the corresponding period of 2010-11. The other is the sign that India’s services exports are turning sluggish, reducing the neutralising effect of an important component of India’s balance of payments. While its is true that net foreign exchange earnings from services increased from $22 billion to $31 billion between the two April to September periods noted above, the pace of growth of services exports has slowed. Growth in services exports (in dollar terms) at 17.1 per cent in the first two quarters of 2011-12 led mainly by software and telecommunications services, was substantially lower than the 32.7 per cent recorded in the first two quarters of 2010-11. The current account was shored up by the fact that that private transfers or remittances that had declined by 1.1 per cent during the first two quarters of 2010-11 rose by 18.8 per cent during April-September 2011-12, driven possibly by the depreciation of the rupee.
The message seems clear. India cannot continue to rest purely on the benefits it has hitherto derived from the exports of software and IT-enabled services. An effort to realize at least a part of the manufactured export competitiveness that liberalization was supposed to deliver, but did not, is crucial. This is particularly important because revenues from remittances or the export of labour services cannot be the mainstay of the balance of payments of a modern nation.