It’s time to worry about the change

Over the past eight months, foreign portfolio investors have taken nearly $40 billion out of India by selling stocks and bonds. During this period, India’s foreign exchange reserves fell by $52 billion. The rupee is falling against the US dollar. Imports are growing faster than exports, which means we need many more dollars to pay than we receive from our export earnings. Even in normal times, India has a shortage of dollars in manageable proportions, i.e. between 1 and 2% of GDP. Typically, this is less than $50 billion and is due to exports exceeding imports. This shortage is financed by inflows in the form of stock market investments, foreign loans, private equity or bond purchases. These capital inflows have always exceeded the current account deficit and as a result India’s “balance of payments” (BOP) account has been in surplus. Of course, having a balance of payments surplus financed solely by debt and external liabilities is not necessarily a good thing, especially when there is over-indebtedness everywhere in the world. But in normal times, foreigners willingly lending to the Indian economy are a sign of confidence.

All of that is about to change drastically, and India’s forex custodian, the Reserve Bank of India, has sent out early warning signals. Hopefully, and assuming a robust inflow of $80 billion this fiscal year, our BOP account will still be negative $30-40 billion. And our current account deficit could climb dangerously to 3.2% of GDP, exceeding $100 billion. Our reserve stack will not be enough to cope with this additional pressure on the forex. Therefore, the RBI has relaxed some constraints to attract more fixed dollar-denominated deposits from non-resident Indians. It also facilitated foreign borrowing and increased the permitted limit on foreign ownership of Indian government bonds. All these measures are aimed at attracting more dollars. These proactive measures were necessary due to some alarming signs, such as the widening of the trade and current account deficit, and the increase in the share of external debt that must be repaid this year. India’s external debt stands at $620 billion, of which $267 billion is due to be repaid over the next nine months. This short-term debt ratio is 44% and dangerously high. To repay this debt, the private companies that have taken out these foreign loans will have to seek new loans to repay old loans, or else tap into India’s foreign exchange reserves. The latter is undesirable because foreign exchange reserves are dwindling and need to be strengthened. And the former will not be easy since the dollars are flowing to the United States and not to developing countries. In any case, new loans will carry much higher interest rates, which will incur a debt service charge in the future.

The precautionary measures of the RBI have accompanied the measures taken by the Union government to save the dollars. Import duties on gold have been increased to 12.5%, in order to stem the outflow of dollars due to gold purchases. Indians have an insatiable demand for gold, and as a result the country is the biggest importer in the world. The higher import duty might reduce demand somewhat, but will also lead to some smuggling. It is also possible that other restrictions will be imposed on non-essential imports to prevent the outflow of dollars.

Currency and exchange rate management is primarily the responsibility of the RBI. In the current circumstances, in addition to the pressures due to the flight of stock market investors, there are added pressures due to high oil prices. This affects India’s total import bill (over 150 billion a year) and an increase in the subsidy bill (since there is less than the full pass-through of oil prices to consumers). The burden of fertilizer and cooking gas subsidies is increased due to rising oil prices. So, to deal with this additional tax burden, the government imposed an export tax on the windfall profits of steel and petroleum refining companies. This is expected to bring over 1 trillion rupees to the Treasury. It is an indirect way of coping with the impact of the falling rupee. But an export tax is a rare and exceptional measure and justified only because of the sharp increase in oil prices linked to the war in Ukraine. The Union government also has the fiscal burden to pursue compensation due to the shortfall of GST collection to state governments. The latter are themselves indebted, with ten states reaching dangerous levels of indebtedness, which can lead to default.

Externally, the pressure on the rupee is not only due to the high import bill caused by oil prices. Non-oil and non-gold imports such as electronics, chemicals and coal increased by 32% between April and June. Gold imports in June were up 170% from a year ago. Let’s see if higher import duties on gold discourage imports. Indians could invest in gold sovereign bonds, which are real substitutes for gold and do not drain valuable foreign currency. An aggressive effort to sell gold bonds by the government is needed.

The coming months will require dexterous macroeconomic management of the twin deficits, on the external and internal front. A higher budget deficit invites higher interest rates. And a higher trade deficit invites a weaker rupee. If these two policy instruments – interest rates and the exchange rate – are diligently managed to gradually reduce deficits, we can avoid a crisis situation. The weakening of the rupee is a natural cushion but in the short term can worsen the trade deficit, until exports catch up. Similarly, reducing the budget deficit requires both expenditure control and increased tax revenue. The latter requires a resumption of growth and employment. If oil prices fall due to recessionary winds around the world, that would be a boon for India – albeit a mixed one, as a global recession is bad for Indian exports which are crucial to closing the trade deficit. Who said macroeconomic management was easy?

Dr. Ajit Ranade is a renowned economist

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