:: Jayati Ghosh

External debt, more than FIIs, drags rupee down

Jayati Ghosh

March.24 : One of the more obvious signs of the impact of the global economic crisis on the Indian economy is the recent dramatic sharp slide in the value of the rupee. In nominal terms, it has fallen from Rs 39.27 to the US dollar on January 15 to Rs 51.10 to the US dollar by March 3 — a decline of more than 30 per cent in less than two months.

Obviously, this reflects developments in the balance of payments. There are many who would conclude that this is because of current account developments, as the global recession has impacted upon Indian exports and reduced export revenues. India’s aggregate merchandise exports have declined in each of the three months starting October 2008. The decline in December alone (relative to the corresponding month of the previous year) was 1.1 per cent.

As a result, over the first nine months (April-December) of this financial year (2008-2009) exports at $130.9 billion registered a 16.3 per cent rate of growth which was significantly lower than the 23.2 per cent recorded during the corresponding period of a year ago.

On the other hand, merchandise imports recorded a higher growth of 30.8 per cent during April to December 2008 as compared with the 27.6 per cent of a year ago, because for much of that period India was still affected by the burden of higher oil prices. The value of imports of petroleum, oil and lubricants rose by 43.3 per cent during these months, as compared with 24 per cent in the previous year.

In the event, the trade deficit rose by 58.5 per cent during April-December 2008 to $93.5 billion, from $59 billion during April-December 2007. Things are likely to have gotten worse during the current fourth-quarter of the financial year.

Even so, the trade balance cannot be the real reason (or at best, can only be a small part of the reason) for the rupee’s downslide. This is because it has been mitigated by the continuing strength of services exports and net inward transfer payments. Both net services (which rose by $22.9 billion during April-September 2008) and private transfers (which rose to $25.7 billion) increased. So while the trade deficit during April-September 2008 was $26 billion higher than a year ago, the current account deficit had only widened by $11.4 billion.

There are significant lags in the effect of the global recession on India’s services exports, possibly contracts in certain areas such as software and BPO services are signed for long periods, two-three years. The effect of the crisis would be on the renewal of contracts and the signing of new contracts. The impact on aggregate revenues would initially be low because of the weight of legacy contracts in the total. So it is possible that when the data for the year as a whole becomes available the slowdown may be greater than suggested by the April-September figures.

In the case of private transfers — mainly remittances from workers abroad — the lag is likely to be even greater because even if workers are losing jobs and returning they would return with whatever accumulated savings they have. This initial windfall effect may more than make up for the fall in the value of ongoing remittances because of lower overseas employment, but such an effect is obviously temporary.

So the sharp depreciation of the rupee must largely be due to capital account changes. This should not be surprising given the extremely important role that capital flows have come to play in India’s balance of payments. Though services exports and remittance incomes have helped India keep its current account deficit low, the large reserves it has accumulated are the result of capital inflows that were far in excess of its current account financing needs.

This is really quite a recent development. Foreign investment flows rose sharply from $4.9 billion in 1995-96 to $29.2 billion in 2006-07 and then more than doubled to $61.8 billion in 2007-08. Obviously this was possible because of the relaxation of sectoral ceilings on foreign shareholding and the substantial liberalisation of rules governing investments and repatriation of profits and capital from India.

But such liberalisation began rather early in the 1990s, whereas the expansion of foreign investment flows occurred much later. Thus, the maximum level of net foreign investment inflow reached was $8.2 billion in 2001-02. This rose to $15.7 billion in 2003-04, partly encouraged by tax concessions offered to foreign investors. Thereafter, India was "discovered" by foreign investors and became the target of a capital investment surge.

The more than doubling of such inflows in 2007-08 to $61.8 billion is especially worth noting since it was very different from the experience in Asian emerging markets. Net direct and portfolio equity investment into Asian emerging markets (China, India, Indonesia, Malaysia, Philippines, South Korea and Thailand) fell from $122.6 billion in 2006 to $112.9 billion in 2007 and an estimated $57.9 billion in 2008. This implied that private foreign investors in equity were pulling out of Asia at a time when investments in India were rising sharply. India was serving as a hedge when uncertainties were engulfing markets elsewhere in Asia and the world. This obviously made such flows especially fragile, since any fresh development could lead to sudden outflows as well. And this is what has happened as the global crisis has caused FIIs, who need cash to meet commitments and cover losses at home, to sell out in Indian markets and repatriate their capital. Thus, over the year ending January 2009, net outflow of FII capital amounted to $23.7 billion.

If anything, foreign direct investment has played a moderating role since net foreign direct investment remained high at $27.43 billion during April-January 2008-09. But another component of capital flows into India, external debt, has been operating to add to pressures against the rupee.

For a few years now Indian corporations had been engaged in a version of the carry trade, borrowing money in foreign exchange from the international markets where interest rates were lower and making investments in India (besides financing investments abroad). Net external borrowing by India rose to $41.9 billion in 2007-08. The stock of India’s liabilities in the form of debt securities, trade credits and loans has risen sharply from $105.1 billion at the end of June 2006 to $175.6 billion at the end of September 2008. This huge expansion means that the demand for foreign exchange to meet interest and amortisation payment commitments will be large in the coming months, when the exodus of foreign capital may continue and even intensify. This could sharply reduce the Reserve Bank of India’s reserves as well as tighten the foreign exchange market.

It could be this expectation which leads those with payments commitments due to buy up foreign exchange and causes speculators to delay the repatriation of foreign exchange earnings back to the country or transfer foreign exchange out of the country.

Indeed, there is growing evidence of the last of these tendencies, in the form of outward remittances under the liberalised remittance scheme for resident individuals. These remittances totalled $9.6 million, $25 million and $72.8 million in the three years ending 2006-07. But they shot up to $440.5 million in 2007-08.

If this is true it does not bode well for the balance of payments and the rupee. In the face of speculation even a reserve in excess of $200 billion is no insurance against a crisis.