Rising external debt a concern

The Reserve Bank of India (RBI) has raised a red flag over the sharp increase in the country’s external debt and emphasised the need for increase in equity flows to finance the current account deficit (CAD).

With external debt likely to increase further, RBI has asked the government to initiate policy action to improve the flow of foreign direct investment. India’s external debt at the end of March was $345.8 billion, an increase of 4.4 per cent over December 2011.

“External debt is likely to rise as increased debt flows bridge the financing gap. As a result, external vulnerability indicators may deteriorate and would make economy susceptible to external shocks, unless the trade balance is compressed and FDI flows improve,” RBI said. “Concerns about the domestic business environment appear to be weighing on FDI inflows as well.”

The government and the central bank recently took steps to invite capital flows into the country after equity inflows dwindled. Foreign institutional investment caps in debt securities (both government and corporate debt) were increased, all-in-cost ceilings for external commercial borrowing and trade credit were enhanced and interest rates on rupee-denominated non-resident Indian deposits were deregulated.

As a result of the greater recourse to such debt-creating flows in financing the CAD, the country’s external debt increased significantly during the fourth quarter of 2011-12.

In addition, according to the central bank’s estimate, the repayment of commercial borrowing of about $15 bn (including foreign currency convertible bonds of about $4.7 bn) is due during 2012-13.

The country’s CAD, as a percentage of GDP, was as high as 4.5 per cent in Q4 of 2011-12, taking the full-year ratio to an all-time high of 4.2 per cent. “Such a high level of CAD, especially against the backdrop of volatile global macro economic conditions and volatile capital flows, raise grave concerns about its sustainability,” RBI said.

Quoting a recent analysis, RBI noted for GDP growth of seven per cent, a 2.5 per cent of CAD was sustainable. “With an increase in deficit beyond this level, financing could be a constraint and the external sector vulnerability may rise further,” it said.

Going forward, the trend in CAD would largely depend on the global macro economic and trade environment. This, in turn, will depend on global liquidity conditions, as well as the domestic investment and policy environment.