Not as well buffered

Sharply rising external debt needs to be seriously tackled

The sharp rise in the absolute value of India’s external debt in recent months merits serious attention. While the absolute volume of external debt rose by an average of $1.8 billion a year between 1990-91 and 2002-03, it has risen by over $25 billion on average over the next eight years. For the last two years, the increases have been $36.5 billion and $45 billion respectively. Even if one normalises for the increasing engagement of India with the global economy, the recent acceleration in the accretion of external debt is a cause for concern. The reasons for the recent surge in external debt can be broadly classified as capital flows into India by foreign institutions seeking to leverage the interest rate differential between India and their respective countries, and External Commercial Borrowings (ECB) by Indian corporates for much the same reason. India’s persistent inflation, which has pushed the RBI to continuously hike interest rates, has proved to be a blessing for these very same entities, by providing easy profits through the “carry trade” route.

The chimera of “adequate” foreign exchange reserves currently standing at around $315 billion needs to be carefully examined. The reserve adequacy ratio, defined as the ratio of foreign exchange reserves to external debt, declined from 138 to 100 between 2007-08 and 2010-11. In other words, while India had a buffer of 38 per cent in 2008 to tide over a sudden external sector shock, it has barely enough today. This vulnerability further increases when one considers the composition of external debt. While the proportion of short-term debt to total debt is still relatively low at 21.6 per cent today, its share has increased nine-fold over just nine years. When combined with increasing liabilities from portfolio investments, India’s vaunted buffer against external shocks is a lot less solid. Unlike China, whose foreign exchange reserves have grown mainly through a trade surplus and hence are in no danger of flying the coop, India’s foreign exchange reserves are predicated upon capital inflows, which can reverse direction without warning. Indeed, in India’s case a trade deficit actually contributes to a decline in foreign exchange reserves.

If India’s current account deficit is not higher than it currently is, remittances by non-resident Indians, officially estimated to be about $55 billion in 2010, take the credit. These inflows cannot be taken for granted given the global situation and the uncertainty in the Arab world. A combination of a persistently high current deficit and external debt to GDP ratio does not augur well, especially if it raises doubts in the minds of lenders about a country’s ability to service those debts. This was precisely what hit India in 1990-91, when lack of lender confidence in the economy forced India to go in for (high-risk) short-term debt. This is a situation that India would want to avoid at all costs. Given that India will not have a trade surplus anytime soon, greater vigilance on the external front, with a strategy to deal with external shocks, is called for.