Leveraging for stability

India's forex reserves are so heavily dependant on external borrowing that any rating downgrade would demand higher interest rates

From barely $3.5 billion worth of foreign exchange reserves when it courted crisis during 1990-91 to $292 billion worth of reserves now, India has indeed come a long way, and is no longer vulnerable to the 1997-style Asian crisis.

While India has been able to build up a prudential level of reserves, a slowing economy and a profligate government are conspiring to push it to an uncomfortable position. To begin with, the latest official estimate puts the country's fiscal deficit at around 5.2 per cent of the gross domestic product (GDP) for FY13. While it is likely to be exceeded - barring some miracle - it will be a touch lower than 5.7 per cent recorded during the previous year. High fiscal deficit leads to a burgeoning trade deficit, which forces the current account deficit (CAD) to move up. High deficit, through channels of excessive government spending and lower household savings (on account of high inflation), widens the savings investment gap in the economy, which then pushes up the trade deficit as demand for import stays elevated.

For the past two financial years, India has been facing a huge twin deficit (fiscal deficit plus CAD) problem. During 2011-12, fiscal deficit and CAD were 5.7 per cent and 4.2 per cent of GDP, respectively. For FY13, both are likely (a conservative estimate) to come in at around 5.2 per cent of GDP. Not surprisingly, the rupee has depreciated. During 2012-13, it depreciated approximately 7.5 per cent against the dollar. One would have thought that the negative effect of these developments would be reflected in its forex reserves position. However, reserves stayed remarkably stable. In fact, foreign currency reserves were down by a mere 0.1 per cent, while overall forex reserves were down only 0.6 per cent.

What, therefore, explains this dichotomous situation?

For one, India has so far been able to finance its CAD through capital inflows in the form of both direct investment and portfolio flows, in fact more of the latter (which is unstable and given to bouts of sudden withdrawal as is currently being experienced) than the former (which is much more stable).

 

While such non-debt creating flows have helped, these still do not explain the stability of India's foreign currency reserve, despite rupee depreciation, which should have resulted in lower level of reserves owing to revaluation of foreign-currency-denominated assets. Rather, treasury international capital data shows that India's holding of US treasury securities by February 2013 increased 29.5 per cent from February 2012, while total foreign holding of these securities increased only 10.8 per cent during the same period.

It seems that unlike China, which was able to build up on its forex reserves through persistent current account surplus, India has to resort to borrowing to achieve the same result in the face of CAD.

As can be seen from the chart, save for India's high growth period, which experienced large non-debt creating inflow, forex reserves have been boosted by external borrowings. Given the prevailing high interest rate, India is able to attract deposits from non-resident Indians (NRIs), running to a few billion dollars. In fact, for April to December 2012, net NRI deposit was in excess of $12 billion. High domestic rates have also forced Indian corporate entities to opt for relatively cheap external commercial borrowings, though the depreciation of the rupee would have nixed any advantage they might have thus derived.

By December 2012, the total external debt stock was $376.3 billion, an increase of $30.8 billion (or 8.9 per cent) over the level of $345.5 billion during March 2012. Within this, long-term debt increased $17.1 billion (or 6.4 per cent) to $284.4 billion, while short-term debt increased $13.7 billion (or 17.5 per cent) to $91.9 billion. In fact, by December 2012, the total external debt was close to 160 per cent of the total foreign currency reserves - the highest since September 2002.

During 2002, India's sovereign rating was BB, which is considered as speculative grade (or "junk" if you will). At this point in time, India's sovereign rating is BBB- or the lowest investment grade and comes with a negative outlook. If India's rating were to be downgraded further to speculative grade, it would need to offer much higher interest rate to entice foreign borrowers to be able achieve the objective of a stable forex reserve, when neither the domestic not the external outlook is encouraging.

A case of medicine being worse than the cure?

The author is a New Delhi-based independent economist
http://kunalsthoughts.weebly.com