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Our external sector was said to be resilient. We were cruising along when, quite suddenly, the tide turned. The slide in the value of the rupee, the rising current account deficit, a substantial net capital outflow, persistent rise in crude prices, the pressure of rising protectionism in world trade, the firming up of the US growth rate and appreciation of the US dollar against major currencies has brought us a host of troubles – all interlinked and collectively leading to storm-like conditions that have resulted in India’s external sector becoming more vulnerable and less resilient.
Now the government is seized of the issue. We already have a slew of measures, including non-monetary measures like restrictions on non-essential imports (like finished electronics, certain textiles, automobiles, high-end consumer products), removing of the five per cent withholding tax on Masala bonds, removal of the foreign portfolio investor exposure limits in corporate bonds and a freer ECB regime. The measures taken together are expected to garner USD 8-10 billion.
We already have a slew of measures, including non-monetary measures like restrictions on non-essential imports (like finished electronics, certain textiles, automobiles, high-end consumer products), removing of the five per cent withholding tax on Masala bonds, removal of the foreign portfolio investor exposure limits in corporate bonds and a freer ECB regime. The measures taken together are expected to garner USD 8-10 billion.
How effective will the measures be? Essentially, the measures are of two types: a) a restriction on imports and b) an encouragement of debt inflows. Import restrictions are fine as tools for crisis management but the measures are against the spirit of reform. Further, measures like the relaxation on “masala” bonds and ECBs amount to a quick fix just to postpone the problem. We are inviting more debt, making it easier for the debt to flow in but this carries the potential of a vicious cycle of debt servicing, higher external borrowing and higher external debt.
The external sector has been under stress as is evident from the latest Balance of Payments (BoP) data for the period April- June 2018. The burgeoning Current Account Deficit (CAD) (USD 15.8 billion or 2.4 per cent of GDP) could not be financed in a non–disruptive manner as the net capital inflows were not adequate. The net inflows stood at USD 5.3 billion but we had a substantial net capital outflow in case of portfolio investments to the tune of USD (-) 8.1 billion. This resulted in a depletion of USD 11.3 billion of the foreign exchange reserves (on a BoP basis) as against an accretion of USD 11.4 billion in Q1 of 2017-18. The reversal is therefore dramatic.
In aggregate, the outflows from the outstanding forex reserves over end-March 2018 till date (07 September 2018) was USD 25.26 billion, which included a net sale of USD 6.18 billion and USD 1.87 billion by the RBI in June and July 2018, respectively for which data are available. These sales clearly could not contain the volatility in the fall of rupee, given the force and quantum of the dollar exodus. The depreciation of the rupee during the financial year so far is around 9 per cent when the rupee moved in the range of 64.92 and 72.75 against one US dollar.
The three important contributing factors for the weak rupee are: a higher oil import bill, an increase of 53.55 per cent during April – August 2018, resulting in a higher trade deficit and higher CAD; substantial outflow in the foreign portfolio segment and strengthening of the US economy in terms of higher economic growth and increase in the Federal fund rate, making investments in the US more attractive vis-a vis India.
Another important aspect is the movement in India’s external vulnerability indicators, which include the ratio of forex reserves to total debt, short term debt (residual maturity) to forex reserves, forex reserves cover to imports and the net international investment position. To the extent the forex reserves had declined around USD 25 billion over end-March 2018, assuming that other items such as external debt, import bills, and short term debt remained at end–March 2018 levels, there could be substantial deterioration in the external sector vulnerability indicators.
The three important contributing factors for the weak rupee are: a higher oil import bill, an increase of 53.55 per cent during April – August 2018, resulting in a higher trade deficit and higher CAD; substantial outflow in the foreign portfolio segment and strengthening of the US economy in terms of higher economic growth and increase in the Federal fund rate, making investments in the US more attractive vis-a vis India.
While the external sector outlook could be guided by the global crude oil prices and hike in interest rates in advanced economies, particularly the US, coupled with the impact of trade wars resulting from increasing protectionism, it is imperative for the Indian economy to look beyond. This means strengthening the non-oil exports. In this context, it is important to note that over the years, India’s exports relative to GDP has been persistently declining. Secondly, income elasticity of demand for India’s export has remained stagnant and therefore, the share of India’s export remained constant at 1.7 per cent in the world export. In addition, as reported by RBI in its Annual Report 2017-18, there has been “protracted stagnation in competitiveness.”
Another important factor is the movement in the Real Effective Exchange Rate (REER). At a conceptual level, increase in the REER index reflects diminishing competitiveness. Going by the trends in the movement of REER, which is showing persistently a rise in the Index, it is recognised that the rupee has been overvalued and is “associated with diminishing external competitiveness”. However, the RBI Annual Report 2017-18 has observed, the rise in REER in India is lower than many economies, which include China, Philippines, UAE, Singapore, Thailand and Saudi Arabia. However, these economies are not seeing such a crash in their currency value as India because they do not suffer from a high CAD.
In this context, it is important to note that over the years, India’s exports relative to GDP has been persistently declining. Secondly, income elasticity of demand for India’s export has remained stagnant and therefore, the share of India’s export remained constant at 1.7 per cent in the world export. In addition, as reported by RBI in its Annual Report 2017-18, there has been “protracted stagnation in competitiveness.”
To sum up, the recent measures announced by the authorities may provide some short term relief but the sustainable solution to the problem is encouraging green field FDI and non-oil exports such as iron and steel, non-ferrous metal, and automobiles. Efforts should also be made to further strengthen marine exports and chemicals. What is important in this regard is to enhance quality control measures. The trend of the direction of exports is required to be shifted towards the Middle East and North Africa, apart from USA, China and the EU. This is the long haul, and this requires clear policies and prioritisation at our end. Unfortunately, the issue is handled only when we see a fall and a crisis is presented. Good work is to be done even when the rupee holds strong, which it was a few years ago. That is the lost opportunity.