After several years of comfort, India’s external account is under pressure. Latest RBI numbers of balance of payments contain several hints of greater deterioration and increasing vulnerability. They show that merchandise imports vastly exceed exports, exports of services and inward remittances are not enough to bridge the gap; portfolio investments are dominating capital inflows and short-term debt is rising, while foreign direct investment is falling. In short, the country is living beyond its means and is increasingly relying on short-term debt and highly unstable investment flows to foot the bill. To complete the picture, for the first time in seven years India’s forex reserves have fallen below its external debt.

The balance of payments is the sum of the current and capital account transactions in a given period. The current account records transactions related to sale and purchase of goods and services or income from services, while capital account records inflows and outflows of debt and investment.

 
Preliminary data released by the Reserve Bank of India (RBI) show that India’s current account deficit (net balance of cross-border transactions of goods and services) rose by a whopping 72 per cent to $15.9 billion during July-September 2010, compared to $9.2 billion in July-September 2009. This was because imports rose more than exports and net income from services was lower during the period.

Although exports at $54.30 billion grew faster (25 per cent) than imports at $89.60 billion (22.8 per cent), the trade deficit in absolute terms went up to $35.4 billion from $29.60 billion in the same quarter in 2009. 

The surplus on the invisibles account (items like software, income from travel & tourism and remittances by the Indian diaspora) was lower at $19.6 billion compared to $20.4 billion in the same period last year. Remittances also dropped to $13 billion from $13.8 billion, but net software earnings for the quarter rose to $12.3 billion from $10.8 billion.

There was a surplus on the capital account, implying that inflows of debt and investment were more than the outgo. However, the composition of these inflows is a serious cause of concern.

The capital account showed a surplus of $19 billion in the quarter ended September 2010, marginally higher than $18.6 billion in the same quarter of 2009. However, much of it came from an increase in portfolio investments, external commercial borrowings (ECBs) and short-term credit.

Foreign Institutional Investors (FIIs) continued to buy shares in Indian bourses on the back of attractive returns during the quarter and therefore, inflows under portfolio investment doubled to $19.2 billion as compared to $9.7 billion in the same period last year. Meanwhile, Indian companies facing liquidity crunch and high interest rates home have been heavily borrowing abroad where liquidity is ample and interest rates are low. As a result, net ECBs went up to $3.7 billion in the quarter, against $1.2 billion in the same period last year. With an increase in imports, short-term trade credit to India recorded net inflows of $2.6 billion as compared $1.2 billion a year ago.

On the other hand, FDI continued to be a concern with inflows declining to $2.5 billion from $7.5 billion a year ago, owing to lower investment in construction, real estate, business and financial services.

India’s external debt profile also has worsened. The overall quantum of the external debt stood at $295.8 billion at the end of September 2010, up from $262.3 billion at the end of March. Short term debt at $66 billion now comprises 22.3 per cent of the total, compared with 20 per cent at the end of March. The other important debt sustainability ratio, the ratio of concessional debt to total debt, also deteriorated. It fell to 15.6 per cent from 16.7 per cent over the review period. And after a gap of seven years, India’s foreign exchange reserves have slipped below its total external debt. The country’s forex reserves worked out to be 99 per cent of its debt at the end of September 2010, down from 138 per cent in March 2009.

Now, a current account deficit is in itself not a bad thing. Several countries have run up current account deficits, especially during their phases of industrial take off, to finance high technology imports. Such imports strengthened their industries and led to higher volumes of manufactured exports, which eventually reduced the trade deficit.

What is worrying in India’s case is that the current account deficit is largely a result of faulty exchange rate policy and it is funded in a manner which makes the country vulnerable to unforeseeable factors beyond its control.

The overall composition of capital inflows thus is a cause for concern. The preponderance of FII inflows shows that India’s current account deficit is being financed by short-term capital or inflows which are notoriously foot loose and could exit at the first sign of trouble or better opportunity elsewhere, leaving India dangerously vulnerable. A healthy capital inflow mix would include a greater share of FDI, which is not only more stable, but also brings benefits such as technology transfer, access to export markets and best management practices which can have economy-wide benefits. But FDI, as these figures show, is languishing.

Meanwhile, the surge in imports suggests that Indian manufacturing sector is losing competitiveness. Our shops are stuffed with imported articles, electrical accessories, furniture, furnishings and toys. Even services like tourism and tailoring are becoming uncompetitive. Economic Times reported on December 22 that Indians find it cheaper to holiday abroad now. It is now much cheaper to buy a made-to-measure suit in Bangkok than in Mumbai. The Philippines is becoming an increasingly strong competitor in the BPO segment, and China in IT.

The country may end the fiscal year with a trade deficit of 7-8 per cent of GDP and current account deficit of 4 per cent of the GDP. Yet, the Reserve Bank keeps assuring us that the rupee is not overvalued. Using a 36-currency Real Effective Exchange Rate (REER) index, it said on November 2 that the rupee had appreciated 0.4 per cent in 2010-11 up to October 22, glossing over what happened in the previous fiscal year.

The present scenario is unlikely to change significantly in the foreseeable future. Quantitative easing in the United States will lead to a surge of liquidity, which will find its way to star performing economies like India to leverage the interest rate differential. India’s ECB is headed north for the same reason. With Indian firms aggressively scouting for natural resources, commodities and technology abroad, outward FDI from India is also expected to increase sharply.

India needs policies oriented to improving the global competitiveness of Indian exports and creating the enabling conditions to attract and retain FDI. There is no dearth of experts and analysts who assure us that ‘as of now the situation is within our comfort zone.’ But, as the West discovered to its cost, in financial markets the music does not play on forever. It has a nasty habit of stopping suddenly.

The author is Executive Editor, Corporate India, and lives in Mumbai