Relevance: GS-3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development, and Employment.

Key Phrases: external sector crisis, Current Account Deficit (CAD), the Balance of Payment (BoP), foreign currency assets, forex reserve, Rupee depreciation, volatility of the exchange rate, External debt, the International Investment Position (IIP).

Why in News?

• India’s external sector is poised to take a ‘U-turn — from an optimistic and sustainable Current Account Deficit (CAD) financed by normal capital flows to what may well be unsustainable levels of CAD and inadequate capital flows, resulting in a deficit in the overall balance of payment (BoP) position.
• The pressure on the rupee and the depletion of foreign exchange reserves will add fuel to the fire.

The reasons for such developments include:

• the protracted war in Europe,
• net capital outflows, particularly foreign portfolio investment in the event of higher interest rates in the US and the strengthening of the US dollar
• an unprecedented increase in crude oil prices.

Trade and BoP data:

• Trade data for April-June 2022 showed a trade deficit of $70.25 billion with a 22.22 percent increase in exports and a 47.31 percent rise in imports. Crude oil imports accounting for 32.12 percent zoomed to 94.34 percent.
• The BoP data for 2021-22 recorded CAD at $38.9 billion (or 1.2 percent of GDP) and with the net capital inflows of $86.3 billion, there was an accretion of $7.5 billion to forex reserves.
• The CAD for 2022-23 is estimated at 3.2 percent of GDP. In nominal terms, this will be around $110 billion. This estimate assumes net capital flows of $80 billion, a shade lower than that of $86.3 billion in 2021-22 because of higher net outflows in FPI and lower FDI inflows due to uncertainty in the global markets.
• This indicates an overall BoP deficit of around $30 billion, which is a record in recent years.
• The last such high level of deficit in overall positions of BoP was recorded in 2008-09, but that too was lower at $20 billion in the aftermath of the global financial crisis. This tells us the severity of the crisis we are heading into.

The Implications:

• Unsustainable CAD:
  • CAD at 3.2 percent of GDP is not sustainable. According to the Report on Currency and Finance published by RBI, growth begins to decelerate with a CAD-GDP ratio beyond 2.3 percent.
• Decline in foreign currency assets:
  • The deficit in the overall BoP position of $30 billion translates to the sale of US dollars by the RBI to the tune of $30 billion.
  • The forex reserve position as per RBI data stood at $593.3 billion as of June 24, of which $529.2 billion accounted for foreign currency assets.
  • Over March 2022, these assets have declined by $11.5 billion and on Y-o-Y the decline of assets was of the order of around $37 billion.
  • Assuming a further decline of $30 billion of reserves as explained above at the end of March 2023, the foreign currency assets position will be around $500 billion.
• Rupee depreciation:
  • The estimated decline in reserves is pertinent from the angle of RBI intervention in the forex market to arrest the rupee’s decline.
  • The rupee has depreciated by 3.93 percent (March-end over June-end).
  • The exchange rate is determined by demand and supply and with a deficit in the overall BoP position, the pressure on the rupee increases.

Volatility vs Depreciation:

• According to the RBI Currency and Finance report of April 2022:
  • It observed that it is the volatility of the exchange rate that impacts exports more than the level of the exchange rate.
  • A 10 percent increase in the average exchange rate volatility decreases export earnings by 1.6 percent.
  • A 10 percent increase in volatility decreases profits by 3 percent,
  • A 10 percent depreciation of the INR against the US dollar, decreases profits by 21 percent.
    • This may be explained by the fact that exchange rate movements may affect the cost of borrowings for firms holding foreign debt.
    • The depreciation of exchange rates increases the interest payments on foreign loans although volatility has no significant effect.
    • Thus, the level and volatility of rupee depreciation are important for exporting firms.
• External debt and the international investment position (IIP):
  • India’s external debt revealed that the short-term debt on residual maturity (debt obligations that include long-term debt by original maturity falling due over the next 12 months and short-term debt by original maturity) constituted 43.1 percent of total external debt and 44.1 percent of foreign exchange reserves.
  • This ratio will further increase given the depletion of forex reserves by $30 billion.
  • The IIP position showed that foreign debt liabilities accounted for 49.2 percent.

Conclusion:

• RBI’s action to attract:
  1. NRI deposits (exemption from CRR and SLR and relaxation of ceiling on interest rates),
  2. ECBs (an increase of limit to $1.5 billion from $750 million), and
  3. FPI investment in debt (relaxation of the limit of 30 percent)  are short-term fixes that will only postpone the problem.
• These will result in fuelling external debt and bringing pressure on repayment and eventually on currency movement.
• There is a need for policy to enhance export competitiveness and ease processes to encourage FDI inflows.

Source: The Hindu BL

Mains Question:

Q. What are the challenges faced by India’s external sector stability? What measures the government should take protect India from external sector vulnerabilities?