India?s worsening external situation likely to fetter RBI monetary policy easing

Sir Humphrey, in one of the Yes Minister episodes, explains the word ?egregious? to his minister as ?outstanding, in one sense or another?. Egregious is probably as good a description of India?s October-December 2011 balance of payments (BoP) and related external metrics, with magnitudes worse than ever before. And actually worse than the weak numbers we had expected after the rapid and sharp weakening of the rupee during the months for which the BoP numbers have now been released.

India?s current account deficit (CAD) worsened to record lows in Q3FY12 (4.3% of Q3GDP), and has been comparatively high during the whole April-December period compared to earlier years. Even during the worst quarters after the financial crisis of 2008, the CAD/GDP ratio had slipped to 4.1%. At this rate, the CAD/GDP ratio may have breached 4% of GDP in FY12 (as a point of reference, the deficit was only 3% of GDP even during the BoP crisis in 1991). Capital account flows, at $8 billion, were also weak, led by weak portfolio investment flows (at $1.9 billion versus $19.1 billion in same period last year) and negative banking capital. As a result, this was the first quarter since the Lehman collapse that overall BoP turned negative.

The only strongly positive aspect in this saga is the contribution of gold imports to the deficit. India imported $55 billion gold over April-February FY12, $46 billion of which was during the first 9 months. Excluding net imports of gold and gems & jewellery, the CAD/GDP ratio is much lower at 2.6% of GDP. There is the sense that gold is actually an asset, and should not be considered a current account item. There are some other positives, not quite as reassuring. Private remittance flows remain strong, with $17.5 billion net inflows during Q3 (cumulatively $48 billion in the first 3 quarters). And, although from the capital accounts side, so have NRI deposits. And, of course, an honourable mention must be made about the strong export performance.

In line with the balance of payments, India?s external debt outstanding too worsened to $335 billion, increasing in proportion to FX reserves (at 113% in Q3 versus 105% in Q2). Short-term debt (in terms of original maturity) is $78 billion, up from $72 billion in Q2, just short of 23% of total external debt. There is no update on residual debt, a more representative indicator of India?s external payments pressures, and prima facie this is also likely to have worsened.

Why should all this be so important now? In itself, the deterioration in India?s external accounts is worrying, indicating excess demand in the economy. Combined with persisting concerns about the global financial system, and likely tepid capital flows into India, this increases India?s external payment vulnerabilities.

But the bigger issue is that this perception is likely to keep the rupee weak, creating problems for managing other domestic economic and financial variables. Foremost will be inflation: imported inflation had increased during the last quarter of 2011, preventing inflation from coming down as much as had been earlier expected. Combined with rising prices of crude and some selected industrial commodities, this will serve to increase the trajectory of inflation in 2012. In addition, the redemption magnitudes of external debt payments (interest and principal) increase, increasing pressures on corporate balance sheets, which are already stressed in the slowing growth and high interest rate environment. A worsening rupee lowers total returns of foreign investors, by giving them anticipated negative returns on their investments, adding another disincentive in an investment climate already fraught with uncertainty.

The effect on the conduct of monetary policy is probably the most debilitating aspect of a worsening external environment. The vulnerability on the external account, and fears of other weakening episodes of the rupee, will further constrain RBI in its options for monetary policy easing. Apart from the flare-up of inflationary pressures noted above, a sharp slide in the rupee and the attendant increase in volatility which it engenders, will force RBI to intervene, with adverse consequences for domestic liquidity, at least partially negating the transmission effects of lower policy rates onto cost of funds. The need to maintain forex reserves at certain threshold levels will further constrain outright intervention.

What might be the only positive aspect of the weakening rupee is that, via enabling greater export competitiveness and consequently more exports, this is an effective growth multiplier and, therefore, an equivalent of easing monetary policy. Recent (and past) trends in exports provide little, if any, evidence of this, and this is not entirely counter-intuitive. India?s comparative rupee fall was much less than the absolute fall, if movements of the local currencies of our key export competitors are considered. India?s exports are also driven by global trade conditions as well as other internal logistics bottlenecks.

There is now a fear that the ?vicious cycle of reflexivity? that this chain of actions-consequences sets up might keep India in a low level trap for extended periods. How do we break out? Although this columnist might sound like a broken record, he does think that an aggressive rate cut might serve to weaken a couple of links in the cycle and allow for calibrated measures to increase investment, which might consequently increase foreign currency inflows and initiate conditions for improving India?s external liabilities metrics.

The author is senior vice-president, business & economic research, Axis Bank. These are his personal views