Funding of CAD via volatile flows risky for economy

Written by feBureau | Mumbai | Updated: Mar 30 2013, 06:17am hrs
Despite a record high current account deficit of $32.63 billion or 6.7% of the GDP, India ran a modest balance of payments surplus in the December quarter. Reason for solace Hardly so. A reading of RBI data over the last few quarters indicates how fragile Indias BoP is to an external shock. Its reliance on volatile inbound investments like portfolio flows and ECBs for financing the CAD has become more apparent, while the infinitely more solid FDI inflows have faltered. In Q3, FDI accounted for just over 8% of the total capital flows that nearly equalled the CAD. Worse, the volatile inflows have truly and increasingly proved to be so, lending credence to the fear that in any quarter, the CAD could be left heavily under-financed. For instance, the FII inflows into debt and equity accounted for 27.7% of total inflows in Q3 against a net outflow of 13% of the capital flows in the first quarter of 2012-13 and a robust inflow of 62% of total inflows in the previous quarter.

Similar wild fluctuations were witnessed in case of external commercial borrowings inflows as well (see graph).

Obviously, the finance ministers claim on Thursday that it is a matter of satisfaction that it (CAD) has been financed without drawing upon the foreign exchange reserve appear to be flimsy. Going forward, we hope to be able to finance the CAD through sufficient foreign inflows, the ministry had said, adding that the deficit would moderate in the coming months with improvement in exports. "CAD for fourth quarter is expected to be smaller. Government is committed to bringing down the CAD over the time, as well as ensuring that it financed safely," the ministry said.

In the December quarter, the country financed its CAD of 6.7% of the GDP through portfolio flows of $8.6 billion and ECBs worth $7 billion. Together, these volatile components formed nearly 50% of the CAD. Another component trade credit, not much less volatile in nature was $6.2 billion. In the September quarter too, these portfolio and ECB flows constituted nearly 50% of the financing of the CAD. However in April-June, they accounted for just 6% while NRI deposits accounted for over 30%.

Of course, in recent history, the country has relied on volatile flows to get dollars for financing the CAD. However, as the CAD becomes far wider, this reliance exposes the economys vulnerability to external shocks.

Indeed, the share of volatile flows have been high in financing the CAD. The governments measures to make the domestic debt market more and more accessible to foreign investors has only increased the dependence on such hot money. The FII investment limit in debt has been hiked several times in the last two years and is currently $75 billion.

"The dwindling FDI inflows, higher FII outflows remain a key external risk increasing Indias vulnerability to global macroeconomic developments and global liquidity flows, said YES Bank in a note.