Why recourse to external debt for current account financing will not be enduring.
India’s growth story is back centre-stage. The near-consensus is it will once again be the fastest-growing major economy in 2018-19, shaking off the temporary setbacks from demonetisation and introduction of GST. And yet, a subtle concern about the widening current account deficit grips some analysts, editorials and opinion-makers who not so long ago were peddling India’s impeccable macro-stability record under the current government to the global investor community. Suddenly, India’s external balance sheet doesn’t look so good as rising international oil prices and US bond yields threaten to mar macroeconomic stability, hurt growth recovery.
The government and RBI appear to have been pushed into a kind of panic-mode last fortnight, rushing to relax a few prudent restrictions on debt fund inflows, as though foreign portfolio investors (FPIs) were fleeing the country in droves. Whereas all that has happened so far is net selling of a mere $3 billion by FPIs in an economy that has accumulated nearly $150 billion in forex reserves since the taper tantrum event in August-September 2013. One wonders what else would policymakers do if outflows were to persist ahead!
The moot point though is why is RBI panicking? If there is a fundamental gap in demand-supply of foreign currency, the rupee must adjust. All that the central bank is expected to do is ensure its orderly depreciation, without undue volatility, which is what RBI seemed to be doing by its strategic, intervening sales of foreign currency. Following this with offsetting OMOs to support rupee liquidity as per its assessments is par for the course.
So, then, why tinker with the capital account, exposing the economy to greater volatilities if things were to worsen in international markets?
The macroeconomic context is even more disconcerting: inflation is still within the set 2-6% corridor, icing on the cake being persistently low food inflation; RBI’s commitment to inflation targeting has gained significant market credibility; the government’s pledge to medium-term fiscal consolidation is fairly intact; while a war-chest of $420 billion reserves’ appears more than adequate. Then how does the stability plank suddenly look so vulnerable when the economy is still in an early phase of recovery?
The recourse to capital account tinkering may work, but only temporarily. If we are doubly lucky, oil prices may retreat to $60 or $50 a barrel, relieve these pressures. But, if oil prices carry on climbing and the exports slowdown persists, things will soon be back to square one, a movie we have seen several times over: current account deficit overshooting the most conservative estimates in a very short span of time (most projections for 2018-19 range in 2-2.5% of GDP, considered sustainable in the current macro-framework) as in 2012-13 and forcing policymakers to scamper towards the second line of defence—raise interest rates, ask banks to offer attractive rates to borrow NRI deposits, and, possibly, float sovereign bonds to borrow more dollars and thwart any possibility of a run upon the currency!
Market concerns appear to be more fundamental, rooted in expansion of the current account deficit. Exports are growing at a far slower pace relative to imports, chiefly due to hardening oil prices. Slowing FDI is proving less than adequate to finance the enlarging current account gap, thus raising the stake on ensuring steady inflows of portfolio and other debt capital such as external commercial borrowings (ECBs). The first line of defence, therefore, appears to be freeing up existing restraints on debt capital inflows.
How have we managed to dig ourselves into such a precarious situation, forcing us to throw all precautions to the winds? We seem to have oversold ourselves to beliefs that oil prices had secularly moved into lower zones, that the current government could defy gravity and attract copious amounts of FDI to comfortably meet the current account gap. Such convictions seemingly resulted in the slackening, which allowed an overvalued currency being sustained far too long. This may have substantively contributed to support RBI’s inflation objectives or temporarily nurtured a political narrative that takes pride in an appreciating currency, but its impact on undermining export competitiveness is now distinctly visible.
This sadly recalls macroeconomic developments from May 2009 through to July 2011: the rupee was allowed to appreciate under false beliefs of productivity gains even as inflation ran high and the fiscal deficit was ballooning—a recipe for macroeconomic disaster that eventually led to September 2013. Readers must not forget it was barely a year and half ago that we managed to repay the high cost NRI deposits raised in October 2013.
Today, whether one looks at the rupee’s external value in terms of the real effective exchange rate or its internal value in terms of tradable vis-à-vis non-tradable prices, the currency seems fairly overvalued over a longer period. The only difference is the fall in global trade volumes in past few years obfuscated the underlying weakness; with the trend reversing recently, the frailty has come to the fore. While exports already suffered from an overvalued currency, they were equally denied full terms-of-trade benefits accruing from the decline in oil-metal prices as the government chose to raise fuel taxes and imposed protective tariffs on metals. The government’s socialistic penchant for pushing up minimum wages, preceding disruption of supply chains during demonetisation and an unexplained delay in settling IGST claims have further eroded export competitiveness.
If exports of goods and services, robust remittances and FDI inflows cannot pay for the country’s imports, then the exchange rate must adjust. Repeated recourse to high-cost borrowings for stabilising the external imbalance within such a short time gap is quite similar to the severely-criticised evergreening of bad loans of banks. Although the comparison may seem odd, the underlying intents are starkly alike: Recent experiences bear out that Indian banks continued refinancing troubled assets, praying corporates would somehow turn around their balance sheets. Likewise, this easy recourse to more and more external debt funding by our policymakers to prop the country’s external balance sheet reflects a fond hope that their policy actions (or even inactions) will somehow raise external competitiveness!
It should be apparent to them by now that as long as the current account components remain structurally weak, its ‘evergreening’ will only give temporary reprieve. As RBI painfully discovered, most evergreened assets of banks did not recover, whereas timely actions could have saved much of their capital value. RBI has now decided to swing to the other extreme—asking banks to recognise default, even for one day. One wishes the central bank would read the same riot act to itself when it comes to the nation’s external balance sheet: let the rupee find its true value in an orderly manner, without much recourse to external debt!