The
rupee's recent fall, which has taken the currency's
value to more than Rs. 50 to the US dollar, is one
of the more visible ways in which the global crisis
has affected India. Underlying that fall are developments
on India's external front that can be directly attributed
to the crisis. One of these is the slowdown in the
country's merchandise export growth. With merchandise
trade data available till December 2008, it emerges
that India's aggregate merchandise exports have declined
in each of the three months starting October 2008.
The decline in December alone (relative to the corresponding
month of the previous year) was 1.1 per cent. As a
result, over the first nine months (April-December)
of this financial year (2008-09) exports at $130.9
billion registered a 16.3 per cent rate of growth
which was significantly lower than the 23.2 per cent
recorded during the corresponding period of a year
ago.
Merchandise imports on the other hand recorded a higher
growth of 30.8 per cent during April to December 2008
as compared with the 27.6 per cent of a year ago,
because India was still affected by the burden of
higher oil prices during that period. Imports of petroleum,
oil and lubricants rose by 43.3 per cent during these
months, as compared with 24.0 per cent in the previous
year. In the event, the trade deficit rose by 58.5
per cent during April-December 2008 to $93.5 billion,
from $59.0 billion during April-December 2007. There
is reason to believe that this trend has only grown
stronger during the current, fourth quarter of the
financial year, giving rise to the view that the rupee's
weakness is partly due to the direct trade effects
of the global recession.
While there is an element of truth in this judgement,
its importance as an explanation of the rupee's performance
should not be exaggerated for two reasons. First,
oil prices have fallen further since December and
would have therefore moderated import growth. Thus,
merchandise import growth decelerated sharply from
24.3 to 8.8 per cent during the month of December
2008 when compared with December 2007, mainly due
to a decline in oil imports. If this trend had continued
the trade deficit across the year as a whole would
have widened by a smaller margin than it did during
the first nine months. Second, the evidence available
for the first six months of 2008-09 suggest that the
effect of the recession on India's services exports
have been operative with a significant lag, allowing
for services incomes to neutralise part of the widening
trade deficit and moderating the increase in the current
account deficit. Thus, net services incomes on the
current account of India's balance of payments, which
rose from $14 billion to $18 billion between April-September
2006 and April-September 2007, registered a further
rise to $22.9 billion during April-September 2008.
Similarly, private transfers (largely remittances)
rose from $12.7 billion to $17.5 billion and $25.7
billion. As a result of these developments, while
the trade deficit during April-September 2008 was
$26 billion higher than a year ago, the current account
deficit had only widened by $11.4 billion.
The lag in the effects of the crisis on net services
incomes may be due to the fact that contracts in certain
areas such as software and BPO services are signed
for long periods such as two to three years. The effect
of the crisis would be on the renewal of contracts
and the signing of new contracts. Since recent years
have been characterised by persistently higher rates
of increase in revenues, even if there is a shortfall
in renewals or new agreements, the impact on aggregate
revenues would initially be proportionately low because
of the weight of legacy contracts in the total. This
could mean that when the data for the year as a whole
becomes available the slowdown may be greater than
suggested by the April-September figures. The lag
is likely to be even greater in the case of remittances
because even if workers are losing jobs and returning
they would return with whatever accumulated savings
they have, and this windfall effect may more than
make up for the fall in the value of ongoing remittances
because of lower overseas employment.
Overall, therefore, while a widening current account
deficit would have a role in explaining the depreciation
of the rupee, the sharp fall in the currency's value
must largely be due to factors reflected in the capital
account. This should not be surprising given the extremely
important role that capital flows have come to play
in India's balance of payments. Though services exports
and remittance incomes have helped India keep its
current account deficit low, the large reserves it
has accumulated are the result of capital inflows
that were far in excess of its current account financing
needs.
This disproportionate dependence on capital flows,
which was substantially in the form of portfolio capital,
is substantially a recent development. Foreign investment
flows rose sharply from $4.9 billion in 1995-96 to
$29.2 billion in 2006-07 and then more than doubled
to $61.8 billion in 2007-08 (Chart 1). This increase
would not have been possible without the relaxation
of sectoral ceilings on foreign shareholding and the
substantial liberalisation of rules governing investments
and repatriation of profits and capital from India.
But liberalisation began rather early in the 1990s,
whereas the expansion of foreign investment flows
occurred much later. Thus, till 2002-03, the maximum
level of net foreign investment inflow reached was
$8.2 billion in 2001-02. This rose to $15.7 billion
in 2003-04, partly encouraged by tax concessions offered
to foreign investors in that year. After that India
was discovered by foreign investors and was more the
target of a capital investment surge rather than an
attractor of such flows.
Chart
1 >> Click
to Enlarge
What
is disconcerting, however, is the 111 per cent surge
in capital flows to India during the financial year
2007-08, from $29.2 billion in 2006-07 to $61.8 billion
in 2007-08. This was very different from the experience
in Asian emerging markets as a group. The Institute
of International Finance estimates that net direct
and portfolio equity investment into Asian emerging
markets (China, India, Indonesia, Malaysia, Philippines,
South Korea and Thailand) fell from $122.6 billion
in 2006 to $112.9 billion in 2007 and an estimated
$57.9 billion in 2008. This implied that private foreign
investors in equity were pulling out of emerging Asia
as a group at a time when investments in India were
rising sharply. India was serving as a hedge when
uncertainties were engulfing markets elsewhere in
Asia and the world. This increased the possibility
that if any development within or outside India warranted
pulling out of that country, the exit can be as strong
as the inflow of foreign capital.
The crisis has indeed resulted in a sharp outflow
of capital, especially capital brought into the stock
market by foreign institutional investors. Needing
cash to meet commitments and cover losses at home,
these FIIs are selling out in Indian markets and repatriating
capital abroad. Thus, over the year ending January
2009, the Reserve Bank of India estimates that the
net outflow of FII capital amounted to $23.7 billion
(Chart 1). This is indeed large when seen in relation
to the estimate made by the RBI that the total stock
of inward investment in equity securities stock stood
at 103.8 billion at the end of December 2007. That
stock had fallen to $80 billion by the end of September
2008 (Chart 2).
Chart
2 >> Click
to Enlarge
However, even here the decline
has been moderated by the persistence of what are
defined as foreign direct investment flows. Net foreign
direct investment which rose from $4.3 billion in
2003-04 to $34.4 billion in 2007-08, remained high
at $27.43 billion during April-January 2008-09. But
for this inflow, the impact of the exodus of portfolio
capital on India's reserves position would have been
far more adverse. India's foreign exchange reserves,
which stood at $292.7 billion at the beginning of
February 2008 fell to $248.6 billion at the end of
January 2009. This is a significant fall, but the
volume of reserves still remains high, amounting to
around 9 months worth of imports. This fall does explain
the weakness of the rupee, but still leaves the recent
sharp decline of the rupee a bit of a puzzle.
Perhaps the resolution to that puzzle lies in the
other component of capital flows into India, debt.
For a few years now Indian corporations had been engaged
in a version of the carry trade, borrowing money in
foreign exchange from the international markets where
interest rates were lower and making investments in
India (besides financing investments abroad). Net
external borrowing by India rose from $24.5 billion
in 2006-07 to $41.9 billion in 2007-08, because of
an increase in net medium and long term borrowing
from $16.1 billion to $22.6 billion and of short term
borrowing from $6.6 billion to $17.2 billion. The
stock of India's liabilities in the form of debt securities,
trade credits and loans has risen from $105.1 billion
at the end of June 2006 to $175.6 billion at the end
of September2008. This huge expansion means that the
demand for foreign exchange to meet interest and amortization
payment commitments would be large in the coming months,
when the exodus of foreign capital may continue and
even intensify. This could sharply reduce the Reserve
Bank's reserves as well as tighten the foreign exchange
market. That expectation may be resulting in a situation
where those with commitments due are buying up foreign
exchange and speculators are holding on to and not
repatriating back to the country foreign exchange
or are transferring foreign exchange out of the country.
One indicator of the last of these tendencies is the
movement of foreign exchange out of the country in
the form of outward remittances under the liberalised
remittance scheme for resident individuals. These
remittances totalled $9.6 million, $25 million and
$72.8 million in the three years ending 2006-07. But
they shot up to $440.5 million in 2007-08 (Chart 3).
This is possibly indicative of the speculative trends
pushing down the value of the rupee.
If this is true it does not bode well for the balance
of payments and the rupee. In the face of speculation
even a reserve in excess of $200 billion is no insurance
against a crisis.
Chart
3 >> Click
to Enlarge
