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Banking
on Debt* |
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| Jul
10th 2012, C.P. Chandrasekhar and Jayati Ghosh |
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Besides
inflation, which has been an issue of concern for
sometime now, the main problem in macroeconomic management
confronting the government is the depreciation of
the rupee. The currency has lost a fifth or more of
its value vis-à-vis the dollar over the last
year, and the bets are that it would move further
downwards.
Needless to say, underlying that tendency must be
changes in the balance of payments that increase the
demand for foreign exchange relative to supply in
India's liberalised foreign exchange markets. Signalling
that change is a decline in India's still comfortable
foreign exchange reserves, with Reserve Assets recorded
in the country's international investment position
having declined from $315.7 billion at the end of
June last year to $294.4 billion at the end of March
this year (Chart 1).
Chart
1 >>
(Click to Enlarge)
Chart
2 helps understand the factors explaining this decline
in reserves. The principal factor is the sharp increase
in the current account deficit from a negative $45.9
billion to as much as $78.2 billion. This $22 billion-plus
increase in the current account deficit has been only
partly matched by the smaller $16 billion plus increase
in inflows on the capital account. In addition, while
in 2010-11 the dollar was depreciating vis-à-vis
many other international currencies, the reverse was
true in 2011-12. Hence valuation changes resulted in
a much larger $12.4 billion ''accretion'' to reserves
in 2010-11 as compared with $2.4 billion in 2011-12.
The net result is that reserves increased by $25.8 billion
in 2010-11, while they declined by $10.4 billion in
2011-12.
Chart
2 >>
(Click to Enlarge)
In sum, three factors underlie India's dwindling India's
reserves. First, a sharp rise in the current account
deficit. Second, the inability of capital inflows to
fully finance this deficit, despite a significant rise
in the volume of those flows. And, third, valuation
changes that contributed to a smaller ‘increase' in
reserves during the last financial year, as compared
with the year before. India's government and central
bank can do little about the last of these, so the problem
of declining reserves is the result principally of the
widening of the current account deficit which was far
too large to be covered by an increase in the inflow
of capital.
What is noteworthy is that one factor seems largely
responsible for the widening of the current account
deficit. As Chart 3 indicates, the only element contributing
to the increase in the deficit is an increase in the
import bill from $381 billion to almost $500 million.
Exports in 2011-12 actually increased, and so did net
income from services and net transfers. Thus, a rise
in the import bill seems to be solely responsible for
the deterioration in the current account. The RBI notes
in its press release of June 29 on developments in India's
balance of payment: ''In 2011-12, the CAD rose to US$
78.2 billion (4.2 per cent of GDP) from US$ 46.0 billion
(2.7 per cent of GDP) in 2010-11, largely reflecting
higher trade deficit on account of subdued external
demand and relatively inelastic imports of POL and gold
& silver.'' While ''subdued external demand'' may be
true of the fourth quarter of 2011-12, it is hardly
true of the year as a whole. So what seems to explain
the essential problem on the external front is the high
oil import bill resulting from the prevailing high prices
of oil in global markets and the high foeign exchange
outlays on gold, which has become the target of speculative
investment for rich Indians.
Chart
3 >>
(Click to Enlarge)
It should be expected that matters may have improved
since the end of March because of the decline in global
oil prices in recent weeks. But unfortunately for India,
this is precisely the time when the effects of the global
recession on India's exports are beginning to be felt.
There were signs of weakness even by the fourth quarter
of last financial year, with growth in merchandise exports
decelerating to 3.4 per cent as compared with 46.9 per
cent during Quarter 4 of 2010-11. Subsequently, in May
2012, India's exports fell by 4.2 per cent. So, even
though imports fell by 7.4 per cent, the trade deficit
remained high at $16.3 billion, though lower than the
$18.4 billion recorded in May 2011.
It should be clear from the evidence above that when
attempting to address balance of payments difficulties
and shore up the rupee, the government should focus
on the import bill, since stimulating exports in the
midst of a global recession would be difficult. Interestingly,
however, the government's focus seems to be on attracting
more capital flows. In its policy response, the government
recently announced a set of measures aimed at increasing
the space for and improving conditions for foreign financial
investors in the debt market in India. The ceiling on
FII investment in government securities has been increased
from $15 billion to $20 billion and the residual maturity
required for investments in excess of $10 billion has
been reduced from 5 to 3 years. Quicker exit has been
allowed even for FII investors in long-term infrastructure
bonds (with a reduction in the lock-in and residual
maturity requirement from 15 months to one year) and
the Infrastructure Development Fund (with lock-in reduced
from three years to one year and residual maturity fixed
at 15 months). Finally, the government has now allowed
new entities such as sovereign wealth funds, multilateral
agencies, insurance companies, pension funds, endowments
and foreign central banks to invest in government debt.
Chart
4>>
(Click to Enlarge)
Thus,
it is not only the focus on capital inflows that
distinguishes the government's response, but the
fact that when doing so it seems to be favouring
the debt market in particular. One reason is of
course that rules and regulations with regard to
FII investments in equity have been liberalised
substantially in the past. The other possibility
is that the slack in debt inflows is perceived to
be greater, making debt flows more responsive to
government policy shift.
The evidence seems to support that perception. If
we consider 2011-12 as a whole and examine the composition
of capital inflows (Chart 4), we find that though
there was a change in the composition of investment
flows away from portfolio flows to direct investment
flows, the aggregate private investment flow into
equity remained more or less the same at $39-40
billion in both 2010-11 and 2011-12. Not much should
be made of the shift from portfolio to direct investment,
since the difference between the two merely consists
of the fact that direct investors are identified
as those who have cumulatively brought in capital
equal to 10 per cent or more of the equity in the
target firm. Further, with the stock market weak
and volatile, investors may have preferred to stay
out of the FII route.
What is remarkable about the capital account is
that inflows into NRI deposits had risen from $3.2
billion in 2010-11 to as much as $11.9 billion in
2011-12. This $8.7 billion increase in these inflows
exceeds the $6.4 billion increase in aggregate capital
flows, suggesting that they contributed to neutralising
part of the outflow under other heads. The increase
in NRI deposits is all the more noteworthy because
that increase has largely been in the non-resident
external (NRE) rupee accounts, where remittances
from abroad are converted into and maintained in
rupees in the account. This implies that the foreign
exchange risk is borne by the depositor and not
the bank. On the other hand, in the case of foreign
currency non-resident (FCNR) accounts, the deposit
is held in dollars and the bank carries the exchange
rate risk.
Given the weakness and volatility of the rupee,
one would have expected that fear of the depreciation
risk would have kept investors away from NRE accounts.
The reason why they have rushed into such accounts
is the decision of the RBI to deregulate interest
rates on non-resident accounts of maturity of one
year and above in the second half of the last financial
year. Following the deregulation, many banks have
chosen to increase the interest rates on NRE and
NRO (ordinary non-resident) deposits, with some
going in for extremely large hikes. The State Bank
of India, for example, raised the interest rates
on NRI fixed deposits of less than Rs. 1 crore with
a maturity of one to two years to 9.25 per cent
from 3.82 per cent.
The net result is that despite the nil or extremely
low interest rates on premature withdrawal, non-residents
have rushed into these accounts. They are clearly
speculating that the depreciation cannot be as much
as to wipe out the high differential between these
rates and international interest rates. The banks
on the other hand are betting that after taking
depreciation into account they would be paying a
lower interest rate on these accounts than on comparable
domestic accounts. Matters went so far that the
RBI had to issue a circular cautioning banks against
offering such high interest rates. Reminding banks
that the interest rates offered on NRE and NRO deposits
cannot be higher than those offered on comparable
domestic rupee deposits, the RBI also recommended
that ''banks should closely monitor their external
liability arising out of such deregulation and ensure
asset-liability compatibility from systemic risk
point of view.''
In sum, there are two aspects to recent developments
on the external account. First there has been a
significant increase in the reliance on debt to
finance a persisting current account deficit. As
the RBI recognised in a June 29 release, ''India's
external debt, as at end-March 2012, was placed
at US $ 345.8 billion (20.0 per cent of GDP) recording
an increase of US $ 39.9 billion or 13.0 per cent
over the end-March 2011 level on account of significant
increase in commercial borrowings, short-term trade
credits, and rupee denominated Non-resident Indian
deposits.'' The second is that this increase in
debt has associated with it a significant speculative
component, which would increase the volatility of
those flows. This is to add another element of vulnerability
to the problems created by a high import bill, especially
on account of gold imports. The government may do
well addressing the latter vulnerability rather
than encouraging further inflows of speculative
debt capital. However, its recent manoeuvres opening
up the debt market to foreign investors suggest
that it is acting to the contrary. Since government
securities are tradable, foreign investors could
invest in them to speculate on expected movements
in the rupee's value. This could increase external
vulnerability and may explain why the rupee remains
weak despite the comfortable absolute (even if declining)
levels of India's foreign reserves.
*
This article was originally published in Business
Line dated 9 July, 2012.
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