MacroScan (Printable Version)

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 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.

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.

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.

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.



Themes > Features	10.07.2012


Banking on Debt*

C.P. Chandrasekhar and Jayati Ghosh

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 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. 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. 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. 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.



© MACROSCAN 2012