In 1991, the loudest of wake up calls, in the form of a currency crisis, aroused India from the stupor of four decades of failed economic policies. Some hope that the decline of the rupee, which hit a record low against the dollar on May 31, and the sharp drop in the GDP growth rate, to 5.3 per cent last quarter, will provide a similar jolt to get India back on the reform track.
After coming within weeks of running out of foreign currency reserves, India changed course. Reforms driven by Prime Minister Narasimha Rao and his Finance Minister Manmohan Singh led to rapid economic growth and the accumulation of a large reserve of foreign currencies. Now the dangers are a reversal of the momentum of reform and a reversion to complacency.
As far as foreign exchange is concerned, India’s persistent trade and current account deficits mean that it has to run just to stand still. For four of the past five years, it has been able to move forward – capital inflows of foreign direct investment and portfolio investment have more than covered the current account shortfall. Over the past year, it has had to run harder. The deficit shot up from 2.7 to four per cent of GDP, thanks largely to higher oil prices, and the current account deficit of $76 billion is the widest ever.
That shortfall should be set against the country’s foreign currency reserves. Those have fallen from a peak in July 2008 of $307 billion, which then covered almost 14 months of imports, to $286 billion, now enough to cover only around seven months of imports. But as our calculator shows, that’s still a more than comfortable defence under most scenarios.
Even if capital flows were to reduce to zero as they did in 2008, following the collapse of Lehman Brothers, reserves would drop by only $40 billion over 12 months, still leaving a healthy $250 billion or so of cover. Of course, the more a country defends itself with foreign exchange reserves, the weaker its defences appear.
In today’s environment, India can cope. But there are two big risks. First, a catastrophe, say in the Euro zone, could lead to a flight of foreign capital. Foreigners own about $200 billion worth Indian equities. A rush for the exit could trigger a spiraling decline. Second, a repeat of the 1991 oil shock could precipitate a sharp increase in both the trade and fiscal deficits, the latter because of wasteful government subsidies of domestic fuel prices.
No country would be immune to such shocks. But India’s dependency on foreign investment, and ballooning trade gap, puts it particularly at risk. India can become more resilient by encouraging more foreign direct investment: lifting caps on retail, aviation and insurance sectors would be a start. It could also reduce fuel subsidies. Even better, it could renew the 1990s political spirit of Rao and Singh. Investors need the red carpet, not red tape