On the heels of Standard & Poor’s decision to downgrade its India outlook, Morgan Stanley has issued a warning that India is vulnerable to a balance of payments shock. This cannot be a surprise to the Reserve Bank of India, since its governor has described the situation as “disturbing”. An unhealthy combination of a record trade gap and a record current account deficit (CAD) has left the central bank perched on a tightrope. The CAD may hit four per cent of GDP in 2011-12 (it exceeded 4.3 per cent in the third quarter). The trade deficit, at $185 billion, was about 10.5 per cent of GDP. External obligations, at $335 billion, also exceed reserves ($295 billion). The government hopes to reduce the CAD to below three per cent in 2012-13. That is still very high and not easy to achieve. The trade gap may widen. In March 2012, exports were down 5.7 per cent year-on-year. IT industry guidances suggest slow 2012-13 growth. Crude oil prices have dropped, offering some relief, but they are unlikely to fall much more.
Thus the rupee is under serious pressure. It dropped from Rs 44 for a dollar in August 2011 to a record intra-day low of Rs 54.3 in December. It’s flirted with the Rs 53.9 zone in the past few days, and closed at an all-time low of Rs 53.83 on Wednesday. This comes after a pullback above the Rs 49 mark during Jan-March 2012. The RBI expended $20 billion in reserves to defend the currency in the second half of 2011-12. As of now, if we discount bullion holdings ($27 billion) and IMF Special Drawing Rights ($7.3 billion), reserves offer about six or seven months of import cover. So, any comparisons with 1991 seem alarmist. The RBI must, however, also reckon with contingencies arising from debt-servicing obligations, and possible portfolio outflows. In end-December 2011, about $78 billion, or 23 per cent of external debt, was repayable in the next 12 months. That must be refinanced to avoid reserve depletion. Also, FII holdings in Indian debt and equity amount to over $205 billion in market value. Sustained FII selling would hurt. Worried about reserves, the RBI has deregulated overseas interest rates to encourage more forex repatriation by NRIs, whose current contributions to reserves amount to about $58 billion. It cannot do much more to boost reserves. Nor can it defend the rupee aggressively, given the numbers cited above. The risks of reserve depletion are too great.
The RBI does have the ability to prevent a sudden run on the rupee and it can prevent speculators from blindly holding long positions on the dollar, through judicious threats of intervention. But it simply cannot engineer a pull-back. At best, the RBI can only buy time for corrective fiscal measures to take effect. By any logic, fiscal policy must now be geared to attract more FDI and to boost export growth. The fiscal deficit is already of alarming proportions. It cannot be reduced without cutting fuel subsidies. Given the current political situation, an all-party consensus would be required however, for any sort of reform. There are few signs that legislators are aware of the gravity of the situation. If they don’t wake up very soon, with at least an increase in retail prices of petroleum products, India’s balance of payments could get worse.