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The gradual normalisation of global output growth post-pandemic has been severely marred by rising food and energy inflation, which the International Monetary Fund (IMF) chief has described as a “clear and present danger” to the world economy. The damage done by the Ukraine conflict is still to be fully assessed as most economies, including India, fervently hope that a solution would moderate energy and food prices.
Governments tend to postpone the full transmission of high energy prices to the consumer. It’s like a pressure cooker being kept at full steam for an extended period. Smaller economies in South Asia and Latin America are already on the brink of a foreign exchange crisis as most are net importers of energy and food.
India, fortunately, has decent forex reserves, but they are depleting gradually for four consecutive weeks. The week ended April 9 saw the central bank’s reserves fall by $11 billion to about $606 billion. The peak of the RBI reserves was at $642 billion in October last year. They fell by $35 billion over five months even before the real economic impact of the Ukraine war was experienced.
India’s external sector may seem stable at present but by no means should it be regarded as foolproof. For one, many economists are predicting a negative balance of payments in the current fiscal. In recent years, India’s current account deficit hovered at 1-1.5% of GDP (roughly $40 billion), which was more than adequately compensated by much higher foreign capital flows ― robust direct foreign investment and positive FII portfolio inflows into the stock market. The forex reserves pile got bigger and bigger.
However, in this financial year, the equation has changed. Foreign investors are seeking a safer haven in US treasury bonds. This situation is exacerbated by the Fed and other OECD central banks gradually withdrawing their easy money policy. Remember, this easy money at near zero interest was flooding the Indian tech and green energy sectors in 2020-2021, adding massively to forex reserves. That honeymoon is all but over.
Capital inflows will slow sharply in 2022-23 and the trade deficit will nearly double, going by present trends. Due to high energy and commodity prices, India’s imports are rising faster than exports, widening the trade deficit. It peaked at $18.5 billion in March. Annualised, the deficit could potentially touch $210 billion.
Accounting for remittances of about $90 billion which overseas Indians annually send home, the current account deficit could reach an unprecedented high of $120 billion or about 3.5-4% of GDP. To be balance of payments neutral, India would need net capital inflows of this magnitude. Is that feasible in the next 10 months, when most large central banks are withdrawing easy money? Most economists predict a negative balance of payments.
For instance, if India needs $120 billion to bridge its current account deficit but receives only $50 billion as net capital inflows, the remaining $70 billion must be taken out of the RBI reserves. It seems certain that India’s forex reserves will be drawn down over the next 11 months. The problem is that negative sentiment can build up to spur further capital flight, like a self-fulfilling prophecy.
For instance, the RBI may still have enough forex reserves after meeting the balance of payments deficit, but the currency could still come under attack and more reserves may have to be deployed to support it.
In such situations, confidence can be eroded and other risk factors begin to look very ominous. For instance, India’s short term external debt on a residual maturity basis (debt obligations that include long-term debt by original maturity falling due over the next 12 months and short-term debt of less than one year maturity) stood at 41.8% of foreign exchange reserves at the end of June 2021. So roughly $250 billion of short term debt is to be repaid by June 2022.
Forex reserves may have to be deployed to pay back some of the short term debt maturing up to June 2022, if it can’t be rolled over. A lot of such debt is normally rolled over, but post Ukraine, conditions are anything but normal.
The IMF has said the state of the global economy may entail “complex policy tradeoffs” making the policy landscape very complicated. One clear tradeoff is that even if the external sector comes under pressure and necessitates reduction of essential imports, it has its limits as the poor and vulnerable populations have to be taken care of. We are witnessing this in Sri Lanka, Peru, Nepal, Pakistan, Afghanistan, etc.
No country, especially in the middle income bracket, is totally immune from this. India’s fundamentals look better today but there is a need to keep a close watch on the balance of payments situation, which tends to slide back every 10-12 years.