People's Democracy

On India's External Strength

C P Chandrasekhar

FOR some time now the Balance of Payments, which used to be a perennial problem in the near-forgotten past, has not been a source of concern for the government. Part of the reason was the continuous and even excessive build-up of foreign exchange reserves (which now stand at more than $310 billion, making India's holding the fourth largest in the world). The problem appears to be one of plenty rather than scarcity, far removed from the days when the foreign exchange constraint was seen as binding upon domestic economic growth. Liberalisation it is argued has strengthened India's external position.

However, it needs to be stressed, this build-up is not the result of India's foreign exchange earnings (through exports and invisible receipts) exceeding the foreign exchange outgo to meet our current requirements. That is true of a country like China which earns a significant share of its surpluses. In India's case reserves accumulated because capital flows in the form of equity investments and debt exceed the current account deficit.

Yet, this has led to an attitude of complacency, not only among policy makers but even among the wider public, whereby balance of payments issues are rarely taken as potential problems. It is even common to hear the argument that the best way to manage the current inflation within the country is simply to liberalise imports further, on the assumption that our foreign exchange situation is presently quite comfortable. Yet this argument is flawed not only because it ignores the potential damage to domestic activity and employment from more imports, but because it underestimates the fragility of recent tendencies in the balance of payments. The build-up of reserves has been accompanied by the emergence and increase of current account deficits.

GROWING CURRENT

ACCOUNT DEFICITS

For much of the past decade, India's current account was in surplus, because the trade deficits were more than compensated by substantial increases in remittances from workers abroad and software exports. However, in recent years deficits have emerged, largely because of the significant growth in trade imbalance. In the past two years the current account has been in deficit in every quarter barring one, and in the past financial year the deficit has been growing continuously.

This despite the very significant role played by net invisibles, which have been growing continuously in almost every quarter. The trade balance, by contrast, has been deterioriating, and quite sharply after April 2007. This has led to a trade deficit for the entire financial year 2007-08 of more than $90 billion. The increase in net invisibles has not been enough to counteract this, so that the total current account deficit for the year was $17.4 billion. This meant that the current account deficit amounted to 1.6 per cent of GDP, and the trade deficit alone amounted to 8.4 per cent of GDP!

The worsening of the trade balance has been particularly rapid after March 2007. This is essentially because of a sharp acceleration in imports, since exports continued to grow at more or less the same rate as before. Over the year, exports increased (in dollar terms) by 24 per cent but imports increased by 30 per cent.  It is often believed that the rapid growth of imports in 2007-08 was essentially because of the dramatic increase in oil prices, which naturally affected the aggregate import bill. Certainly this played a role, but some non-oil imports also increased rapidly. Therefore, while oil imports in the last quarter of 2007-08 were 89 per cent higher (in US dollar terms) than in the same quarter of the previous year, non-oil imports were also higher by 31 per cent.

While merchandise trade may show a large imbalance, in the past the surplus on invisibles has generally been large enough to make the current account positive or in very small deficit. This was generally because of two important inflows: the receipts from exports of software services, which include many IT-enabled services such as Business Process Outsourcing, and remittances from Indian workers abroad which come in as private transfers.

However, in 2007-08, while these inflows remained large, there are other indications that invisible payments cannot be counted upon to finance the trade deficit to the same extent in future. Thus, while software exports remained buoyant, they are unlikely to remain unaffected by the slowdown in the major market, the US, in the current year. Private transfers, on the other hand, are more complex. That part of remittances which is from the US may be adversely affected, but the rise in oil prices is imparting new dynamism to oil-exporting West Asian countries where most Indian workers abroad currently reside.

Inward remittances amounted to nearly $43 billion in 2007-08, increasing by 47 per cent over the previous year. They were almost equally divided between inward remittances for family maintenance, and local withdrawals or redemptions from NRI deposits. In 2007-08, the inflows and outflows under NRI deposits were almost the same. But a growing proportion of withdrawals from NRI deposits are repatriated, rather than used within the country. This ratio increased from 15 per cent of total withdrawals in 2006-07 to 35 per cent in 2007-08.

TWO NEGATIVE

ELEMENTS

Two negative elements of the invisibles balance deserve more analysis. Investment income predictably exhibits a deficit. Both inflows and outflows of investment income have increased sharply in 2007-08. However, the rise in inflows should not suggest that the much-vaunted new international clout of Indian corporates is finding expression in the balance of payments as well, as reinvested earnings of Indian investment abroad accounted for only a small part of the inflows. Instead, these inflows were dominated by the interest earnings on foreign exchange reserves held abroad, which amounted to more than $10 billion, or 73 per cent of the total inflows on this account.

Meanwhile, interest payments on external commercial borrowing (ECB) emerged as one of the largest outflows of investment income in 2007-08, amounting to $4.2 billion - an increase of 250 per cent over the previous year! The relaxation of rules for ECBs has clearly led to a significant expansion of such borrowing by Indian companies, and some of this may become more problematic as higher global interest rates and deceleration of growth affect the ability to repay. Repatriation of dividends and profits by multinational firms operating in India remained high at $3.3 billion.

The other significant negative item is that of business services. While the deficit on this account was small, it is still significant because this was a positive item until very recently. In fact, this account turned negative only in the middle of last year. Within business services, over the entire year, the categories of business and management consultancy and architectural, engineering and other technical services showed substantial deficits.

In sum, many of the strengths on the current account in the recent past are being diluted by global and domestic developments. Clearly, therefore, there is cause for concern with regard to recent trends in the current account. When these are combined with the clear signs of fragility in the captial acount, including the heavy dependence upon short-term flows, we cannot continue to treat the accretion to the country's foreign exchange reserves as a sign of strength.