India’s External Sector Looks Vulnerable : Daily Current Affairs

Relevance: GS-3: Indian Economy, mobilization of resources, changes in industrial policy and their effects on industrial growth.

Key Phrases: External Sector, Geopolitics, Balance of Payments, Current Account Deficit, Weak private equity/venture capital, Foreign Investment Inflows, External Threats, Tightening Global Liquidity, Capital Outflows, Forex Reserves, External Stability.

Why in News?

FPIs pulling out money, worsening current account deficit, and hawkish stance by central banks could run down the forex reserves.

Economic Recovery in India:

India’s external sector is facing serious challenges. As a net importer of oil and other commodities, India traditionally faces a balance of trade problem whenever oil and commodity prices go up. This time is not different. For the third quarter of 2021-22, India’s current account deficit (CAD) has reached $23 billion, which is a nine-year high. India’s exports are doing well, but as imports are growing faster, widening of the trade deficit is likely in the near term.
To make it worse, foreign portfolio investors (FPIs) have pulled out a significant amount of money from the Indian capital market over the last six months. It is believed that the imminent interest rate hike in the US is one possible reason behind this sustained withdrawal of FPIs from the Indian market.
An overall pessimistic global outlook on growth, continued uncertainty with geopolitics, and Covid related worries are adding to the pressure. The RBI recently highlighted that external sector vulnerability has increased significantly in the last few months.

Balance of Payments

The balance of payments (BOP), also known as the balance of international payments, is a statement of all transactions made between entities in one country and the rest of the world over a defined period, such as a quarter or a year. It summarizes all transactions that a country's individuals, companies, and government bodies complete with individuals, companies, and government bodies outside the country.
The BOP is divided into:
- Current Account: The current account is used to mark the inflow and outflow of goods and services into a country. It shows export and import of visibles (also called merchandise or goods - represent trade balance) and invisibles (also called non-merchandise). Invisibles include services, transfers and income.
- Capital Account: The capital account is where all international capital transfers are recorded. It deals with foreign exchange reserves, investments, loans & borrowings. External Commercial Borrowing (ECB), Foreign Direct Investment, Foreign Portfolio Investment, etc form a part of capital account.

Why is There External Sector Vulnerability?

Current account deficit: Though the RBI has managed to control the volatility of the rupee until now, the external sector is facing pressures both in the current and the capital accounts. Over the years, high capital inflows have allowed India to finance its CAD and build up a sizeable foreign exchange reserve. However, this equilibrium has got disturbed in the last six months as pressures are building up on the balance of payments front.
Foreign portfolio capital outflow: Foreign portfolio capital flows, which are a large component of foreign investment in India, have turned negative in a big way. FPIs have been net sellers every month from October 2021 to March 2022, resulting in a total outflow of $21.5 billion in just six months, highest in the last 20 years.
Weak private equity/venture capital: In the last two years, India’s growing startup ecosystem has attracted a high volume of funding through the PE/VC route. Data for 2021 shows that of the $55 billion of FDI, PE/VC funding accounted for around $35 billion. But in the last few months, there are indications that PE/VC inflows are slowing down, with 36 per cent lower than in October-December 2021.
As per RBI data, the cumulative foreign investment inflows during April-February 2021-22 were only $24.6 billion against a much higher $80.1 billion during corresponding year-ago period. In a period of worsening CAD, a steady exodus of FPIs and a dwindling inflow of PE/VC funds pose a challenge for maintaining India’s overall external balance.

Effects of External Sector Vulnerability

A combination of these unfavourable economic factors has led to a sharp decline in forex reserves. India has lost around $30 billion worth of forex reserves during the last three months. Weekly data of the RBI shows that the country’s total forex reserves have come down from around $633 billion on February 18, to around $604 billion on April 15. This erosion of reserves has raised some worries about India’s external stability.

Foreign Exchange Reserves

Foreign exchange reserves are assets held on reserve by a central bank in foreign currencies, which can include bonds, treasury bills and other government securities. It needs to be noted that most foreign exchange reserves are held in US dollars.
India’s Forex Reserve includes:
- Foreign Currency Assets
- Gold reserves
- Special Drawing Rights
- Reserve position with the International Monetary Fund (IMF).

Is India Protected from External Threats and Vulnerabilities Because of High Forex Reserves?

There is a feeling that with more than $600 billion still in its coffers, India is well protected from external threats and vulnerabilities. It is indeed true that India is one of the top 10 countries with the highest foreign exchange reserves (Table).
However, India is somewhat of an outlier among these countries because most others in the top 10 are current account surplus countries.
In fact, if one leaves out the US, India is the only net-commodity importing, current account deficit country on the list. This essentially implies that India’s forex reserves are structurally different from other countries as it is made up entirely of liabilities, namely the foreign capital inflows. This makes India’s forex reserves more vulnerable to the threat of a sudden exodus of foreign capital.
A regime of tightening global liquidity and possible hawkish moves by the global central banks can trigger more capital outflows. India faced this problem during the ‘taper tantrum’ of 2013 and possibly will face it again.
In such a scenario, the RBI may have to aggressively intervene in the foreign exchange market to control any undue short-term volatility of the rupee.

Way Forward:

The forex reserves will be an essential policy tool for achieving external stability in such an eventuality. Over the years, India has incurred significant opportunity costs by holding its forex reserves in relatively low-yield, liquid assets.
This opportunity cost is an insurance premium that India has paid to mitigate the threat associated with increased integration with global trade and finance. Possibly the time will soon come to evaluate how adequate this insurance cover is when the going gets really tough.

Source: The Hindu BL

Mains Question:

Q. Discuss the scope of forex reserves as an essential policy tool for achieving external stability of an economy? Critically Examine.