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External debt growing to unmanageable proportions, putting pressure on rupee
Wed, 26 Jun 2013 11:08:00 0530
One of the major successes in economic policy management in India has been the management of the external debt after the balance of payments, or BoP, crisis of 1991. After battling the crisis, policy makers - at the ministry of finance and the Reserve Bank of India - drawing on lessons from that experience and subsequently the East Asian crisis in 1997-98 worked out a prudent strategy to manage the country's external debt. For a good part of the decade post 1991, there was an improvement in external debt indicators such as the quantum of debt, proportion of short-term debt to total debt and the ability to service debt obligations based on the level of exports and goods and services.

But the sheen is fast wearing off, going by the deteriorating key external debt and macro indicators, and as reflected by the weakening local currency. At the height of the 1991 crisis, when India's foreign exchange reserves could barely cover six weeks of imports, the proportion of short-term debt to foreign exchange reserves was 146.5% and short-term debt to total debt was 10.2%, while the debt service ratio was 35%. In the decade that followed, this was reversed as the government and the central bank put a lid on short-term debt, granting approvals only for trade credit, raising maturities for foreign borrowings by Indian corporates by insisting on minimum tenures and a policy bias in favour of more enduring flows such as direct investments and building up foreign exchange reserves.

Now, the rising level of short-term debt vis a vis reserves is worrying many. From a low of 5.1% in 2002-03, it rose to 14.8% in 2008-09 after the global financial crisis and ballooned to 31.1% in December 2012.

Similarly, the proportion of short-term external debt to foreign exchange reserves shot up to 31.1% at the end of December 2012 from 14.8% in 2007-08. Another key indicator - the import cover of foreign exchange reserves - is now down to 6.5 months from 15 months in May 2008, when the economy was booming, capital flows were robust and the currency was strong. And unlike in the earlier decades, the composition of this debt has changed with greater borrowings by Indian firms as concessional forms of debt such as borrowings from multilateral institutions like the World Bank and bilateral credit have tapered off. It also comes at a time when India is facing a major challenge in boosting exports and accretion of foreign exchange reserves.

Critics of the government may be tempted to draw comparisons to the mid and late-1980s, when India took recourse to foreign borrowings to finance public investments after concessional sources of finance dried up, raising the debt burden and finally leading to the crisis of 1991. In that decade, the share of commercial debt rose 10-fold. It was also the phase when the fiscal deficit and inflation were high. Such comparisons may be overblown but, clearly, the deteriorating indicators are worrying since they have serious implications for currency and debt management and, in turn, on sovereign rating.

Former governor of RBI Bimal Jalan who handled the fallout of the East Asian crisis in India says that though the country does not have a problem relating to balance of payments, the rise in total debt to gross domestic product or national income and short-term debt is a matter of concern. However, both Jahangir Aziz, chief Asia economist, JP Morgan who worked in the ministry of finance, and Abheek Barua, chief economist, HDFC BankBSE, say they are worried about the high level of short-term debt and the composition of the debt. "The rising proportion of short-term debt is clearly disconcerting. More so because much of the increase is concentrated in a few sectors. More recently, there has been a rising tendency for corporates in the non-tradable sector to also access foreign capital. As a result, even though gross inflows have not declined much, net capital inflows have and given the rising current account funding needs, this has put significant pressure on the currency," says Aziz.

According to Barua, the country might be heading towards a BoP crisis. To illustrate his point, Barua points out that while short-term debt in terms of original maturity is 31.1% of forex reserves, in terms of residual, or what is known as remaining maturity, a much larger proportion of debt is short-term. That is, a lot of what was originally long-term is also coming up for maturity. "Since some debt exposure is unhedged, there is pressure on the currency. And if the debt does not get rolled over, then there is a pressure on balance of payments (current account deficit, or CAD). That is what we are seeing," he says. The situation is very fragile, he warns.

Jalan reckons there is no such problem, although it is a far cry from the days of allowing borrowings only to the extent of the ability to repay. Though the scenario on the external debt front has changed dramatically - from the earlier dependence on aid flows to greater borrowings by corporates, including those who are expanding operations abroad - it has to be borne in mind that India has never defaulted on its debt obligations, he says.

He says the government needs to tackle trade deficit urgently. India's trade deficit rose to $20.14 billion in May from $17.8 billion in April, the lowest in seven months. In May, exports fell 1.1% from a year ago to $24.51 billion, the first annual fall in five months. "I don't think there is a need for any major shift in strategy except for addressing the trade deficit. If you are importing and don't have enough exports to balance it, there will be problems," says Jalan, who wants the government to focus especially on manufacturing and productivity. Barua, too, shares this view. "We need to resolve the current account deficit, or CAD, through a more sectoral and trade policy approach." That would mean selective increases in tariffs within the limit prescribed by the World Trade Organisation, or WTO. "We need to identify sectors that are responsible for high imports like coal and see what can be done domestically. In exports, for example, we export iron ore . But the mining ban in Goa has hit exports and this needs to be addressed," he says.

Jalan reckons that once the huge trade deficit is lowered, it will automatically help settle the challenges on the debt management front. Barua says if policy-makers try to curb short-term debt at a time when there is a current account deficit, it could lead to pressure on the rupee as the two are related. "Just relying on fiscal compression won't work. We need to address both simultaneously. If we try to address the debt problem without addressing the CAD, then we will be in a peculiar scenario that will put rupee under pressure," he says. The rupee has fallen by over 10% this year.

Aziz, however, feels part of the problem is the lack of reforms in the domestic capital markets that have kept interest rates in India structurally high. "A lot has to do with policy rates that are kept significantly above global rates because of the much higher inflation in India." He traces this to the inability of the government and the RBI to reduce inflation even after four years. Average inflation has been over 7% during the last four years. He does not foresee a reversal of this trend in the absence of either further liberalisation of the financial markets or a steep reduction in inflation. According to him, this is because after 2008 there has been stiff resistance to liberalise markets on the misplaced belief that somehow the regulatory and structural features on India's capital markets "saved" the economy from facing the full wrath of the global crisis. "Nothing can be further from truth," he says.

(Economic Times)
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