Capital inflows underscore the downgrade impact
When the RBI Governor says, even if just by way of abundant caution, that “we need to prepare for” a ratings downgrade, it’s time to get worried, very worried. It is true, as Duvvuri Subbarao said at the Cornell lecture, “we have managed outflow in the past and we can manage … should our rating be downgraded, I think we’re quite prepared.” The immediate impact, however, could be quite traumatic, and just how traumatic has been highlighted by two recent presentations by Subbarao’s colleagues, to be found on the RBI website. The first, a speech by Executive Director Deepak Mohanty on Tuesday, talks of how unsustainable India’s current account deficit is at 4.2% of GDP for FY12 and how “increasing vulnerability of India’s external sector can deter confidence of global investors and impair financial flows required to meet the domestic saving-investment gap”.
And, on August 18, Deputy Governor HR Khan presented some frightening pictures of this vulnerability (reproduced on page 1 of today’s newspaper). Inward FDI has halved to $5.6 billion in Q1FY13 from $12.2 billion in Q1FY12, net FII flows to $728 million in April-August FY13 from $2.2 billion in the same period in FY12, ECB approvals are down a fourth but net ECB inflows were minus $409 million (India’s ECB repayments exceeded inflows) in April to July FY13 as compared to plus $5.4 billion in April to July FY12. The only saving grace, thanks to high interest rates, was the nearly six-fold hike in NRI deposits to $6.5 billion in Q1FY13. As a result, India’s net international investment position—the difference between external financial assets and liabilities—rose from minus 6.4% of GDP in the pre-Lehman 2003-08 period to minus 10.6% in the post-crisis 2008-12 period and to minus 13.2% of GDP in FY12. A recent analysis by Citigroup put it a bit differently, but made the same point when it said the ratio of India’s forex reserves to short-term debt by remaining maturity had fallen from 3 in 2007 to an estimated 1.5 this year, making India one of the more externally vulnerable countries.
It’s not immediately clear how individual flows will be affected in the event of a downgrade—certain classes of investors will be mandated to leave India by their individual charters while others, especially NRIs, may be encouraged to come in if interest rates are further hiked. The more important issue, however, is that India’s options, as Subbarao stressed again, are increasingly getting limited—certainly any fiscal stimulus can be ruled out. Very aggressive budgeting—overestimating tax growth and underestimating expenditures (including an impossible 0.6% of GDP compression of subsidies in FY13)—meant the fiscal deficit was going to go for a toss even before the economy started slowing so dramatically. Which leaves a sharp hike in diesel prices as the only credible option for the government to show it means business and, at least till now, there are no signs the government is moving on this.