This July marked the completion of two decades after India experienced the balance of payments crisis of 1991. With substantial reserves, the external situation today appears and is different. But there are similarities as well.

In the muted celebration earlier this year to mark the completion of two decades of reform, one statistic often referred to was the size of India's foreign exchange reserves. With foreign reserves having crossed the $300-billion mark, India is seen as having convincingly left behind the fragility that led to the collapse of reserves in July 1991 to levels equal to just two weeks worth of imports. Today, reserves can finance close to a year's imports.

While the resulting confidence regarding India's external position is understandable, there are trends and indicators that call for an element of caution. To recall, the 1991 crisis was the result of a loss of lender confidence in India's ability to meet its debt service commitments. A rising external debt-to-GDP ratio and persisting current account deficits in the balance of payments were seen as responsible for that loss of confidence. This led, in the first instance, to a growing reticence to provide long-term debt to India, resulting in a rise in the share of short-term debt in the total.

At some point lenders were unwilling to roll over that short term debt, and others like non-resident Indian depositors withdrew the deposits on which they were earning attractive rates of interest. As a result, India had to draw down its reserves to finance its net import bill, leading finally to the collapse of reserves that defined the crisis. Fear of default due to inadequate access to international liquidity was the proximate cause.

What was surprising, however, was that this occurred in a context where the country's external debt-to- GDP ratio was by no means alarming. In 1990-91, the external debt-to-GDP ratio was just 29 per cent, which was moderate when compared to the levels that indicator had reached in Latin America at the time of the debt crises of the 1980s. The difficulty was that international banks had already burnt their fingers in Latin America, and therefore were far more wary. From their point of view, what seemed to matter was not the level of external debt relative to national income, but relative to indicators of balance of payments strength. A country recording a combination of persistent current account deficits and a rising debt-to-GDP ratio was suspect, and was likely to lose the confidence of investors.

It is in this light of that experience that recent trends in India's external debt position need to be assessed. Gross external debt has been rising significantly in recent times. Having risen at a slow pace from $83.8 billion on 1990-91 to $104.9 billion in 2002-03, the magnitude of outstanding external debt has more than tripled to $316.9 billion at the end of June 2011 (Chart 1). That is, as compared to an average annual absolute increase of $1.8 billion during the 12 years following the 1991 crisis, the average annual increase has risen to more than $25 billion in the subsequent eight years. Over the five years ending 2010-11, the annual average absolute increase in debt had risen to $33.5 billion. And, during 2009-10 and 2010-11, outstanding external debt rose by $36.5 billion and $45.5 billion respectively. This does point to a substantial acceleration in the rate of accretion of external debt.

Why the acceleration

Five factors, among others, have been principally responsible for this trend. The first is that the period since 2003-04 has been one in which there has been a supply-side driven surge in capital flows to emerging markets worldwide, and India has been one of the beneficiaries. A part of that flow has been in the form of debt, as opposed to portfolio and direct investment.

Second, during this time the government has been raising the ceiling on the volume of external commercial borrowing the country can resort to in a year, and has been lax in implementing that ceiling. Moreover, the extent to which any single corporate can resort to external commercial borrowing has also been raised over time.

Third, on an average the rate of interest in India has been significantly higher than in the international market, encouraging “carry-trade” investments, or borrowing in foreign markets where rates are lower and lending in India were the rates are higher to benefitfrom the differential.

Fourth, with the onset of the financial crisis, international banks and financial institutions obtained access to large volumes of cheap liquidity at near-zero interest rates. These funds were pumped into the system by the Federal Reserve of the US and other central banks to bail out the financial system. A part of this liquidity was used by financial firms to indulge in carry trades in emerging markets.

Finally, in India, this period of global excess liquidity was one in which inflation was ruling high, forcing the Reserve Bank of India to hike interest rates 12 times in a little more than a year. This made India an attractive destination for such flows looking to carry-trade opportunities for easy profits.

Borrowing spree

Needless to say, Indian corporates were quick to exploit this opportunity. They chose to borrow from international markets, since they could obtain credit at rates lower than available in the domestic market, especially during the period when domestic interest rates were on the rise. Many firms even chose to pay off past debt mobilised in domestic markets and replace it with borrowing from abroad.

Two factors favoured this tendency of accelerated, external-debt accretion. One was that, since this was a period when GDP was rising fast, the accretion of debt did not result in any significant increase in the external debt-to-GDP ratio. Thus over the period starting 2002-03, the external debt to GDP ratio fluctuated in the 17-20 per cent range, which would be considered acceptable (Chart 2).

The other factor was that the surge in capital inflows into the economy over this period had strengthened the rupee. In fact, the rupee had to be prevented from appreciating too much through central bank purchases of foreign currency, leading to the observed build-up in reserves. This meant that domestic borrowers taking on debt service commitments in foreign exchange terms did not fear that a depreciation of the rupee vis-à-vis the dollar, for example, would substantially increase their debt servicing burden in rupee terms. The result was a borrowing spree.

What was being missed, however, is that the rapid increase in the absolute volume of external debt is occurring in a context in which India is faced with persisting and even rising current account deficits.

This, together with the fight to safety to the dollar in the current uncertain global environment, has resulted in a sharp depreciation of the rupee against the dollar in recent weeks. According to one estimate (Business Standard, October 10, 2011) the fall in the value of the rupee since August would increase the redemption cost on foreign currency convertible bonds issued by 30 companies that are maturing over the next 12 months by as much as Rs 500 crore, from around Rs 1500- 2,000 crore. Thus the sudden increase in the quantum of exposure to external debt can render corporations vulnerable, even if the economy as a whole is not.

Points of concern

But even when in comes to the economy, there are some reasons for concern. As noted earlier, at the time of the last debt-driven balance of payments crisis, the run-up to the crisis was characterised by a rise in the share of short-term debt in aggregate external debt.

In 1990-91, the inability to refinance a significant volume of short-term debt prior to the crisis had brought its share in the total down to 10.2 per cent. Having burnt its fingers, the government made an effort to reduce dependence on such debt, so that its share came down to as low as 2.8 per cent at the end of March 2002 (Chart 3).

Since then, however, dependence on short term debt began to rise, and that tendency has got strengthened during the period when aggregate external indebtedness has been accelerating. In the event, the share of short-term debt to aggregate debt stood at 21.6 per cent at the end of June 2011.This increase in the proportion of short-term debt could reflect the fact that international lenders are increasingly wary about lending long to India, given its substantially increased external debt burden and the deficit on its balance of payments.

That would not be a good sign. But even if that were not true, the high dependence on short-term debt makes India vulnerable to a situation in which international lenders choose not to roll-over debt or provide new funding.

Sanguine perspective

The official understanding seems to be that this is unlikely to happen and even if does, the situation can be managed given the large reserves available with the RBI. This may be too sanguine a perspective.

Consider for example the relationship between the level of foreign exchange reserves and the magnitude of external debt outstanding (Chart 4). After having risen from 42 to138 per cent between 2001 and 2008, the ratio of foreign reserves to external debt has fallen and stands currently at close to unity.There are two messages that can be read into this picture. Since these foreign reserves were accumulated during a period when India was running deficits on its balance of payments, it is widely known that our reserves have not been “earned” through net exports, as China's reserves have been, but “borrowed”. They are the counterpart of some of the liabilities in foreign currency terms the country has accumulated.

What emerges now is that the reserves are adequate only to cover one component of these liabilities, consisting of debt. Liabilities in the form of direct and portfolio investment, especially the latter, have to be serviced with earnings from net exports of goods and services or with receipts from remittances.

At the end of June 2011, India's outstanding net portfolio investment liabilities stood at $175 billion, or about 55 per cent of accumulated reserves. Since both short-term debt and portfolio flows can dry up and quickly reverse themselves, our foreign reserves may not be as high or as adequate as they appear to be.

It could, of course, be claimed that long-term debt cannot be withdrawn too quickly, and their amortisation can be planned for.

The difficulty is that the ratio of short-tem debt to foreign exchange reserves at 21.7 per cent is close to the mid-1990s level from which it had subsequently collapsed (Chart 5). Together with accumulated portfolio liabilities they amount to three-fourths of available reserves. If a significant chunk of this capital is withdrawn from the country, the effects could be destabilising, even if not similar to the one in 1991, when reserves could finance only half a month worth of imports.

(This article was published on October 17, 2011)
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