The Centre’s response to the recent bout of weakness in the rupee has been surprisingly nonchalant. While the RBI was mum, the Finance Minister decided to talk up the rupee by tweeting that India’s foreign exchange reserves are comfortable, going by global standards and sufficient to mitigate any undue volatility in the foreign exchange market.

The Finance Minister is partially right, for the country’s reserves are better than many other emerging economies. But given the changing global liquidity conditions and their impact on the FDI and FPI flows in to the country, it might not be right to feel complacent about the country’s reserves.

Also given the structural issues in the country’s external account — widening trade deficit, sluggish export growth and growing imports — our forex arsenal is likely to be under further threat in the coming quarters. It would therefore be better to acknowledge the challenges and think about corrective action rather than be in denial.

Depleting reserves

After the 2013 crisis in the rupee when the taper tantrum and the widening current account deficit, eroded the reserves, the RBI has been careful about building its forex reserves. Reserves had therefore increased from $275 billion in September 2013 to the life-time high of $426 billion in April 2018. Strong inflows from foreign portfolio investors as well as foreign direct investors in the interim period helped to a large extent in shoring up reserves.

But this support is likely to be withdrawn in the coming quarters. Foreign direct inflows had been robust in the first two years of NDA rule, growing at 25 per cent and 23 per cent in FY15 and FY16 as Prime Minister Narendra Modi reached out to overseas investors to fund the country’s growth. But the momentum has slowed down since then with the FDI inflows growing 8 per cent in FY17 and at an even slower pace of 3 per cent in FY18.

The cushion provided by FII inflows is also likely to reduce. Foreign institutional investors have withdrawn ₹15,771 crore from the equity market for far in FY 19 while the outflows from debt segment has been ₹35,449 crore. This is contrary to the copious inflows of ₹1,44,682 crore in equity and debt markets in FY 18 when a rallying stock market and appreciating rupee had attracted foreign investors to Indian markets.

While the reduction in foreign inflows makes it difficult for the RBI to mop up reserves, it has also had to sell dollars to stave off a sharp depreciation in rupee. In the three months from April to June 2018, the RBI has net sold $14 billion. It is therefore not surprising that the reserves are down 10 per cent from their peak level recorded in April.

The Fed’s action

Reduction in foreign money inflows in to the country is a function of the global liquidity conditions and everyone knows that these are far from conducive lately. After pumping in trillions of dollars since the 2008 crisis, the Federal Reserve began shrinking its balance sheet since October 2017. While this is reducing liquidity in global markets, the rate hikes from the Fed are making the cost of financing expensive. It is therefore not surprising that global investors have less to spend and are reducing their investments in emerging markets including India.

RBI Governor Urjit Patel acknowledged this problem in a recent column in Financial Times , through which he had appealed to the Federal Reserve to go slow on its monetary tightening. The IMF estimates that the Fed’s tightening can result in reducing flows into emerging markets by $35 billion a year.

It’s therefore apparent that the world is moving from a period of easy money to one were liquidity becomes tighter and funds become more expensive.

Burgeoning debt

The widespread belief that the cover provided by forex reserves to imports is comfortable, is debatable too. While the current import cover is much higher than the 7-month cover in 2013, continued deterioration in trade deficit can mar this number. While the import cover was 11.1 in April 2018, it is already down to 9.9 in August.

The other data that reflect adequacy of reserves is the country’s external debt. Due the excessive liquidity in global markets after 2008, the country’s external debt has doubled from $224 billion in 2008 to $529 billion now. Indian companies have made the most of the easy liquidity conditions overseas, increasing the non-government portion of external debt to almost 80 per cent. External commercial borrowings account for over one-third of the country’s debt.

The cover provided by forex reserves to external debt has deteriorated significantly in this period from 138 per cent in 2008 to 80 per cent now. Another factor that is worth noting is that the share of concessional debt from multilateral agencies has been coming down over the years — from 46 per cent in 1991 to 20 per cent in 2008 to 9 per cent in 2018.

The worrying factor is that short-term debt on a residual maturity basis that include long-term debt falling due over the next 12 months and short-term debt by original maturity, account for 42 per cent of total external debt towards the end of March 2018 and stood at 52.3 per cent of foreign exchange reserves. With central banks including the Federal Reserve and the Bank of England hiking rates, the cost of refinancing these loans is going to become difficult, leading to repayment of some of these loans, causing forex outgo.

There are however no short-term fixes to this problem. While the measures taken to improve the ease of doing business and the implementation of GST will improve FDI flows in the long term and foreign investment flows will improve once the global liquidity conditions improve, addressing the structural trade imbalance will take longer.

The government needs to renew the efforts initiated in the initial period of its term to boost exports and reduce dependence on imports in order to ensure a sustained improvement in the country’s reserves.