In the past eight months, foreign portfolio investors have moved out nearly $40 billion out of India, by selling stocks and bonds. During this time, India’s foreign exchange reserves have fallen by $52 billion. The rupee has been falling against the American dollar. Imports are rising faster than exports, which means we need many more dollars to pay out than what we receive in our export earnings. 

Even in normal times, India has a dollar shortage of manageable proportions, i.e., between 1 and 2 percent of GDP. Typically, this is less than $50 billion and arises due to exports exceeding imports. This shortage is funded by inflows in the form of stock market investments, foreign loans, private equity or bond purchases. These capital inflows have always exceeded the current account deficit, and hence India’s “balance of payment” (BOP) account has been in surplus. 

Of course, having a BOP surplus funded by foreign debt and liabilities alone, is not necessarily a good thing, especially when there is debt distress all around the world. But in normal times foreigners readily giving loans to India’s economy is a sign of their confidence.  

RBI's warning signals

All this is about to change sharply, and the custodian of India’s forex, the Reserve Bank of India, has sent out early warning signals. With any luck, and assuming a robust inflow of $80 billion during this fiscal year, our BOP account will still be negative by $30-40 billion. And our current account deficit might rise dangerously to 3.2 percent of GDP, reaching beyond a 100 billion dollars. 

To tackle this extra pressure on forex, our pile of reserves won’t be sufficient. Hence the RBI has relaxed some constraints to attract more dollar denominated fixed deposits from Non-Resident Indians. It has also made foreign borrowing easier and has increased the allowed limit on foreign ownership of Indian government bonds. All these measures are meant to attract more dollar inflows. 

These proactive measures were needed due to some alarming signs, such as the widening trade and current account deficit, and increase in the share of foreign debt which is to be repaid this year. India’s foreign debt is $620 billion, of which $267 billion is due to be repaid in the next nine months. This ratio of short-term debt is 44 percent and dangerously high. 

Falling forex reserves

To repay this debt, the private companies which have taken those foreign loans will need to seek fresh loans to repay old loans, or else dip into India’s foreign exchange reserves. The latter is not desirable since the forex reserves are falling and need to be shored up. And the former won’t be easy since dollars are flowing toward the US and not toward developing countries. In any case, the fresh loans will be at much higher interest rates, causing a future burden of debt servicing.

The RBI’s precautionary moves came alongside measures taken by the Union government to conserve dollars. Import duty on gold has been hiked to 12.5 percent, to stem the outflow of dollars owing to gold purchases. Indians have an insatiable demand for gold, and hence the country is the highest importer in the world. The higher import duty might reduce the demand somewhat but will also induce some smuggling. There is also a possibility that other restrictions may come on non-essential imports to prevent the dollar outflow.

Management of foreign exchange and the exchange rate is primarily the responsibility of the RBI. In the present circumstances, apart from pressure due to the flight of stock market investors, there is additional pressure due to high oil prices. It affects India’s total import bill (upwards of 150 billion annually), and an increase in the subsidy bill (since there is less than full pass through of oil prices to the consumers). 

A sliding rupee

The fertilizer and cooking gas subsidy burden is increased due to higher oil prices. So, to deal with this additional fiscal burden the government has imposed an export tax on windfall profits on the steel and oil refining companies. This is expected to raise more than 1 trillion rupees for the exchequer. It is an indirect way of dealing with impact of the falling rupee. But an export tax is a rare and exceptional measure and justified only because of steep increases in oil prices which is linked to the Ukraine war.  

The Indian government also has the fiscal burden of continuing with the compensation due to the shortfall of GST (goods and service tax) collection to state governments. The latter are saddled with debts of their own, with 10 states reaching dangerous levels of debt, which can lead to default.

On the external front, the pressure on the rupee is not just because of the high import bill caused by oil prices. Non-oil and non-gold imports such as electronics, chemicals and coal rose by 32 percent between April and June. Gold imports during June were 170 percent higher as compared to a year ago. Let’s see if higher import duty on gold deters imports. Indians could invest in sovereign gold bonds, which are demat substitutes of gold, and do not drain precious foreign exchange. An aggressive selling effort of gold bonds by the government is needed.

Needed deft macroeconomic management 

The coming months will call for deft macroeconomic management of the twin deficits, on the external and internal front. A higher fiscal deficit invites higher interest rates. And a higher trade deficit invites a weaker rupee. If these two policy instruments (interest rates and the exchange rate) are handled diligently in order to gradually reduce both the deficits, we can avert a crisis situation. 

Weakening rupee is a natural cushion but in the short term can aggravate the trade deficit, until exports catch up. Similarly, reducing the fiscal deficit calls for both expenditure control and higher tax revenues. The latter requires growth and employment to pick up. If oil prices go down due to recessionary winds in the world, that would be a boon to India, albeit a mixed one, since a global recession is bad for India’s exports, which are crucial to close the trade deficit gap. 

Who said macroeconomic management was easy?

(The writer is a noted economist. Views are personal. By special arrangement with The Billion Press)