How UPA has increased our external vulnerability; Modi needs to fix this

The UPA government has been rejoicing over the recent fall in our current account deficit (CAD). Finance Minister P Chidambaram, with little else to show by way of economic success in the last two years, has been tom-tomming the fall in the fiscal and current account deficits as though these were signs of achievement.

“On the CAD, the budget speech says it will be contained below $45 billion. Today, 23 days before the end of the year, we can say confidently that the CAD will be contained at below say $40 billion,” Chidambaram crowed in early March. What he has actually ended up doing is reducing the deficits by killing growth.

But even this miracle is being achieved at a high cost: increasing external vulnerability.

India is becoming heavily indebted to foreigners. And this trend has been growing as the UPA prepares to leave office in May.

If all of India’s foreign lenders were to ask for their money back today, India will be able to return only 69 percent of it based on our current foreign exchange reserves. This is because we have been borrowing heavily from foreigners and non-resident Indians (NRIs) in dollars in order to increase our reserves and prevent the rupee from crashing.

According to figures released by the Reserve Bank last month, India’s foreign debt rose to $426 billion in December 2013, while its foreign exchange reserves were around $298.6 billion as in March 2014. For every dollar we owe to outsiders, we have only 69 cents in reserves. In 2009-10, our reserves were good enough to pay up the entire foreign debt - which shows that UPA-2 created all of our debt problems through economic mismanagement.

To be sure, a high level of foreign debt is not necessarily bad. If the money is going into investment, if it is helping build factories and infrastructure and creating jobs, it is good.

But this is not what the money has been borrowed for in recent months.

While the total debt increased from $402 billion to $426 billion in the October-December quarter of 2013, almost the whole of the incremental money came from NRI deposits ($23.8 billion). NRIs deposits are essentially bank deposits in dollars that earn interest. All this money came in because the RBI offered a “swap” arrangement to banks at a very low cost for three years. A swap means the RBI will buy dollars now from banks which raise deposits, and then sell the dollars back to them when the deposits fall due at a predetermined price.

Banks happily raised NRI dollars since these are low-cost deposits compared to domestic deposits. A three-year dollar deposit with the State Bank pays less than 3 percent interest, while fixed rupee deposits earn 8.5-9 percent, depending on tenure. Add the swap rate of 3.5 percent offered by the RBI, and the total cost of these NRI deposits is less than 6.5 percent.

Why did the RBI do this? Basically, because the rupee was falling last year (touching nearly Rs 70 to the dollar) and its foreign exchange reserves were being depleted. So, to reassure investors that it can pay back foreign debt, it borrowed more dollars to show high reserves.

There is a price to pay for showing “reserves” that are really only additional borrowings from NRIs. Three years later, this money has to be repaid, and even otherwise, India will have regular outflows on other forms of short-term debt. For example, in 2014, India will have to repay nearly $100 billion of short-term debt.

However, even this situation does not tell the full story. Beyond debt, there are hot money flows that have come into India over the last two decades. As at the end of December, foreigners had invested $177 billion in equity and government debt ($132 billion in equity and the rest in debt), and this money can leave almost instantly. Reason: the stocks can be sold in the share markets, and the debt can be sold in the money market.

Of course, this won’t happen unless there is some kind of panic about the Indian economy. Moreover, even foreigners know that if all of them sell, the share market would crash - which will ruin their own profits. So there is no likelihood that they will all sell at the same time or in a hurry.

But we need to be clear that UPA has made the Indian economy more vulnerable to foreign hot money flows. We have become both heavily indebted to foreigners and dependent on their money to keep stock prices high.

The next government, presumably one headed by Narendra Modi, will have to try and reduce this vulnerability.

(Parts of this article first appeared in Dainik Bhaskar)