Is Manmohan taking us back to the 1991 external mess?

India is on its way to another debt-induced crisis - if it does not watch out.

On Thursday, the government raised the investment limits for foreign institutional investors (FIIs) in government and corporate bonds by $5 billion each - raising the ceiling from current levels of $10 billion and $15 billion, respectively.

The reason: with the rupee tanking against the dollar (over Rs 51 at last count), and with FIIs not investing in equity, debt is the only option left to bridge the gap in capital flows created by our high import bills. Our current account deficit (CAD), the gap between our external incomes and inflows and our expenditures and payments to foreign parties, is now upwards of 3 percent of GDP - and this gap can only be bridged by capital inflows in the short run.

Given the interest rate differential between western economies and India, this is like giving FII hot money flows a free run in India precisely when our external front is looking extremely vulnerable and can't handle these dangers.

Taken together with the $25 billion limit for investment in infrastructure bonds, and the $30 billion in external commercial borrowings (ECBs), not to speak of foreign currency non-resident Indian (FCNR) deposits with banks, India has essentially offered FIIs and foreign lenders a $90 billion debt investment option - a Rs 4,60,000 crore hot money red carpet.

But that isn't our only vulnerability. As on 17 November 2011, India had another $102 billion of FII money invested in equity - money that can flow out in the wink of an eye. The only think preventing that is the falling rupee - which means they have to take losses on exchange rates even to exit equity.

If there is one lesson the 2008 crisis and the current ongoing euro-drama should have taught us, it is to shun dangerous debt.Reuters

Put another way, at current exchange rates, we are sitting on $102 billion of FII investment in equity, and a potential $90 billion of FII debt - which amounts to a near Rs 10,00,000 crore vulnerability to the whims and fancies of foreign capital when foreign capitalists are themselves at their most skittish.

Given the serious crisis in the eurozone, and the likelihood of banks and governments having to take hair-cuts and losses on sovereign debt (Greece, Italy, etc), and also given the fact that the US may force its banks to recapitalise to reduce their vulnerability to defaults, the probability that capital will be pulled out of emerging markets - including India - is rather high in the coming months.

So what is the big idea in opening up our debt markets further to FIIs?

The government has already indicated that it may ease the $30 billion limit for ECBs, and the lock-in period for FII investment in infrastructure has been reduced to one year. This is like an open invitation to volatile flows instead of seeking the longer-term - and more stable - foreign direct investment.

If there is one lesson the 2008 crisis and the current ongoing euro-drama should have taught us, it is to shun dangerous debt.

India, due to the bankrupt policies of a government excessively committed to populism, is essentially putting off the day of external reckoning by easing up on external borrowing - in government, corporate and other instruments.

Moreover, our problems are not that far away - they may surface as early as next year. Ritesh Jain, writing in Business Line, pinpoints two key threats: the high value of debt maturing next year, and the declining foreign exchange cover to buy our imports.

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He says: "...A much worrying fact is that the total external debt maturing within the next one year, short-term and long-term debt (with residual maturities of less than one year), is about $137 billion as of June 2011, constituting about 43.3 percent of the aggregate external debt - one of the highest witnessed in the last decade, and 43.5 percent of India's total foreign currency reserves."

He says the import cover is narrowing. Our monthly imports are in the range of $35 billion. This means our $314 billion of exchange reserves are enough to finance just 8-9 months of imports. Of course, exports will help us meet part of the bill, but import cover is an important indicator of future vulnerabilities. This level of cover is "the lowest in the last decade," says Jain.

The wolf is already at the door. Between now and December 2012, over $5.6 billion of foreign currency convertible bonds (FCCBs) will fall due for redemption, says The Times of India. European banks, which were major lenders to Asia and India in the recent past, will be unwilling to roll over debts falling due because of their own capital needs.

Our foreign exchange reserves fell last week by $5.7 billion - thanks to the Reserve Bank's interventions to stem the rupee's fall and other outflows. At a time like this, the Centre is talking about creating a sovereign wealth fundto invest in energy assets abroad when the forex cupboard is developing a sizeable crack.

If the UPA government does not reverse its short-term preference for debt flows, it is going to land us in a bigger external mess than what Manmohan Singh rescued us from in 1991. A huge build-up of foreign debt and declining reserves was what got us into the 1991-92 mess, when we had to mortgage our gold to borrow. Manmohan Singh's government is leading us back there.