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India's economy: What is external sector vulnerability?
In the past few years, since the 2008 global financial crisis, India's external sector has become increasingly vulnerable. The plunge taken by the Indian rupee recently is an effect of this perception of an increase in vulnerability.
What is external debt? External debt is the portion of its debt borrowed from foreign institutions. India's external debt has seen a stark rise in the last six years. According to data by the Reserve Bank of India, India's external debt stood at $390 billion as of March 2013, up 12.9% from $344.6 billion seen in March 2012. This amounts to 21.2% of the Gross Domestic Product (GDP) - used to measure growth - from 20.6% in December 2012.
External debt is calculated as a sum of its External Commercial Borrowings (ECBs), Foreign Currency Convertible Bonds (FCCBs) and also takes into consideration the country's trade bill. An inability to pay off its external debt may spark a crisis.
So far, India has been financing its debt by a surplus in foreign fund inflows. In the event of an unavailability of such capital flows, the country then turns to its foreign exchange reserves to finance its debt repayment.
Why has it shot up? A number of reasons have contributed to this rise. According to an assessment by the Reserve Bank of India, the increase in the total external debt in 2012-13 was primarily due to a rise in short-term trade credit. This means businesses are borrowing overseas due to near-zero interest rates prevailing in those markets. In India, interest rates are far too high. Besides this, many non-resident Indians are buying short-term Indian deposits to take advantage of interest rate differential in India and outside India.
"In terms of major components, the share of external commercial borrowings continued to be the highest at 31.0 per cent of total external debt, followed by short term debt (24.8%) and NRI deposits (18.2%)," the RBI said.
The widening of trade deficit - the net difference in imports and exports - on account of a higher import bill has also caused a rise in external debt. A depreciation in rupee has made debt costlier as it must be paid back in the same currency it was loaned in.
How will it impact the economy? A rise in external debt - especially short-term debt - increases a country's vulnerability to capital inflows. This is even more risky now as the US Federal Reserve has indicated a withdrawal of its bond-buying programme, which had led to influx of foreign funds into emerging markets like India. Foreign investors have thus moved their funds out of emerging markets, thus resulting in a net outflow of funds.
At such a time of volatility in global markets, analysts warn that financing will be a challenge for India. This will in turn put pressure on its forex reserves, which are now at its lowest levels since 1997, according to a report by Business Standard. The ratio of foreign exchange reserves to total debt dropped to 74.9% by end-March, down from 85.1% a year ago.
At a time when the rupee has depreciated to its all-time low against the dollar, the RBI needs sufficient forex reserves to stem the free-fall. A rise in debt, thus, puts pressure on the rupee too.
Inflow of funds into the country has moderated to $20.5 billion in the January-March quarter, according to RBI data. This is down from $31.8 billion seen in the December quarter. While this is still enough to fund India's current account deficit and still see a surplus of$2.7 billion, analysts say the recent outflow of foreign funds - which contributes 55% to India's capital account - indicates a major risk in the coming quarters.