The gradual normalization of global output growth after the pandemic has been severely marred by rising food and fuel inflation, which the head of the International Monetary Fund (IMF) has described as a “clear and present danger” to the economy. ‘Mondial economy. The damage caused by the conflict in Ukraine has yet to be fully assessed as most economies, including India, are fervently hoping that a solution will moderate energy and food prices.
Governments tend to delay the full transmission of high energy prices to the consumer. It’s like a pressure cooker kept on full steam for an extended period of time. Small economies in South Asia and Latin America are already on the verge of a currency crisis as most are net importers of energy and food.
India, fortunately, has decent foreign exchange reserves, but they are gradually depleting for four consecutive weeks. The week ended April 9 saw central bank reserves fall by $11 billion to around $606 billion. The peak in RBI reserves was $642 billion in October last year. They fell by $35 billion in five months before the real economic impact of the war in Ukraine was felt.
India’s external sector may seem stable at present, but it should by no means be considered infallible. On the one hand, many economists are predicting a negative balance of payments for the current fiscal year. In recent years, India’s current account deficit has hovered between 1 and 1.5% of GDP (around $40 billion), which has been more than adequately offset by much higher foreign capital inflows― robust foreign direct investment and positive inflows of FII portfolios into the stock market. The pile of foreign exchange reserves grew bigger and bigger.
However, during this exercise, the equation has changed. Foreign investors are looking for a safer haven in US Treasuries. This situation is exacerbated by the progressive withdrawal by the Fed and the other central banks of the OECD from their policy of easy money. Remember that this easy money at near-zero interest rates has flooded India’s tech and green energy sectors in 2020-2021, adding massively to foreign exchange reserves. This honeymoon is almost over.
Capital inflows will slow sharply in 2022-23 and the trade deficit will almost double, following current trends. Due to high energy and commodity prices, Indian imports are growing faster than exports, widening the trade deficit. It peaked at $18.5 billion in March. Annualized, the deficit could potentially reach $210 billion.
Considering the approximately $90 billion in remittances that overseas Indians send home each year, the current account deficit could reach an all-time high of $120 billion, or about 3.5 to 4% of GDP. To be balance-of-payments neutral, India would need net capital inflows of this magnitude. Is it doable in the next 10 months, when most major central banks are withdrawing easy money? Most economists predict a negative balance of payments.
For example, if India needs $120 billion to cover its current account deficit but receives only $50 billion in net capital inflows, the remaining $70 billion must be taken from RBI reserves. It seems certain that India’s foreign exchange reserves will be depleted over the next 11 months. The problem is that negative sentiment can accumulate to spur capital flight, like a self-fulfilling prophecy.
For example, the RBI may still have enough foreign exchange reserves after closing the balance of payments deficit, but the currency could still come under attack and more reserves may need to be deployed to support it.
In such situations, trust can be eroded and other risk factors start to look very worrisome. For example, India’s short-term external debt on a residual maturity basis (debt securities which include long-term debt by original maturity maturing in the next 12 months and short-term debt maturing in less than one year) amounted to 41.8% of external debt foreign exchange reserves at the end of June 2021. Thus, around 250 billion dollars of short-term debt must be repaid by June 2022.
Foreign exchange reserves may need to be deployed to pay off some short-term debt maturing until June 2022, if it cannot be rolled over. Much of this debt is normally rolled over, but after Ukraine, terms are anything but normal.
The IMF said the state of the global economy could lead to “complex political trade-offs” making the political landscape very complicated. A clear trade-off is that even if the external sector is under pressure and requires a reduction in essential imports, it has its limits because poor and vulnerable populations must be catered for. We see it in Sri Lanka, Peru, Nepal, Pakistan, Afghanistan, etc.
No country, especially in the middle-income bracket, is completely immune to this. India’s fundamentals look better today, but keep an eye on the balance of payments situation, which tends to decline every 10 to 12 years.