The global economic scene is getting cloudier by the day and international investors continue to pull out money from the Indian stock market. Should we begin to worry?
India needs global capital inflows to bridge its current account deficit, or the gap between its total exports and total imports. The Reserve Bank of India (RBI) said last week that the excess of capital inflows over the current account deficit --- or what is called the balance of payments surplus --- was $5.4 billion in the first three months of FY12. The current account deficit in the quarter was 3.4 of gross domestic product (GDP).
Also See | Declining Ratio (PDF)
The current account deficit will likely remain high through the year, despite some relief from lower global oil prices. In a recent report, Citi predicts that the Indian central bank may even have to dip into its foreign exchange reserves to fund part of the current account gap.
There is a problem here, however. RBI has stayed clear of the foreign exchange market over the past few years, reportedly intervening only a few times to curb sudden bouts of volatility in the value of the rupee. In other words, it has not bought too many dollars. So the foreign exchange reserves pile has not kept pace with the growth in imports.
The number of months of imports that can be bought from the forex hoard is a standard measure of the adequacy of such reserves. The news here is not good. The import cover is just 7.58 for months, the lowest level in a decade. The number was almost double this in the months before the global financial crisis of 2008.
India has been using volatile capital flows to fund its current account deficit. In case the global economy continues to deteriorate, then such capital flows would slow down to a trickle. The strength of our reserves could then be tested.
Some long-term action is needed. Steps should be taken to keep the current account deficit within a manageable 2.5% of GDP. In order to not face any problems in financing this deficit, India should do more to attract more stable foreign direct investment, keep inflation down and fix the fiscal problem, while maintaining growth at 8%.2.