Contracting external debt financing

Lone measures to attract short-term debt financing will only deliver short-term benefits

India is to raise caps on foreign institutional investment (FII) in bonds and expand resident firms’ access to overseas borrowings, according to recent reports. This follows a series of easing restrictions on foreign borrowings and deposits by non-resident Indians, measures to boost foreign capital and finance the current account deficit that remains at unsustainable levels. Last year, its unstable, capital account financing dried up followed by a steep, sustained depreciation of the rupee.

Demand management, viz. gold import tariffs and a belated, partial diesel price adjustment, has coupled financing efforts, but is inadequate for the extent of required adjustment and has had temporary impact. Import appetite has returned, the trade gap is expanding once more, and the trend deterioration of the current account looks set to persist this year. The situation, never really out of the mini-crisis, is wobbly again.

Policy responses have chiefly addressed the imbalance from the financing side, especially seeking foreign capital of a certain genre—short-term, debt-creating inflows—where the headroom for liberalization exists, but which increases vulnerability to “sudden stops" like last year, apart from adding to the stock of debt. Worryingly, it fails to heed trends of recent years and neglects to recoup export competitiveness. Consider that:

1. India’s net international investment position, which reflects the external balance sheet (as opposed to balance of payments that record external transactions on flow basis) shows a sharp rise in external indebtedness—from 4% of gross domestic product (GDP), end-March 2008, to 14% of GDP at end-March 2012. The trend suggests that macroeconomic plans are fast becoming unviable from not just a “flow" perspective, but also from a stock point of view. FDI liabilities are the major drivers, rising 10 points to 33% of GDP by March 2012.

2. Inward-FDI is concentrated in the non-tradable segments, failing to reach the export-oriented industries. Given the sharp increases in foreign borrowings for infrastructure and other non-tradable sectors, this foretells future stress in the balance of payments: debt-service obligations are mounting; offsetting foreign resources are not being generated.

3. Despite the exchange rate adjustment, expenditure-switching effects to shift production between tradable and non-tradable sectors are unobserved: widening trend of the trade deficit—7% of GDP, March 2008 to 10% at end-March 2012 and a likely 12-13% of GDP in the current quarter—persists.

4. High external, private sector borrowing abroad coupled with declining reserves to short-term external debt ratio is a sign of macro imbalances spilling over: high government borrowing at low-costs has effectively shifted risk on to private balance sheets—through currency, maturity and other risks—with cascading effects on other sectors.

In this light, lone measures to attract short-term debt financing will only deliver short-term benefits, at the risk of creating unsustainable, future debts. Even if a persistently large current account deficit can be financed so in the short-run, a sharp, medium-term correction cannot be ruled out, as witnessed last year. Equally, it is risky to base policies on the assumption of real appreciation from a “catch-up" perspective: it may be possible to sustain relatively large stocks of debt in the medium-term, but eventual correction could be very costly.

Contracting external debt has to follow some basic principles: the idea of running current account deficits is consumption-smoothing to tide over a temporary shock or, in a growing economy, to finance productive activity through increased investments. In the former, external liability is kept short-term and restricted; in the latter, the country acquires capacity to generate foreign-exchange resources to pay off future obligations. India seems to be doing nothing close to that.

Renu Kohli is a New Delhi-based macroeconomist; she is currently Lead Economist, DEA-ICRIER G20 Research Programme and a former staff member of the International Monetary Fund and Reserve Bank of India.