All is not well with India’s external account. True, there is no crisis just around the next corner, but trade and current account deficits are at levels not seen since the crisis year of 1991. Foreign capital is being pulled out of the stock market. And the rupee has been dropping against the dollar despite the recent dollar sales by the Reserve Bank of India.

The overall balance of payments (BoP) surplus for the first quarter of the current fiscal year—April to June—is a modest $2.2 billion; it was a healthy $25 billion in the last quarter of the previous fiscal year. Given the fact that the trade deficit has widened further in August and foreign investors continue to sell in the local stock market, we could end up with a far worse situation in the quarters ahead—perhaps even a BoP deficit.

Illustration: Jayachandran Nanu / Mint

The portfolio flows have now suddenly reversed thanks to the global credit crisis. The first warning signs came in the fourth quarter of the last fiscal. Portfolio flows had turned negative (-$3.7 billion). In the first quarter this fiscal, they dropped further to $4.2 billion.

The 1991 crisis occurred against a backdrop of high and negative trade balances. The Gulf war saw a drop in remittances from abroad and a sudden exit of non-resident Indian, or NRI, money from India. That unleashed the subsequent macroeconomic crisis. An external shock (such as a continued freeze in global credit markets) may cause the same problem again. The one big difference is that the Reserve Bank has ample foreign exchange reserves as insurance against potential BoP trouble. These are sufficient to cover 10 months of imports. This, however, is no reason for complacency. The warnings are pretty clear.India has limited potential to control damage due to portfolio flow volatility but it needs to control the runaway demand for oil that has been feeding the trade deficit.

Expensive oil or financial chaos: what’s a bigger threat to India? Write to us at views@livemint.com

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