India received its highest Net FII inflows ever in 2012-13. But, this is a frightening question. Raised by Crisil Research it goes on to ask: What if the big river of inflows dries up? It’s a question that not many will have an answer to. Yet, these foreign inflows are the only aspect that is much relied upon by the Indian economy, especially in these times when the global economy continues to struggle and the fears of currency corrections remain large.
Bringing attention to this fear, Crisil goes on to say “If the river flows, life flourishes. If capital inflows flow, the currency fares well.” This is especially true when large inflows are required to fund the ballooning current account deficit (CAD) of a country. While India’s current account deficit hit a record high of US$ 32.6 billion (6.7 % of GDP) in October-December 2012, capital inflows were sufficient to cover the deficit. As a result, the rupee did not depreciate during Q3FY13 relative to the previous quarter.
But while exports have begun to recover, high import requirements, especially energy imports imply that the demand for US dollars will remain high in 2013-14 as well. Hence, believes Crisil, “India will need the river of capital inflows to continue and provide support to the rupee. We believe that if the domestic reform momentum continues, India should be able to attract sufficient inflows to cover its CAD in the next fiscal. If however, there are any signs of a global economic drought, capital flows can dry up suddenly resulting in a temporary, but a sharp depreciation of the rupee.”
Already, CAD has surged in Q3FY13 on the back of a record merchandise trade deficit of US$ 59.6 billion (12.3 % of GDP). While exports grew at 0.5 % compared to a year ago, a strong growth in oil and gold imports increased imports by 9.4 %. A sustained increase in trade deficit, says Crisil, tends to indicate a wider structural weakness in the economy – a high level of import demand combined with a loss of export competitiveness.
Moreover, India’s Net FDI inflows fell to US$ 2.5 billion in Q3FY13 from US$ 8.9 billion in Q2FY13. In contrast, net portfolio investment rose to US$ 8.6 billion in Q3FY13 as against US$ 7.6 billion in the previous quarter. As per SEBI data net FII inflows have rose further to around US$ 12.0 billion in Q4FY13. This suggests that India received its highest net FII inflows ever in 2012-13, despite domestic economic slowdown. Given the volatility of these inflows, dependence on FII inflows for funding high CAD exposes the economy to a sudden decline in rupee.
More so because, with the surge in the import bill, India’s import covers (in months) of foreign exchange reserves has fallen steadily in the recent years. With reserves of around US$ 297 billion at end-December 2012 the import cover has fallen to around 7 months as against over 11 months in March-2010.
Internationally, 3 months of import cover is deemed necessary as a protection against an external shock.
What happens if the exchange reserves fall further? As of now the situation is under control. But if the inflows reverse, the economy could be in trouble; deep trouble. Let’s keep our fingers crossed!