Losing the balance

Fixing exchange rates only tackles the symptoms of the brewing BoP crisis

Last week, the RBI released the latest balance of payments data for India. This data highlights the grim economic situation faced by the country. Unless corrective steps are immediately taken, the problem could quickly turn into a bigger disaster. It could mean further rupee depreciation, stress on balance sheets of companies who have borrowed in dollars, a higher import bill, difficulties for banks whose clients have borrowed in dollars, higher inflation as the price of tradables rises, and capital flight from India.

The data shows that for the year 2011-12 India ran a current account deficit of 4.2 per cent of the GDP. This is the first time India has run such a large current account deficit. It means that India overspent to the extent of $78 billion during the year. In the last quarter of the year, from January to March 2012, the current account deficit had risen to 4.5 per cent of the GDP. In these three months alone, India overspent to the tune of nearly $22 billion. The main sources that financed this overspending were portfolio flows of $14 billion and dissaving through depletion of reserves by $5.7 billion. In the coming quarters we cannot expect these two to be the stable sources to fund our overspending.

Many observers argue that FDI is a stable source of funding. But during the period in which there has been a crisis in international banking and poor investment sentiment, and lack of FDI-related reforms in India, many foreign firms have pulled money back. In recent years, foreign firms repatriated money from India. This reached a high of $10.7 billion in 2011.

The above data is till March 2012. The period April to June 2012 has been equally difficult. Although the balance of data for this period is not available yet, the volatility in the exchange rate market reveals the supply demand mismatches in the foreign exchange market. What happens to the rupee may be good for some and bad for others, but that is only part of the story. A sharp depreciation gives us information on how the economy is behaving. It tells us what investors feel about the country. It informs us about how households and firms value Indian assets.

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