RBI's latest release on external debt reveals some interesting developments over the years. The total external debt in June 2014 was $ 450.1 billion, around $8 billion more than in March. How is one to view this number in the context of a growing economy in a globalised world, that offers opportunities to borrowers to procure funds at a lower cost, which has to be balanced with the macro-economic strength of the economy?
A ten-year analysis reveals that between FY04 and FY09, the average annual compound growth rate was 14.7% which remained stable at 14.5% in the next five years i.e. FY09 to FY14. Assuming this number to hold for the next five years too, which cannot be ruled out considering that the ECB and NRI routes are favoured sources of debt, this number could range between $800-850 billion by FY19, which is quite startling. Also, there would be repayments of around $175 billion within a year ($55 billion could be rolled back through NRI deposits) and another $100 billion over 3 years.
A useful ratio to gauge its severity is the forex reserves to external-debt ratio. This has changed from 100.2% in FY03 to 96.5% in FY09 to 68.7% in FY14 and 70.1% in June 2014. Therefore, debt has been increasing at a higher rate than our forex reserves and if this level crosses the $800 billion mark by FY19, our forex reserves would have to increase to approximately $550 billion while maintaining the two-third cover ratio. From a policy perspective, efforts have to be on making the balance of payments more robust, especially on the CAD front, with full support from other non-debt capital inflows.
The main causes of this increase has been due to the liberalisation policies pursued by RBI where companies have been allowed to access the international markets to raise funds which have come with the benefit of a good interest rate differential given the Fed's and the European Central Bank's quantitative easing and low interest rates. This, along with a relatively stable rupee till FY14, helped companies counter high domestic interest rates. The share of external commercial borrowings (ECBs) in the total debt is now 34%, compared with 27.8% in FY04 and 27.8% in FY09.
The second factor was NRI-based deposits, which have increased from $31.2 billion in FY04 to $41.6 billion in FY09 and then to $103.8 billion in FY14. The growth in the second period was 20%, while it was just 6% in the first. We aggressively garnered these deposits in FY14 when the RBI opened the swap window on FCNR (B) deposits; This brought in over $30 billion. Once again, the interest rate differential worked for banks to draw in cheaper funds which offered better returns to the overseas deposit holders.
The third factor is trade-credit, which rose sharply in the last five years by more than double, from $43.3 billion to $89.2 billion. This is directly related to the flow of trade which has been buoyant during the period when both exports and imports grew at healthy rates, though there was a slowdown in the last year. The so-called official flow of funds, through bilateral and multilateral agencies, has actually come down in terms of share in total from 41.1% in FY04 to 17.4% in June 2014.
Therefore, ECBs, trade-credit and NRI deposits are the three components that need to be monitored regularly. The NRI boost was a one-time shot and would probably not replicated to the same extent in future. The ECBs would need to be watched as these are bound to go up sharply in the coming days. The approach would be to monitor, though not curb, this flow as, in a globalised setting, companies should have access to all sources of finance. This is important since the funding gap in the country is high, as banks are subject to limits on provision of funds and the debt market is still not very active.
To counter the growth in external debt, the focus has to be on getting in more non-debt capital inflows and the needle once again points to FDI. FII flows have been active of late with an expected $35-40 billion on an annual basis. The preference has been 'equity' though the government has been trying to open the doors for 'debt' too. However, while there have been only 2 years when these flows were negative, they would still not be regarded as a strategic source of foreign exchange. Therefore, we need to work on the FDI side and get in committed funds so that the forex position becomes stronger. The government has already started work on this aspect and, hopefully, one would get to see the opening up of the retail and insurance sectors attracting many investors.
At the same time, the CAD needs to be kept under control and not allowed to cross the 2-2.5% mark. This means that growth in import of items like gold needs to be closely watched as well as other mining products which have tended to distort the CAD in the past. Also, the uncertainty around coal needs to be dispelled soon so that domestic activity can alleviate the situation.
Lastly, the exchange rate has to remain stable and, here, the onus is on RBIa volatile rupee will increase the cost of servicing debts. Therefore, the exchange rate is also a critical part of this story.
The PM's aggressive bid to attract foreign investors is, hence, very pragmatic. To use a clich�, there is very less room for complacency.
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