These reserves were accumulated by way of capital inflows, including borrowings. There are liabilities against these reserves. And liabilities come with an expiry date.
India’s external debt grew by 2.7x over last 12 years on higher commercial borrowings and short-term trade related borrowings. This has resulted in India’s external debt to forex reserves ratio to decline (become adverse).
While India appears to be covered when it comes to short term debt, forex reserves are only to the extent of ~80% of total external liabilities.
Meaning, if it had to pay all its liabilities today, India does not have adequate reserves to pay all of them.
![](https://d3ab4qsk6phbuk.cloudfront.net/app/uploads/2022/01/Reserves-to-external-debt.png)
![](https://d3ab4qsk6phbuk.cloudfront.net/app/uploads/2022/01/External-debt-breakup-Sep-19.png)
Below table gives India’s foreign exchange liabilities coverage. As at Dec-19, it had only twice as much reserves to cover its short-term liabilities.
![](https://d3ab4qsk6phbuk.cloudfront.net/app/uploads/2022/01/Maturity-of-Indias-external-debt_v2.png)
India lost some of its forex reserves during March-20, but subsequently appears to have regained it during April and May of 2020 because of lower oil prices and trade deficit.
However, this repayment schedule brings out a vulnerability with respect to India’s dependence on short term money.
Structural problem of INR
INR remains a structurally depreciating currency as of now. India remains a net importer of goods and services that are offset by capital inflows.
![](https://d3ab4qsk6phbuk.cloudfront.net/app/uploads/2022/01/INRUSD-Currency-Price-from-73-to-20.png)
The issue with India is partly structural and can be seen from the real interest rate differential with the US (red line in below chart). Over the long term, it has averaged near 0% i.e. real interest rate in India is same as that in US over long term!
India receives large amounts of FII, FDI and NRI deposit flows to balance its net imports and build forex reserves. Large proportion of that came in post 2013/14, when the real interest rate differential was positive, and India promised a “growth story”. With real interest rates turning negative and GDP growth slowing down, capital flows especially FPI’s can be a risk.
![](https://d3ab4qsk6phbuk.cloudfront.net/app/uploads/2022/01/India-minus-US-real-interest-rate-differential.png)
Long term real interest rate differential with US near 0% also probably tells us that over long term, India has attracted foreign capital for its high GDP growth rate potential.
This also tells us about India’s structural inflation problem that surfaces in some years. India’s inflation differential with US has stayed high at 4.4% over long term (has started to rise again now). This inflation problem is rooted in its sustained fiscal deficit. Basically, government is taking resources and not paying adequately for that from savings, resulting in inflation spurts every few years. A borrower cannot support high real interest rates to attract capital if the productivity (low) does not compensate for the high real rate!
For a trade deficit country like India, foreign capital can be attracted structurally by way of improving productivity. Investments chase improved productivity. Higher output at lower input costs. If an economy has high productivity, high interest rates, are sustainable attracting people and capital. There is some evidence of countries like Taiwan, South Korea, Thailand, etc. being able to do it and have high real rates. Maybe we will try to dig a little deeper in this area in a separate follow up piece.
But for now, we should expect things to remain the same. We may get occasional INR appreciation when some input factors aiding INR (like lower oil prices) excite market participants. But the larger trend for INR remains that of a depreciating currency. We can expect government policies directed towards attracting foreign capital to balance its foreign exchange reserves to give it.
financial flexibility, especially during a time of US$ shortage.
To conclude…
- INR remains a structurally depreciating currency at this point. It remains a net importer of goods and services to support its growth, that are offset by capital inflows.
- A large amount of capital inflows is by way of US$ borrowings. In negative real interest rate scenario, attracting and rolling over forex borrowings can be a risk.
- Low/slow growing economy also poses a risk with respect to FII-Equity and FDI flows into India.
- Currently, India has adequate reserves to meet its short-term obligations (~52% of reserves held). Coverage is only ~80% of total foreign exchange obligations giving it vulnerable to capital flight from past FPI investments. This ability has deteriorated over a period. INR therefore remains dependent upon incremental flow of US$ loans and investments to support a higher growth rate that is not matched by domestic financial savings.
- Over near term, important indicators to monitor will be the trade and services deficit, NRI deposits and FII flows in equity and bond markets.
Annexure:
INR India Balance of Payment break up: