India’s External Sector is on the Brink of Vulnerabilities

A serious threat to the external sector of India, is leading to an increased vulnerability in India’s forex reserve. Since India is heavily dependent on middle-eastern nations for its oil and other essential commodities like coal, it is severely hit whenever prices goes up. India is currently standing at USD 23 billion current account deficit (CAD), which, by the way, is at a nine year high.

Foreign portfolio investors (FPI’s) have also pulled out a significant amount of money from the Indian capital market over the last six months. One possible reason is the hike in the interest rate in the US, which is leading to withdrawal of FPIs from the Indian market.

On top of that, the continued uncertainty with geopolitics pertaining to Russia-Ukraine war, and the spike in the Covid-19 cases is adding fuel to the fire. In the last few months, the Reserve Bank of India (RBI) highlighted these external vulnerabilities as a threat to India’s export sector and took several steps to mitigate it. Despite managing the volatility of the rupee, the external sector is still facing pressure in current and capital accounts of the country.

At present, India has a chronic current account deficit problem, mainly due to the issues mentioned above, and the deficit gap is only increasing. Even after having a high capital inflow over the years that has allowed India to finance its CAD to build up a sizable foreign exchange reserve, the equilibrium has been disturbed in the last two quarters due to the increased pressures on the balance of payments (BOP) front.

Foreign portfolio capital inflow, which has a huge chunk of foreign investment in India, has also turned negative. Additionally, foreign direct investment (FDI), which acts as a steady source of capital for the country, has also witnessed a slowdown in the last couple of months. According to IVCA-EY report dated April 12, pure-play Private equity/Venture capital (PE/VC) investments were recorded at USD 14 billion in January-March 2022, which is 36 per cent lower than in October-December 2021.

These are several factors that has led to an unfavorable economic condition for the external sector in the country, leading to a sharp decline in the forex reserves. In the last quarter, India has lost around USD 30 billion worth of forex reserves. In April, the total forex reserve came down to USD 604 billion from USD 633 billion.

Despite being listed in the top ten countries with the highest foreign exchange reserves, India’s forex reserve is structurally different from other countries as it is made of foreign capital inflows, making it more vulnerable to the threat of a sudden exodus of foreign capital. The RBI needs to step up to control any undue/short-term volatility of the rupees.