An employee arranges Indian currency notes at a cash counter inside a bank in the northeastern Indian city of Agartala, Feb. 18, 2010.STRINGER/INDIA/Reuters
India's ballooning trade deficit means it has to run just to stand still. Without steady capital inflows, the currency will collapse. But without a steady currency, it is hard to attract foreign capital. The rupee's 19-per-cent fall against the U.S. dollar over the past year is worrying.
During most of the last decade, the current account deficit has been funded without great difficulty. Foreign direct investment, portfolio investments and about $60-billion (U.S.) a year of remittances have usually exceeded the shortfall in trade. India has accumulated around $300-billion of foreign currency reserves, equivalent to 17 per cent of gross domestic product.
But the annual trade gap has widened from $104-billion to $185-billion. At 3.7 per cent of GDP, the current account deficit is the highest since 1980, when the International Monetary Fund starting collecting data. High energy prices are the main culprit for the recent deterioration – oil accounts for two-thirds of the country's import bill. Of course, the blow would have been less painful if India had a stronger export sector.
The support of foreign investors is more necessary than ever, but New Delhi's mismanagement has discouraged them. Foreigners bought an average of $3-billion a month of Indian debt and equities in the first three months of 2012, according to the Securities and Exchange Board of India's website. So far in April, they have been net sellers of $403-million.
The currency's fall threatens to create a negative spiral. More expensive imports are inflationary and put pressure on corporate profits. Government subsidies of domestic fuel prices become more costly, adding to the fiscal deficit, which swelled to 5.9 per cent of GDP in the fiscal year that ended in March. Furthermore, the rupee's slide creates financial stress for Indian companies that have borrowed in dollars.
India's currency reserves provide a buffer. But if capital flows turn sharply negative the reserves could melt away quickly. And if investors start to believe that the rupee is a one-way downwards bet, they will race for the exit. Predictions of a declining currency – UBS suggested a further 6- per-cent fall last week – could prove self-fulfilling.