Since then, India’s economic fundamentals have indeed shown signs of improvement, with inflationary pressures ebbing, and the stress on our balance of payments easing. RBI has also been able to build up currency reserves over the past year. Yet, there is one big hole in India’s national balance sheet which has remained unaddressed: rising external debt.
The turbulence in currency markets this week reflects increased investor anxiety over our external debt vulnerabilities at a time when global liquidity growth is slowing, and India’s economic recovery is still looking fragile. Recent economic data show India’s industrial output has collapsed, and the trade deficit has widened to its highest levels in 18 months. These depressing data releases have added to the volatility in Indian markets.
But it is the fear of receding global liquidity that has led stocks and currencies to tumble globally. The panic sell-off in emerging markets ahead of a US Federal Reserve meeting, widely expected to signal the fate of future monetary tightening, bears an uncanny resemblance to the rout emerging market currencies faced in the summer of 2013, when fears of monetary tightening or tapering had first surfaced.
The most credible explanation of the taper tantrum of 2013 comes from the head of research at the Bank of International Settlements (BIS) and the former Princeton University scholar, Hyun Song Shin. Shin traces the roots of taper tantrum to the foreign borrowing binge of emerging market corporations. Through inter-corporate transfers and cross-border bank deposits, non-financial firms in the emerging world have been replacing banks as the key conduits of capital flows across the world. But by financing local investments through dollar-denominated bond issuances, these corporations have contributed to massive currency mismatches.
In essence, emerging market companies have taken on a carry trade by financing local assets with apparently cheap dollars. So far, the arrangement has suited both purchasers of emerging market corporate bonds, who desired higher yields in a low-yield environment, and the issuers, who have received access to cheap finance. But the turning tide of global liquidity can prove lethal for such trades.
Given the scale of currency and risk mismatches involved, even a slight indication of monetary tightening is enough to cause turbulence in global markets. Recent research by Shin and his colleagues at BIS show companies from India and China have been among the most aggressive in using such channels to finance local investments.
Typically, Indian companies use their offshore arms to issue debt instruments abroad, and then transfer such proceeds to the parent entity onshore. Such transactions are usually not reflected in our official debt positions, leading to an under-appreciation of the gravity of the problem. Our official debt statistics are themselves worrying. According to RBI data, India’s external debt-to-gross domestic product (GDP) ratio has steadily risen from 18% in 2010-11 to 23% in 2013-14, surpassing the pace at which forex reserves have grown.
The increase has largely been fuelled by rising corporate borrowings. But these numbers are likely to be gross underestimates of India’s true external vulnerability. Research by BIS economists shows the gap between official debt figures and the actual foreign exposures of companies has grown since 2010 in a number of emerging markets including India.
The overseas borrowing binge of Indian companies is one of the foremost economic challenges facing the country. Many firms have abandoned hedging altogether, just to save costs. Others have made innovative use of loopholes in foreign debt regulations to raise money through related offshore entities.
Such corporate myopia poses a great risk to India’s financial stability. RBI has been slow to wake up to the gravity of the problem. It must act resolutely now, in concert with the government, to plug the big hole in India’s national balance sheet.
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