India Insight:A review of India’s external vulnerability

India is less vulnerable to external risks but is not immune.

We believe India’s external vulnerabilities have moderated since the 2013 taperepisode on policy initiatives and the building of possible buffers against externalshocks. The current account deficit (CAD) has narrowed sharply from the peakof 4.8% of GDP in FY13 to well within the sustainable level at 1.4% of GDP inFY15 and is expected to remain contained over the next two years on lower oiland gold prices. The capital flows have been buoyant even though financing mixin favour of stable FDI flows could be improved upon. The foreign exchangereserves have also increased to an all-time high of US$356bn as of Jun-15 andseem adequate to withstand volatility in the case of global risk aversion.

External vulnerability indicators remain stretched but haveimproved considerably over the past two years.

While external debt increased by US$66bn between FY15 and FY13, forexreserves were up by US$50bn during the same period, suggesting that externalbuffers are being created. Forex reserves cover 72% of the external debt as ofFY15. The ratio of short-term debt (original maturity) to forex reserves hasreduced to 25% vs. 33% in FY13 but remains higher than 19% registered fiveyears back. The import cover for reserves stood at 9 months as of FY15, muchbetter than 7 months seen in FY13 but lower than 11 months seen as of FY10.

At the same time, foreign holdings in the government bond market remain low inIndia at less than 2% of outstanding stock versus some other Asian economieslike Indonesia (39%), Malaysia (31%) and Thailand (17%), thus limiting theadverse impact of any turmoil in the US bond market on a relative basis.

Modest depreciation bias in USD/INR in the short term.

According to our estimates, the Indian rupee is trading within the +/-1 standarddeviation band on a 36-currency trade weighted real effective exchange rate(REER) basis though slightly on the higher side. In the event of the Fednormalising interest rates (likely in Sept-15), we do see scope for USD/INRweakening by ~3-5% in the short term from the current levels of ~64. However,we expect US$ strength to fade later this year as markets price in gradual hikesfrom the US Fed after the initial euphoria, thus stabilising that rupee in the 64-65range over the year end. We expect the RBI to let the currency depreciate in theshort term while intervening in the forward and spot market to manage the neartermvolatility for a favourable transition. The policymakers should also look forincreasing the bilateral and multilateral swap lines with trading partners and/orwork out on measures to attract NRI deposits to curb volatility.

Despite slow recovery on the ground, economic prospectsremain good.

Even as the Indian economy has stabilised, the pace of recovery on the groundhas been quite gradual. While there are some green shoots emerging as seen inthe case of public capex, overall investments are yet to bounce backmeaningfully. Consumption, especially in rural areas, has slowed significantlyand exports continue to remain a drag on weak global growth. Whilst theeconomic recovery is getting delayed, we remain optimistic about the Indianeconomy’s growth prospects in the medium term. We believe the governmentshould work toward building a consensus so that critical bills like GST and theland acquisition bill could be passed quickly.