India’s external debt has doubled from levels of USD 224 billion seen in 2008 to levels of USD 440 billion as of end March 2014. In terms of fx reserves, external debt as % of fx reserves has deteriorated from 72% of reserves to 140% of reserves as fx reserves have hardly moved from USD 304 billion seen in 2008 to USD 310 billion as of March 2014. Deterioration in levels of external debt as % of fx reserves is a worry when there is capital flight leading to a sharp fall in value of the Indian Rupee.
In fact the INR has depreciated from levels of Rs 40 to the USD as of end March 2008 to levels of Rs 60 as of end March 2014, a fall of 50%. A good part of this fall can be explained by India’s deteriorating external debt position. Ratio of external debt to GDP has moved up from levels of 18% to 23.3% in the 2008-2014 period. Ratio of short term debt to foreign exchange reserves has moved up from 14.8% to 29.3%.
In terms of major components of external debt, commercial borrowing and NRI deposits form 33.3% and 23.6% of total external debt. India has been witnessing rising external commercial borrowings and more flows from NRIs. In fiscal year 2013-14, FCNR B deposits of USD 26 billion accounted for most of the USD 33 billion inflows from NRI deposits. RBI had opened a FCNR B swap window for banks in September 2013 to attract FCNR B flows to prevent INR depreciation. (Read our analysis on FCNR B swap window).
Short term debt of residual maturity of less than one year stood at 39.6% of total external debt as of March 2014 against 42.1% as of March 2013. Elongation of external debt maturity is a good risk prevention practice to protect the country from capital flights in times of stress.
India clearly requires to build up foreign exchange reserves to prevent wide fluctuations in the INR in times of global volatility in market.
Tutorial on External Debt
Build up of external debt in fast growth economies is accompanied by a rally in asset and currency markets. However when external debt becomes unsustainable, the repercussions are severe with economic contraction and sharp fall in asset and currency values. Over the years, the boom bust cycle led by external debt has panned geographies. South America in the 1980’s, South East Asia in the 1990’s and Iceland in the 2000’s. The build up of external debt of a country leads to an asset boom as foreign money seeking high returns go into speculative asset classes. When the asset bubble bursts, the foreign money tries to find its way out of the country leading to panic selling of assets. Central banks have grappled with external debt problems and have resorted to various methods including sterilisation of flows, taxes on flows and capital controls. Some of the methods adopted by central banks have worked and some have not but the underlying rise and fall in asset prices have not been contained.
What is external debt?
External debt is the money owed to non residents in the form of interest and principle payment. Debt securities including bonds and money market instruments, deposits, loans and advances and trade credits are forms of external debt. External debt is categorised into long term and short term. Long term external debt is any debt that has maturity of one year or more while short term external debt is any debt that has maturity of one year or less.
Trade credits, money market securities, short term loans, foreign currency deposits and debt/loans with residual maturity of one year and below are all categorised as short term debt.
How to look at external debt?
External debt is looked at in terms of external debt to GDP ratio, net interest payment to GDP ratio, short term external debt to total external debt ratio and external debt to foreign exchange reserves ratios. The higher the ratios the higher the risk an economy is running if there is a run on the currency. The external debt indicators for all the countries that suffered crisis have been at higher levels.
The South American debt crisis in the 1980’s saw external debt to GDP ratios for the countries in the region rise by multi fold times. South American countries defaulted on their external debt due to the sharp rise in debt levels.
The South East Asian crisis in the 1990’s saw countries in the region devaluing their currencies and imposing capital controls to stem the crisis of capital outflows. Countries such as Thailand, Malaysia, Indonesia, Korea had all seen their short term external debt to total external debt ratios rise significantly to over 60% and when capital started moving out the countries found it impossible to service the short term debt.
Iceland, which was affected by external debt crisis in 2008, saw its external debt go over 1000% of GDP and its net interest payments on debts go close to 20% of GDP. Iceland had to be bailed out by the IMF as it faced an economic collapse due to the burden of its external debt.
All the crisis ridden countries had external debt much higher than foreign exchange reserves.
What are levels of external debt ratios to get worried about?
There is no single threshold level of external debt that signals destabilising signs. A research done by BIS (Bank of International Settlement) shows that net external debt higher than 50% of GDP and net interest payments higher than 3% of GDP are levels to worry about. The lower the short term debt to external debt ratio the better as there is less pressure on a country to depend on capital flows to service short term debt. Short term debt at over 50% of total external debt will exert pressure on the country’s ability to service the debt. Foreign exchange reserves should be able to cover a few months of imports as well as repayment of short term debt.