External Sector Vulnerability - The Indian Economy

In the past few years, since the 2008 global financial crisis, India's external sector has become increasingly vulnerable. The plunge taken by the Indian rupee recently is an effect of this perception of an increase in vulnerability.
About External Debt
External debt is the portion of its debt borrowed from foreign institutions. India's external debt has seen a stark rise in the last six years. According to data by the Reserve Bank of India, India's external debt stood at $390 billion as of March 2013, up 12.9% from $344.6 billion seen in March 2012. This amounts to 21.2% of the Gross Domestic Product (GDP) - used to measure growth.
This composes of various bonds (like FCCBs) and borrowing (like ECBs). An inability to pay off its external debt may spark a crisis. So far, India has been financing its debt by a surplus in foreign fund inflows. In the event of an unavailability of such capital flows, the country then turns to its foreign exchange reserves to finance its debt repayment.
Why has it shot up?
A number of reasons have contributed to this rise. According to an assessment by the Reserve Bank of India, the increase in the total external debt in 2012-13 was primarily due to a rise in short-term trade credit. This means businesses are borrowing overseas due to near-zero interest rates prevailing in those markets. In India, interest rates are far too high. Besides this, many non-resident Indians are buying short-term Indian deposits to take advantage of interest rate differential in India and outside India. The widening of trade deficit - the net difference in imports and exports - on account of a higher import bill has also caused a rise in external debt. A depreciation in rupee has made debt costlier as it must be paid back in the same currency it was loaned in.
Impact
A rise in external debt - especially short-term debt - increases a country's vulnerability to capital inflows. This is even more risky now as the US Federal Reserve has indicated a withdrawal of its bond-buying program, which had led to influx of foreign funds into emerging markets like India. Foreign investors have thus moved their funds out of emerging markets, thus resulting in a net outflow of funds. Financing would be a challenge in India. This will in turn put pressure on its forex reserves, which are now at its lowest levels since 1997.
At a time when the rupee has depreciated to its all-time low against the dollar, the RBI needs sufficient forex reserves to stem the free-fall. A rise in debt, thus, puts pressure on the rupee too.

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The Myth Surrounding Safe Investments

Financial media tends to re-define 'safety' of asset classes every time there is a change in market sentiment. Prior to the financial crisis of 2008, even derivatives were sold as safe investments. Ironically the weapons of mass destruction have only made the case for so-called safe investments stronger. So much so, that post crisis, the adage of safety shifted from smallcap stocks to gold to finally debt funds. Many Indian investors who managed to sail through the crisis of 2008 lost their shirt betting on risky smallcaps. Gold then became the favourite asset class endorsed by financial media and banks alike. Once the sterling rise in gold prices halted and government cracked down on gold buying, even the yellow metal lost its luster. 

The street then shifted focus to debt funds. Until last month every major financial daily propagated the wisdom of putting tons of money in 'safe' debt funds. Banks too were happy to tie up with mutual funds to propagate the safety of their debt funds. All they had to do was convince prospective investors that the RBI's move in the next monetary policy was a 'rate cut'. After all with the Finance Ministry breathing down its throat, the Reserve Bank of India (RBI) had little option! Reducing interest rates would be the most certain way to push GDP growth rates higher. And the cut in interest rates would be a blessing in disguise for the debt funds. Given the inverse relation between interest rates and bond prices, investors would not just keep their money 'safe' but also reap rich gains in a short time. 

The promise of 'safety' and quick returns worked wonders for debt funds. Even while equity mutual funds saw lumpsum redemption, inflows into debt funds touched record highs. Brokers and advisors even convinced their clients to shift money from long term equity funds to short term debt funds. The dream run lasted only until the RBI's sudden rate hike caught both mutual funds and investors unawares. In its typical style the RBI chose to curb liquidity to stem the rupee's fall against the US dollar. The concern over higher rates impacting near term growth is not on the central bank's mind. Once again the RBI indirectly hiked the cash reserve ratio (CRR) for banks. These measures took the 'safety' quotient of debt funds to new lows. Investors who had been lured into them painfully realized that no investment is 'safe' if the underlying rationale is speculation as against fundamentals. Also those who chose to shift funds from long term equities did so at their own peril.
We wonder if investors would finally start evaluating riskiness of asset classes more carefully. 

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