In the five years leading up to 2020, India recorded capital account surpluses which offset its current account deficits, leading to an annual balance of payments surplus except for CY2018 where there was a deficit. The Reserve Bank of India appears to have intervened in foreign exchange markets to stem an appreciation in the real effective exchange rate (REER) and has steadily increased its foreign exchange reserves by $ 149 billion. With the onset of COVID-19 in the first quarter of 2020, there has been a sharp withdrawal of portfolio capital which has been offset by inflows of FDI. FDI inflows have been a relatively stable source of external finance over the years compared to volatile portfolio flows (see Figure 1). Quantitative easing by the US Federal Reserve and other major central banks in response to the pandemic has likely had “spillovers” in emerging markets such as India. Record foreign capital inflows of $ 79.7 billion into India between the second and fourth calendar quarters, a trade surplus in two consecutive quarters and substantial remittances led to an increase in RBI reserves of 103 , $ 9 billion in 2020. relating to
a significant fundraising of 20 billion USD.
The surge in foreign exchange inflows in 2020 posed challenges for the competitiveness of India’s exports and impacted domestic liquidity conditions. Despite the RBI’s numerous interventions in the forex markets (with the US Treasury Department adding India to its “currency manipulator” watch list), the Indian rupee has remained at high levels in real terms. The 36-country trade-weighted RRSP index for the Indian rupee was 119 in October 2020, close to December 2019 levels; thus undermining India’s trade competitiveness. One can visualize the foreign currency markets in 2020 as a bathtub where a faucet spins at high speed on one side and water flows on the other; the drain is barely able to remove enough water. The appreciation of the REER is not a recent phenomenon but dates back to the first half of 2019. While in previous periods the RBI would have sterilized foreign inflows to mitigate an effect on domestic liquidity, the excess liquidity in rupees owed to RBI’s foreign exchange interventions in 2020 likely supported its efforts to counter the upward pressure on government bond yields (G-Secs).
As the second wave of COVID intensified in India, foreign portfolio investors have withdrawn about $ 2 billion in the second quarter so far, reversing inflows of $ 7.6 billion in the first quarter of 2021, according to the reports. NSDL FPI Monitor data. With comparatively lower FDI inflows expected this year, global liquidity conditions and India’s recovery from the current wave should drive FDI inflows and, in turn, the Indian rupee. While the impact of the second wave of COVID on the economy so far has been less intense than last year, its effect on health and human life has been quite significant. Workers in all sectors in both urban and rural areas have been affected. The service sector namely. Hospitality, entertainment and travel returning to normal in 2021 have been shocked by the resurgence of COVIDs and state-level lockdowns. In early May, Moody’s revised its 2021-2022 GDP growth forecast to 9.3% from an earlier estimate of 13.7%, while CRISIL forecast GDP growth of less than 10%. Vaccination bottlenecks and an upsurge in cases in rural India have introduced considerable uncertainty about the recovery expected for the current year. Global companies with R&D and back-office services in India have reassessed their nationwide exposure to India due to COVID-19 from an overall risk concentration perspective.
To build confidence in future foreign investment, we need to increase our contribution to the health sector. India’s annual expenditure of 3.5% of GDP (including public and private spending) is significantly lower than the global average of 9.8%. By comparison, Brazil, South Africa and China invest 9.5%, 8.3% and 5.4% of GDP respectively, according to World Bank data. Without significant investments in health care, the advantage of favorable demographics can prove to be a scourge with an impact on labor productivity. Health indicators could also be part of state level rankings based on action plans for business reforms that impact ease of doing business. This would encourage states to compete in improving health care to attract foreign and domestic investment, with the added benefit that in the medium to long term this would effectively translate into better health facilities for their residents and improved the quality of human capital.
Sanket Mohapatra is a faculty member in Economics at IIM Ahmedabad. Sushil Thaker is a student in the ePGP program at IIM Ahmedabad. Opinions are those of the authors and do not represent those of their respective employers or institutions.