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External economy uncertainties

The Reserve Bank of India which has managed the external economy amidst both propitious and not so favourable circumstances might now face a few daunting challenges. The rather dramatic changes in India's balance of payments (BoP) during 2004-05 coupled with the increasing global uncertainty call for appropriate policy responses that might test the mettle of the central bank. Merchandise trade deficit has widened by more than two and a half times to $38 billion from about $15 billion during 2003-04. Although `invisibles', representing mainly software exports and remittances, have grown from $26 billion to $32 billion, the spurt in both oil and non-oil imports has converted a current account surplus of $11 billion during the previous year to a deficit of $6 billion. The news that the current account has gone into a deficit after having been in surplus for three consecutive years can be interpreted favourably: a deficit indicates a pick up in investment activity within India, a hypothesis further corroborated by a jump in external borrowings by companies as well as in non-oil imports. Yet the fact that merchandise trade deficit has continued to increase relentlessly — it rose by $11.5 billion during the first quarter of this year, sharply higher than the $6 billion in the same period a year ago — brings into focus the crucial dependence on capital flows for bridging the gap. Fortunately, foreign institutional investors have continued to pump in money. Their aggregate investment between January and June is of the order of $5.5 billion, well on course to exceed last year's tally of $8.5 billion. With portfolio managers from newer destinations, notably Japan, looking at Indian stock markets favourably, there should not be a dearth of funds from abroad.

However, a large reliance on capital flows merits more than the customary caution of the RBI, which has been weighing them against liquidity risks. With domestic stock indices breaking records day after day, investors, domestic or foreign, need to be wary of the dangers in investing at these levels in the Indian stock market. Besides, global economic growth is expected to slow down this year, partly due to the high oil prices. While that would affect the continuity of cross-border flows, a bigger worry is that the risks to global growth, though easily identified, cannot be contained easily. These include serious imbalances in the current account of the BOP, fiscal imbalances in the U.S., hedge fund activities and excessive leveraging especially in the developed world. If, as it is thought, global saving is tending to be in excess of global investment opportunities, it might have serious consequences for the financial markets as risks might get under-priced. The process of correction might be painful especially for India and other emerging economies. As the RBI has cautioned recently, the macroeconomic framework has demonstrated considerable resilience but heightened uncertainties call for closer attention to the underlying factors.

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