RBI says financing CAD key challenge as inflows turn volatile

Cautioning of large scale capital outflows that could make economy vulnerable to "stops and reversals", RBI Thursday said financing CAD, which touched record high of 4.8 percent of GDP in 2012-13, is a big challenge.

Mumbai: Cautioning of large scale capital outflows that could make economy vulnerable to "stops and reversals", RBI Thursday said financing CAD, which touched record high of 4.8 percent of GDP in 2012-13, is a big challenge.

On a positive note, the central bank said the growth outlook for the current fiscal is relatively optimistic, though it termed slowdown in growth as the most worrisome factor.

RBI in its half-yearly Financial Stability Report said, "There is risk that the capital flows could reverse on a large scale if the risk-off sentiment intensifies causing increased volatility in the domestic markets ... And volatile capital flows have made the country vulnerable to 'stops and reversals'."

"In addition to the magnitude of flows needed to finance the CAD, the composition of flows, particularly dependence on portfolio and short-term debt flows represent an added source of concern," the report released today said.

Earlier in the day, RBI said CAD hit a record high 4.8 percent of GDP in FY13, fuelled by rising imports of oil and gold, but it was lower than expectations.

Significantly, for the March quarter of the past fiscal, CAD improved massively to settle at 3.6 percent, steeply down from 6.7 percent in the previous quarter.

On the volatile capital flows, the report said they are making the country "vulnerable to sudden stops and reversals" and that this trend was seen recently following the "slightest hint of exit from quantitative easing by the US Federal Reserve".

Foreign investors have sold a net USD 7 billion in domestic debt and equities in June, pulling down the rupee to a record low of 60.72 to the dollar yesterday.

The RBI report said external sector vulnerability indicators have shown a worsening trend and that high gold imports and external debt are sources of greater concern.

"The macroeconomic risks to the economy have increased over the past six months, mainly on the dimensions of domestic growth, external sector and corporate sector performance," the central bank said in its half-yearly Financial Stability Report, released this evening.

On the slipping growth, the report, which pegged GDP growth at 5.7 percent for the current fiscal, up from near-decade low of 5 percent in FY13, noted that growth slowdown is the most worrisome factor as of now.

"The slowdown in growth is the most worrisome factor as industrial activity is stubbornly subdued and services remain below the trend," Subbarao said in his foreword to the seventh Financial Stability Report.

Noting that there has been a steady decline in ratio of total debt to GDP, the report pointed out that the same rose to 20.6 in December 2012 from 17.5 percent in March 2011. It was 19.7 percent in March 2012 and remained stable at 19.7 percent in June 2012 but improved to 19.3 percent in September 2012.

The central bank also warned companies of the risks to their balance sheets once interest rates start rising from unhedged currency exposures following an increase in overseas borrowings to avail of low-cost funding.

However, the RBI report noted on the positive side that lower commodity prices and moderation in gold imports may have a positive effect on CAD balance, but warned that even this will not be sufficient for finance a high CAD in a sluggish economy which poses difficult macroeconomic policy challenges.

On CAD, the report noted gold imports have been a continuing concern and said the share of gold in total imports has been increasing since 2007-08 and was close to 3 percent of GDP in FY13.

On the rupee, which was largely range bound during January-April 2013, the report said it started weakening in May. Among other factors, strengthening dollar and relatively high trade deficit during April-May exerted pressure on the rupee.

With inflation easing and positive actions from the government on the fiscal deficit front, RBI has taken the growth-propping measure of cutting rates but has been of late held back by high current account deficit.

The report said the perception of difficulties in doing business in the country still persist and noted that this is inhibiting investments. "There is a need to introspect as to why we rank low (111/144 in economic freedom index and 59/144 in global competitive index) and keep slipping in the rankings."

The RBI report also said that asset quality of banks has improved in the final quarter of last fiscal with the gross non-performing assets ratio of the system declining to 3.4 percent of the total loan outstanding, from 3.6 percent in the September quarter.

This had a positive impact on the net NPAs of banks, which improved to 1.4 percent of the total loans outstanding in the March quarter from 1.6 percent six months ago in the September quarter, it said.

"The improvement was due to lower slippages, improved recovery and higher write-offs during the March quarter."

Going ahead the improvement in the quality of fiscal consolidation will be crucial for ensuring sustainable high growth and macroeconomic stability, the FSR report said. On the corporate sector, the report said its performance has been "subdued" and flagged concern over corporates' increasing external borrowing and unhedged exposures, saying this can further "increase their vulnerabilities".

The FSR, however, also noted some positive factors like risks from global growth, domestic inflation and fiscal stance having receded.