India’s foreign exchange reserves may be close to its record high, but the rapidly widening trade deficit and capital outflows could test the sustainability of external strength, though India would be tackling it from a position of strength, the Reserve Bank of India said in its state of the economy report.

The disruptive spillovers from geo-political hostilities has led to a surge in commodity prices, tightening financial conditions and terms of trade

shock to India, the report said.

Foreign portfolio investors (FPIs) turned net sellers in domestic equities in March 2022 for the sixth consecutive month with large outflows from financial services and software services sector.

“Rapidly widening trade and current account deficits co-existing with portfolio capital outflows weigh on external sustainability, although the strength of underlying fundamentals and the stock of international reserves provide buffers,” said the report prepared by RBI’s research wing.

The surge in commodity prices is already posing inflation risks, especially through the conduit of surging imports.

The report said that India faces these challenges from a position of strength built on broadened vaccine coverage, financial sector resilience, robust export and remittances and the government’s push to spur capital spending on infrastructure.

India’s foreign exchange reserves were at $604 billion as of April 8 equivalent to about 12 months of imports. RBI already had to dig in its reserves to prevent a steep fall in rupee’s value against the dollar. The hardening oil import cost and portfolio outflows continued to put pressure on the rupee, which depreciated 1.6% against the dollar in March 2022.

The reserves got depleted by a massive $29 billion since February 18, two days before the beginning of the Russia-Ukraine war. Forex reserves were at its peak at $642.453 billion on September 3 last year.

The near-term global outlook appears grim with strained supply chains and the quickening pace of monetary policy normalisation. “Emerging market economies are bracing up to contend with swift shifts in risk sentiments and tightening of global financial conditions that could produce real economic consequences which may thwart incipient recoveries or even precipitate rocketing inflation and economic downturns,” the report said, adding that the Indian economy is not immune to these negative externalities.