Over a decade ago, when the NDA government , now back in power, lost elections, the incoming government — the UPA — didn't have much to worry about the state of the economy then.A strong rupee with a stable external sector current account surpluses for a few quarters and a GDP growth of over 8 per cent in the last quarter before it was voted out marked its scorecard in the five years of 1999-2004. But much of those gains have been eroded since.Two major developments — the oil price shocks from August 2004 and the global financial crisis of in 2008 — in the subsequent decade led to a sharp deterioration of external finances. Add to it the policy paralysis during the second term of UPA, which accelerated the worsening of the external sector position.The Modi-led NDA government now needs not just to clean up the fiscal mess, but has to face the challenge of ensuring the country's external sector balance sheet is in good order. Last week, RBI released the latest data on external debt which rose 7.6 per cent y-o-y to $440.6 billion in March-end 2014. This appears much better than the 13.5 per cent rise a year earlier.Notably, short-term debt at $89.2 billion accounted for 20.3 per cent of the total external debt at March-end 2014 compared with 23.6 per cent in March 2013. Based on residual maturity, shortterm debt accounted for 39 per cent of total external debt in March-end 2014 compared with 42.1 per cent at March-end 2013. There are other encouraging signs, too.The current account deficit — the excess of spending overseas than savings — declined to less than 2 per cent of GDP from about 4.7 per cent a year ago, thanks to the government's move to curb gold imports by raising import duty on gold and RBI's prudential measures, along with measures to boost dollar inflows. Yet, India's external debt indicators continue to be vulnerable.In terms of per centage of GDP, external debt rose to 23.4 per cent, from 22 per cent last year. While the short-term share of external debt has improved recently, the current share at 20 per cent is significantly higher than what used to be a decade ago. This share was only 4 per cent in 2004. It started rising sharply since the global crisis of 2008.Other indicators, too, are far from satisfactory. Take, for instance, the ratio of foreign exchange reserves to total external debt which has almost halved to 69 per cent in March 2014 from 138 per cent in March 2008. Besides, the import cover of reserves now is only adequate to fund eight months of import compared with 15 months of imports in the period prior to the crisis in 2008. But most importantly, India's net international investment position — excess foreign currency liabilities over foreign currency assets — is rising rapidly.Net liabilities have more than doubled from $150.2 billion in March 2010 to $331.6 billion in March 2014. India's external debt profile appears similar to that of other major emerging market economies. But its short-term external debt stock is now higher than countries such as Brazil and Russia (in terms of per centage of GDP), according to Taimur Baig and Kaushik Datta, economists at Deutsche Bank.India's share of short-term debt relative to the stock of total external debt is also higher than other emerging market economies, with the exception of Turkey, they say. Though short-term debt was contained in FY14, it was largely due to a slowdown in imports and may again rise once there is a rebound in growth and imports pick up.Some economists point out that since GDP is expressed in dollar terms, a weak rupee translates into a lower GDP number and hence, a lower ratio could be misleading. However, the composition of long-term term debt which is reckoned to be durable and 'safe' is also worrisome.While the share of almost risk-free sovereign, multilateral and bilateral credit has reduced significantly over the years, it is private corporate sector debt and 'retail' component in terms of NRI deposits that has swelled over the years.Proceeds from the FCNR (B) swap and overseas borrowing schemes were, in fact, the main contributors to the $31.2 billion increase in external debt in FY14, which were facilitated by the Reserve Bank to stabilise the Indian currency. "NRI deposits do not pose material risks (as they are generally rolled over). But the increase in the share of external commercial borrowings (ECBs) exposes the domestic corporate sector significantly to external shocks, including adverse exchange rate movements," says Samiran Chakrabarty, chief India economist, Standard Chartered Bank.Every year about $20 billion is scheduled for repayment. The amount may not seem alarming, but the risk arises if there is a global liquidity squeeze. The recent trouble in Iraq has added another dimension to external sector woes which is that the reduction in trade deficit in FY14 may reverse again."Already struggling with a record low growth, high inflation , a weak currency, low manufacturing growth and possibility of sub-normal monsoon, the threat of oil supply shock and the resultant increase in prices add to the risks faced by the country, which could hamper India's envisaged improvement in economic growth in FY15," say Madan Sabnavis and Kavita Chacko of Care Ratings.If crude price risks persist, the current account deficit which was contained in 2013-14 could deteriorate further and also add to pressure on the rupee. Care Ratings has projected a CAD for the year at 2.5 per cent of GDP assuming stable crude oil prices and a recovery in industrial production.Higher persistent crude prices would upset this calculation. The scenario may not be as worrying as 1991, when foreign exchange reserves were just 7 per cent of total debt and India was struggling to ensure payments on imports.Almost all economists are unananimous that the RBI should build a war chest of reserves. The Reserve Bank of India under Bimal Jalan had faced the challenges arising from the fallout of the impact of the Asian currency crisis of 1997-98 and sanctions by the US after the nuclear test.Between 1998 and 2000, two overseas quasi sovereign bond issuances by SBI — Resurgent India Bonds in 1998 which helped raise $4.2 billion and India Millennium Bonds, another $5.5 billion — bolstered the country's foreign exchange reserves.During that phase, India followed a conscious policy of building its reserves. India now has foreign exchange reserves of $315 billion which can support a current account deficit of $51 billion and short-term external debt of $174.6 billion, notes a Deutsche Bank report. But geopolitical risks in the Middle-East and India's heavy dependence on crude imports make its external sector more vulnerable.As a measure of protection, building a war chest by augmenting foreign exchange reserves and strengthening the reserve adequacy position are vital. India's foreign exchange reserves have hovered between $300 billion and $320 billion for over five years now. But clearly, it needs to be bolstered."We need to rebuild reserves by getting more equities or FDI. Otherwise, we need to rely on very long-term sovereign debt that may attract SWFs and pensions," says Indranil Sengupta, chief India economist, Bank of America Merrill Lynch. In the final count, what will facilitate durable flows is growth, which in turn could attract more inflows and ensure a stable rupee, besides a complementary policy to boost exports.Having clawed back after a major threat to its sovereign ratings last year, India's policy makers now need to consolidate. After the crisis of 1991, India's policy makers worked hard to ensure that its external debt vulnerabilities were reduced by building reserves and discouraging short-term debt. That was partly undone in the last couple of years, especially when CAD rose to a record high last fiscal. This is as good a time as any to restore that balance again.