The real change in India's balance of payments is a growing presence of debt in the capital account, driven by private commercial borrowing and NRI deposits.
AMONG the many indicators of India's post-reform economic success is one that is proving an embarrassment: swelling foreign exchange reserves. Over the year ending May 4, 2007, these reserves rose by close to $42 billion to touch $204 billion. Two-thirds of this 26 per cent increase in reserves has occurred over the first four months of this year. This galloping rise in reserve levels reflects the effort being made by the Reserve Bank of India to mop up the large inflow of foreign exchange into the country. By filling the gap between the demand for foreign exchange and its availability within the country, the central bank has in the past ensured a degree of stability of the rupee.
However, more recently the rupee has been gaining in strength despite the RBI's efforts, as reflected in the sharp increase in reserves. Over the period ending May 11 this calendar year, the rupee has appreciated by 8.2 per cent vis--vis the dollar, 6.8 per cent vis--vis the pound, 5.7 per cent vis--vis the Euro and 9.2 per cent vis--vis the yen.
Such appreciation over a short period of time is bound to affect the competitiveness of India's exports. The Cotton Textiles Export Promotion Council (Texprocil) has already called on the government to stop and reverse the rise of the rupee, as have many other industry associations. And more recently the Union Minister of Commerce has joined the chorus.
There is a view gaining ground that this appreciation is because of a growing unwillingness on the part of the central bank to mop up foreign exchange because of concerns about inflation. The reasoning underlying this perception is well known. If the foreign exchange assets of the central bank rise, the potential level of money supply in the economy increases unless the increase in foreign exchange assets is neutralised by a retrenchment of the other assets of the central bank such as government securities. Since the stock of government securities held by the RBI has dwindled, such "sterilisation" is ruled out. Hence, increases in the institution's foreign exchange assets create a situation of easy liquidity and tend to increase money supply. The consequent liquidity overhang is potentially inflationary if it results in increased credit either to finance consumption and investment or to finance speculation.
Given recent inflationary trends, the argument goes, and the RBI's avowed focus on containing inflation, the bank is averse to increasing the assets side of its balance sheet any further. Hence, it is holding back from intervening in the market for foreign exchange to buy foreign currencies and prevent an appreciation of the rupee. Unfortunately, the figures cited earlier do not warrant such a conclusion. The RBI has indeed been intervening vigorously in foreign exchange markets, which has led to a sharp increase in the foreign exchange reserve it holds. The problem seems to be that the inflow of foreign exchange has been so massive that it has not been matched by even this enhanced intervention by the central bank, resulting in an excess supply of foreign currencies and a consequent appreciation of the rupee.
What accounts for this surge in foreign currency inflow? Can it be attributed to India's export success, especially in the areas of software and services? It is indeed true that India's net earnings from the exports of software and other Information Technology-enabled Services (ITeS) rose by a massive $10 billion from $23.7 billion to $33.7 billion between calendar years 2005 and 2006. Moreover, net inflows on account of private transfers, consisting largely of remittances, rose by an additional $3 billion from $23.2 to $26.3 billion between these years. A significant share of such inflows is on account of remittances from those providing software services onsite in foreign countries. Thus, services exports have been a factor explaining the rise in India's invisibles income from $39.4 billion to $55.0 billion between 2005 and 2006.
However, this close-to-$16 billion increase in the surplus from the invisibles trade was more than exhausted by a widening of the deficit on India's merchandise trade account by almost $17 billion - from $47.2 billion to $64.1 billion. As a result, the deficit on account of the all current transactions of the country (the current account deficit) increased by $1.2 billion - from $7.8 billion in 2005 to $9 billion in 2006. While India's services trade success helped shore up the current account of India's balance of payments (BoP), it cannot explain the increase in the availability of foreign exchange within the country.
A second possible explanation could be the growing attractiveness of India as a destination for foreign investors. The flow of foreign direct investment (FDI) into India, according to the RBI's BoP statistics, rose sharply between 2005 and 2006 by more than $10 billion - from $6.7 billion to $16.9 billion. Much of this is in the form of new equity inflows. Moreover, portfolio flows, which were earlier the dominant form of inflow into the country, actually declined from $12.2 to $10.6 billion. Thus, India seems to be witnessing a new phenomenon of greater inflows of FDI as opposed to portfolio capital, with inflows of foreign investment rising by more than $ 8 billion in the aggregate.
It needs to be clarified here that this shift from portfolio to direct investment inflows cannot be interpreted as a sign of India transforming itself from a destination for short-term inflows seeking capital gains to one for direct flows interested in long-term engagement in productive activity in the country. The distinction between direct and portfolio flows is arbitrary, with inflows involving a single investor acquiring an equity stake of 10 per cent or more being characterised as fixed investment. As the ceiling on acquisition of shares by foreign investors is relaxed and share acquisition occurs through the private placement route, a number of purely financial investors tend to acquire an equity stake of 10 per cent or more with capital gains in mind. Thus, FDI figures need not reflect investments by investors with a long-term interest.
That having been said, it is indeed true that the aggregate foreign investment flows into the country have increased substantially, raising the possibility of foreign investment flows being the prime explanation for the surge in foreign currency inflows and the RBI's foreign currency reserves. However, this too does not appear to be true, because the rise in foreign investment flows has been accompanied by a sharp rise in investments by Indian firms abroad. One of the ways in which the RBI has been seeking to cope with the increased inflows of foreign capital is by relaxing restrictions on acquisition of foreign exchange by resident individuals and corporations to acquire assets abroad. This facility has been substantially enhanced in its recent Credit and Monetary Policy Statement. As Business Line noted in its editorial of April 26, 2007: "Indian corporates can now invest a lot more overseas than what they were allowed to earlier. The retail investors too are being told that they can indulge little more their fancy for overseas stocks. More significantly, resident entities have now been enabled to take speculative views on future exchange rate movements even when there is no immediate/direct exposure to foreign exchange risk. The RBI is evidently counting on the participation of even those who had until now viewed it as something remote to their interests so that a vibrant two-way movement gets established in the market for foreign currency as people with divergent views back their judgment with money."
The fact of the matter is that even before this recent announcement, the liberalisation of rules and a growing appetite for bigger-ticket acquisitions abroad had raised the outflow of foreign investment from the country from $2.5 billion to $9.7 billion. The outflow of more than $7 billion consumed a large part of the incremental foreign currency coming into the country on account of enhanced inward investment. As a result, net inflows of foreign investment into the country increased from $16.3 billion to just $16.7 billion between 2005 and 2006.
What then accounts for the observed excess supply of foreign currency within the country in recent months? With India being graduated out of bilateral and multilateral "aid", net external assistance to India fell from $2.3 to $1.5 billion between 2005 and 2006, so that does not offer an explanation either. The real change in recent times seems to be a huge increase in commercial borrowing by private sector firms. With caps on external commercial borrowing relaxed and interest rates ruling higher in the domestic market, Indian firms seem to be taking the syndicated loan route to borrow money abroad at relatively lower interest rates to finance their operations, investments and acquisitions. Net medium-term and long-term borrowing increased from $1 billion in 2005 to $13 billion in 2006, or by a huge $12 billion. Figures from the RBI indicate that during the first two months of 2007 external commercial borrowing had already touched $4.5 billion.
Thus the real change in India's balance of payments is a growing presence of debt in the capital account, driven not by official borrowing but by private commercial borrowing and non-resident Indian deposits. To the extent that such debt is used to finance expenditures within the economy, it increases the domestic supply of free foreign exchange, worsening the RBI's exchange rate and monetary management problems. To the extent that such borrowing is used to finance spending abroad, encouraged by the RBI, it increases India's future foreign exchange commitments with attendant risks. Above all, in the short run these funds that involve much higher interest payments than those obtained from assets in which India's reserves are invested, imply a loss of revenue for the central bank and a loss of net foreign exchange for the country.
According to the United States Treasury Department figures quoted by Business Line (April 22 , 2007), investments in US treasury securities by Indian financial institutions and the RBI touched $19.5 billion or around 10 per cent of reserves in February this year. Much of this investment occurred recently with the figure having risen by $9.5 billion relative to a year earlier. Between January and February of 2007 alone, investments rose by $3.7 billion. With returns on such investments constituting the floor of the international interest rate structure, the losses are bound to be substantial. It is time, therefore, for the RBI to rethink its position on capital inflows and for the Finance Ministry to enforce a stricter ceiling on external commercial borrowing.
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