India's dollar glut

The Reserve Bank of India building in Mumbai. - PAUL NORONHA

The bulging foreign exchange reserves and the currency appreciation that India is experiencing and the government's response are reminiscent of the perilous path taken by East Asian and Latin American countries that had relatively healthy economies.

INDIA'S external balance of payments appears robust. In the net there is far more foreign exchange flowing into the country than flowing out. As a result, the year 2002 ended with foreign exchange reserves crossing the $70-billion mark. This followed the accretion of as much as $10 billion over the previous four months and another $10 billion in the six months prior to that. As has been noted in the financial media, this trend represents a substantial acceleration of the rate of growth of reserves, which rose from $20 billion to $30 billion over a period of more than four years ending December 1998 and from there to $40 billion over a two-year period ending December 2000. A part of the increase in reserves is the result of a revaluation of the dollar value of non-dollar foreign currency holdings, as a result of the depreciation of the dollar against other currencies, especially the Euro. But even an overgenerous estimate suggests that over the period April-September 2002, only about $2.5 billion of the $9 billion dollar reserve accumulation was the result of such revaluation. The dollar excess is substantially owing to an excess of inflows over outflows.

Interestingly the recent acceleration in the pace of reserve accretion occurred despite the fact that in the past the government had issued Resurgent India Bonds (in August 1998) and India Millennium Bonds (November 2000), which together resulted in an inflow of close to $9 billion in foreign exchange. Despite the lack of any such concerted effort in recent times to mobilise foreign exchange through borrowing against bonds and despite indications that both the government and the private sector are retiring and reducing their holding of high-cost foreign debt, the Reserve Bank of India has been forced to mop up foreign exchange inflows to prevent any undue appreciation of the rupee.

The RBI's efforts notwithstanding the rupee has indeed been appreciating, nudging its way "upwards" from above Rs. 49 to the dollar to below Rs. 48 to the dollar. This could be seen as reflective of the strength of the rupee and the growing weakness of the dollar. But appreciation of the currency in a country that has not been able to trigger any major export explosion despite 10 years of neoliberal economic reform is not necessarily a good sign. At given prices, appreciation of a country's currency by definition increases the dollar value of exportables and reduces the local currency value of its imports. Inasmuch as this triggers a decrease in aggregate export earnings and increases the import bill, appreciation can be damaging for the balance of trade. And since this occurs in India at a time when oil prices are hardening internationally, the rupee's appreciation does threaten to widen the balance of trade deficit, or the excess of imports of goods and services over exports of goods and services.

There are two reasons why this has as yet not given cause for worry to the government and the central bank. First, the most recent figures on exports point to some recovery in India's export performance. Thus the dollar value of India's exports rose by 15.7 per cent during the first eight months of the current financial year (April-November), which compares well with the performance during the corresponding period of the previous year. However, while this may dampen concerns about the possible damaging effects of exchange rate appreciation, it cannot be held responsible for the improvement in India's reserves position. A sharp 21 per cent increase in the dollar value of oil imports and an unexpected 12 per cent increase in the dollar value of non-oil imports have actually increased the size of the trade deficit recorded during the first eight months of this financial year ($6,247.65 million) as compared with the corresponding figure for the previous year ($5,814.93 million).

The second reason why the rupee's appreciation has not given the government and the central bank cause for concern is the fact that as a result of a $1.3 billion increase in Private Transfers (largely remittances) and a $1.5 billion increase in net receipts from Miscellaneous Factor Services (which includes software and business services exports), the current account of the balance of payments recorded a surplus of $1.7 billion during April-September 2002-03 as compared with a deficit of $1.5 billion during the corresponding months of 2001-02. That is, the relatively new tendency for the current account of the balance of payments to record a surplus noted over the whole financial year 2001-02, has persisted and gathered strength during the first six months of 2002-03.

But even allowing for this increase in the current account surplus and after taking into account the possible effects of dollar depreciation on value of reserves, there remains around $5 billion dollars of reserve accretion that remains to be explained even for the April-November 2002 period. What is more, since the balance of payments statistics indicate that there was a net outflow of $2.2 billion under the external assistance and commercial borrowing heads, we must account for more than $7 billion of inflows on the capital account if reserve accumulation during that period is to be explained. The RBI's Balance of Payments Statistics suggest that about $1.3 billion of this is on account of foreign investment, another $1.4 billion on account of NRI deposits, around $1 billion on account of Other Banking Capital, $2.1 billion on account of Other Capital and $1.4 billion on account of `errors and omissions'.

Put simply, large `autonomous capital inflows', occurring at a time when India's requirements of capital inflows to finance any deficit on the current account have vanished, have played a major role in explaining reserve accumulation. And inasmuch as the easy availability of dollars on account of such inflows has resulted in an appreciation of the rupee's value in India's liberalised exchange markets, exporters who in the past preferred to delay repatriation of receipts in order to benefit from any depreciation of the rupee have been keen on bringing back their dollar receipts in order not to lose out on the rupee value of receipts because of the appreciation of the domestic currency. Such delayed repatriation of exports receipts get included, according to the RBI, under the `errors and omissions' head.

Thus when we break down dollar receipts by source, it becomes clear that the robust balance of payments position as indicated by reserve accumulation and currency appreciation are largely due to autonomous flows from abroad. Those autonomous flows result in a tendency towards currency appreciation, which has a peculiar effect on export receipts. In the short run, by encouraging the quick repatriation of past and current export receipts rupee appreciation increases such receipts. But in the medium and long-term, by raising the unit dollar value of India's exports it affects export revenues adversely.

If any such appreciation-induced worsening of the balance of trade combines with other factors such as an increase in oil prices and a rise in imports on account of buoyancy in the domestic market, a country can be confronted with a situation of rising reserves and an appreciating currency precisely at a time when trade and possibly even current account `fundamentals' are worsening. The process can be especially damaging if foreign investment inflows that involve servicing costs in foreign exchange do not contribute to the country's foreign exchange earning. This would be true of portfolio flows, of acquisition of domestic companies catering to the domestic market by foreign firms and of foreign direct investment flows into joint venture companies catering to the domestic market where the existing foreign partner seeks to use the benefits of liberalisation to increase equity share. These are the principal forms of foreign investment flows into India. Despite all this, as we have seen earlier, India is still not in a situation where its balance of payments has been substantially damaged.

Yet, there is cause for concern for a number of reasons. Virtually pushed by the embarrassingly large level of reserves, and unable to keep acquiring dollars from the market in order to prevent the rupee from appreciating too fast, the central bank has accelerated liberalisation of rules relating to availability of foreign exchange for both current account and a growing set of capital account transactions. Easier access of foreign exchange for travel, education and the like, larger access to foreign exchange for companies wanting to establish or acquire a presence abroad, slack rules governing use of international credit cards, increase in the limits to which foreign exchange can be used by importers without RBI clearance and changes in rules regarding hedging of foreign exchange transactions are all signs of a process of creeping liberalisation. The thrust is clearly in the direction of encouraging use of foreign exchange and liberalising rules governing cross border movements of goods and capital. In fact, discussion on moving towards full convertibility of the rupee, as recommended by the Tarapore Committee, which had been shelved after the East Asian crises, has once again revived.

Unfortunately, liberalisation can aggravate rather than resolve the problem currently confronting the government. It is to be expected that when a country with a relatively liberalised trading environment experiences currency appreciation, incentives for investors in that country to produce tradable commodities that can be exported or are substitutes for imports deteriorate relative to the incentive to invest in activities involving the production or provision of non-tradable goods or services. The desire to borrow abroad to invest in infrastructural activities producing non-tradable services, to invest in real estate and construction and to invest in the stock market increases substantially. This most often leads to excess capacity in certain infrastructural areas and even sets off a speculative investment boom in real estate and stock markets. Such irrational and speculative investments have in other contexts been the precursors for a crisis.

The danger is all the more real because the costs of the inflow of foreign exchange into the country have to be serviced in time in foreign exchange. Further while the emerging trends increase dependence on foreign capital inflows, it also increases the risk that such flows can dry up and that past inflows are rapidly repatriated. That is, reserve accumulation and currency appreciation of the kind that India is experiencing, the factors that underlie those tendencies and the government's liberalising response to the tendencies are reminiscent of the process by which countries that were relatively healthy in East Asia and Latin America were pushed into crisis. This curious similarity makes India's remarkable dollar reserve even more noteworthy than it is being made out to be. It could be the first sign of a crisis that India has managed to stave off thus far.