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TOO MUCH OF A GOOD THING
- India’s foreign exchange reserves are posing a dilemma in policy

The author is an economist at the Indian Statistical Institute, New Delhi

Our foreign exchange reserves are proving to be an embarrassment of riches. The country’s reserves now exceed $ 68 billion. This is significantly higher than the stock of foreign exchange required to meet any unforeseen contingencies that might result in a sudden sharp increase in foreign exchange outflows. The extra benefits from additional reserves are zero if not negative. But, inward remittances show no signs of easing up, and so the reserves keep piling up.

In fact, our foreign exchange reserves also seem to be in the grip of another of those vicious cycles which economists love to talk about. Since reserves are high, everyone feels confident that the external value of the rupee will improve or at worse remain at its current value. This encourages exporters to send back their foreign earnings to India, while non-resident Indians also park their excess funds in the special NRI deposits. The increased flow of remittances results in even higher reserves, and the pattern may be repeated all over again unless the Reserve Bank of India intervenes.

But should the RBI intervene' Or should it allow the demand and supply for foreign exchange to determine the “price” of rupees' And if public intervention is the optimum policy, what instruments should the RBI use' The inflow of dollars increases the foreign demand for rupees, and consequently puts a strong upward pressure on the value of the rupee. The naïve nationalist may view an appreciation in the value of the rupee with jingoistic pride. However, this completely ignores the more practical consequences. In particular, any increase in the external value of the rupee increases the price of Indian goods in foreign markets, and so makes Indian exports less competitive. This is perhaps the only reason why the RBI has been forced to intervene in the foreign exchange market repeatedly in order to prevent any significant appreciation of the rupee.

It will have to continue to mop up dollars in order to protect the interests of Indian exporters. Unfortunately, this intervention is not costless. Every dollar purchased by the RBI releases additional rupees into the system. Given the scale of intervention, the excess liquidity will normally create severe inflationary pressures. That is why the RBI also carries out the process of “sterilization”. This is the sale of government securities in the RBI’s portfolio in the domestic market to contract the supply of money in the economy. However, since there are limits to the volume of government securities which the public is willing to buy, other solutions have to be found.

Questions have also been raised about whether there are more “direct” ways in which the excessive inward flow of foreign exchange can be moderated. There is more than a grain of truth in the assertion that government policies relating to the external sector are a throwback to the days when the scarcity of foreign exchange constituted a binding constraint on prospects of reaching a high growth path.

In particular, this is borne out by the various incentives which are offered in order to attract foreign exchange. For instance, NRIs are offered returns which vary between 6 to 8 per cent on fixed deposits. In addition, these deposits are repatriable in foreign currencies at exchange rates prevailing at the time of conversion. The rate of interest is significantly higher than the returns which prospective investors can get abroad in view of the lower rates of interest prevailing abroad.

The higher rates of interest on NRI deposits made sense in earlier periods when the external value of the rupee was volatile — the higher rates of interest in India acted as a sort of risk premium offering protection against a devaluation of the rupee. But now that the rupee is relatively strong against major foreign currencies, there is no longer any need to provide any insurance against a possible devaluation of the rupee.

Since the original source of the problem is the excessive inflow of foreign exchange, the more attractive solutions must be those which increase the outflow of dollars. In other words, the Indian demand for dollars has to be stimulated. The reduction of customs duties has made imported inputs relatively more attractive. However, the extent of increase in the demand for imported inputs obviously depends on how fast the industrial sector can grow. Most industrialists had reacted very positively to this year’s budget. Given the strong backward and forward linkages, a favourable monsoon and hence abundant agricultural harvest will provide an added stimulus to industry. The finance ministry is obviously hoping for a healthy rise in imports since it has projected a huge increase in revenues from customs duties despite the lower rates.

This is also a propitious time to effect a significant relaxation in the rules governing imports of consumer goods. The most important argument against consumer goods imports — that this would aggravate balance of payments difficulties — is obviously inapplicable today. Even if steep duties are levied on such imports, the affluent classes will be more than willing to pay for foreign goods. More than one bird will be killed in the process. The demand for imported goods will partially neutralize the inflow of foreign exchange. The exchequer will also gain in the form of additional revenues from customs duties. And the imported goods, by adding to the total supply of goods in the domestic economy will help contain inflationary pressures.

There have also been suggestions that the government make the rupee fully convertible in order to partially revise the flow of foreign exchange into the country. During the course of his budget speech, the finance minister remarked that “the time has come for preparatory work towards capital account convertibility”. On a more upbeat note, the managing director of the International Monetary Fund, Michael Camdessus, mentioned during a recent press conference that India is now ready for capital account convertibility. The prime minister has also affirmed the National Democratic Alliance government’s commitment to usher in full convertibility of the rupee as soon as possible.

This may be a precipitous step at this stage. It must be remembered that the rupee is not even fully convertible on the current account. After all, there are still several quantitative restrictions on the amount of foreign exchange which an Indian can spend on most current account transactions. The restriction on imports of consumer goods is perhaps the most important example of this. But, there are others. The systematic elimination of foreign exchange controls governing transactions on the current account must precede any attempt to relax restrictions on the sale or purchase of foreign assets. The removal of these restrictions will also help the RBI in its twin attempts to prevent appreciation of the rupee as well as to control inflation.

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