The author is professor of economics, Indian Statistical Institute, Calcutta
The Indian economy is reported to be on an upswing. The stock market is vibrant, there has been a good monsoon and, above all, foreign exchange reserves are piling up like never before. The Reserve Bank of India, in its recently published annual report, has expressed optimism about the future of the economy. It has especially expressed happiness over the foreign exchange position of the country. Foreign exchange reserves, which had reached a nadir of mere $ 5 billion in 1991, have crossed the 90 billion mark in the week ending October 10, 2003, exhibiting a more than 18-fold increase over the last twelve years. Gone are the days of scarcity; gone are the days of mean and miserly control. Foreign exchange reserves are now swelling every year, every month and even every week. Indeed, one seems to have a reason to rejoice.
It does not harm to be a bit finicky though. While the government has started partying over the foreign exchange position and the media is spreading the news around with great fanfare, one might ask the apparently simple-minded question: is more foreign exchange always better than less'
After all, when are we going to use our reserves if we keep on accumulating them forever' Is there an optimal level beyond which it is meaningless to accumulate'
Before we try to find answers to these questions, it is necessary to know exactly where the reserves are coming from. The Reserve Bank of India’s recently published annual report gives an excellent account of the sources of foreign exchange earnings. In the financial year, 2002-03, for instance, India experienced a net inflow of almost 17 billion dollars. Out of this, 3.7 billion came from a current account surplus and another 12.6 billion from a positive balance in the capital account. The surplus in the current account could be maintained in spite of a 12.4 billion deficit in merchandize trade partly due to substantial private transfers from abroad and partly because of an impressive performance in the export of services, especially that of software. Even merchandise trade did not perform as poorly as it may appear. A large chunk of our expenditure on imports was on oil, a necessity we could hardly avoid. If import of oil is excluded from merchandise trade, the balance is indeed positive.
The capital account surplus, on the other hand, was due to the inflow of capital under three main heads. 3.6 billion came into the country as foreign direct investment, a little less than a billion as portfolio investment and 8.2 billion as banking capital of which 2.8 billion came as non-resident-Indian deposits. Portfolio investment, as we all know, is unstable because it can be withdrawn and repatriated out of the country at a very short notice. But the figures reveal that the contribution of portfolio investment to the total foreign exchange inflow was negligible last year. Indeed, one finds a decreasing importance of portfolio investment since the stock market boom in the Nineties. So, at the moment, we need not worry about the possibility of a speculative run on our foreign exchange reserves on account of too much portfolio investment. The remaining capital inflows, except for short-term trade credits, which are small anyway, are regarded as stable by the RBI.
What do these numbers tell us' First, these numbers tell us that we have sizeable foreign exchange reserves at present. Second, they tell us that a part of the reserves is our own, being earned through export surplus and transfers from abroad. Third, a significant part of the remaining, though strictly speaking owned by foreigners, need not be kept liquid because the owners are not expected to want them back in the immediate run. So at present we can use it for our own purpose as we can use the part which is truly our own.
The advantages of having a comfortable reserve of foreign exchange can be hardly overstated. We can use the reserves to increase our consumption of foreign goods, we can use them to buy technology and investment goods from abroad and most important, we are no longer compelled to take loans from foreigners in the event of an unanticipated crisis, as we had to in 1991 from the International Monetary Fund. The last advantage allows us to adopt our own policies independent of any foreign imposition. But do these advantages suggest that we keep on accumulating reserves indefinitely'
Indeed, there are costs of piling up reserves. As more and more dollars flow into the country, the domestic money supply has a tendency to expand. Those who are bringing in the dollars would typically exchange them for rupees. Again, the banks, getting fresh dollar deposits, would increase their advances in terms of the domestic currency. All this would tend to increase money supply at home and, if left unattended, would lead to inflation.
Therefore, to control money supply and inflation, the government has to sterilize the increase in domestic currency by buying back domestic money from the public with government debt. In India, inflation has been kept very much under control in spite of a large inflow of foreign currency. Thus substantial sterilization must have taken place. But this sterilization has led to an increase in public debt. This, in turn, has been a drag on the government budget, especially at a time when the government is already over-burdened with debt.
Secondly, a steady inflow of foreign exchange has led to a slow but steady appreciation of the Indian rupee. The appreciating rupee has at least two disadvantages. First, it puts pressure on exports by making them less competitive in the world market. Second, it has the potential of opening up a speculative process by attracting further inflow of foreign exchange. The economy would be in serious trouble when the bubble blows up, as it surely will sooner or later.
Thirdly, there is a direct cost of accumulating foreign exchange. Reserves are usually kept in safe foreign assets. While some of these assets, like the US treasury bills, yield very low rates of interest, some others yield somewhat higher rates. The overall yield, however, is quite low. Last year, for instance, the average yield on foreign assets of the RBI was only 3.1 per cent. On the other hand, we pay much higher returns to the foreigners on their investment. Clearly, this involves a cost. We are thus paying a 4.5 per cent interest to an American NRI on his deposits and then keeping his money in US treasury bills yielding not more than 2 per cent. For us, it is awful economics, for the Americans, it is an opportunity of having one’s cake and eating it too.
Unbounded accumulation, therefore, is not a boon. There is an optimal level of reserves beyond which the usefulness sharply declines. In fact, the recent swelling of reserves signals a deeper malady. It signals that the economy is unable to use up the foreign exchange that is flowing in. The best use of foreign exchange would have been the purchase of capital goods and technology from abroad, for it would have enhanced future growth potential. But this requires domestic investment to go up.
Unfortunately, private investment in the economy is still quite low and this can be hardly compensated by old instruments changing hands at a higher velocity exhibiting vibrant trade at the stock market. If genuine investment projects are not forthcoming, the banks might be tempted to invest in spurious and highly volatile projects like real estate. This had happened in east Asia before the crisis and was, in fact, one of its major causes. We hope it will not happen in India.