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An embarrassment of riches
Ila Patnaik

India’s forex reserves exceed its needs and it doesn’t know how to use them

Last week Bimal Jalan advised the government to use India’s growing forex reserves to prepay a part of its external debt. The government turned down the proposal.

This despite the fact that the Budget relaxed controls on corporates and mutual funds to invest abroad, allowed pre-payment of ECBs and eased norms for NRI deposits. Clearly, Mr Sinha shares Mr Jalan’s view of the country’s forex reserves.

He may not be willing to undertake more rupee borrowing to pre-pay his external debt. But he is willing to let capital flow out.

Mr Jalan had built up such a high level of reserves when the post-Pokhran US sanctions were in place and there was concern that, in the event of a balance of payments crisis, India might not be able to get an IMF loan. With India and the US now on such good terms, that danger has passed. The question now is which way to go? Should the country go on adding to its reserves or is there a way to reduce them?

There are no easy answers, especially if one takes into consideration the fact that the repayment of the Resurgent India Bonds and the Millenium India Bonds will be due over the next two years. Indeed, this outgo might lead some to conclude that reserves are not all that comfortable and that they should be added to.

A rule of thumb used to be that a country should hold at least a few months worth of imports. More recently, with more open capital accounts, Alan Greenspan and Pablo Guidotti have proposed another rule.

They say that reserves should be such that a country does not need to borrow for a year and can still meet its debt obligations. India meets this requirement comfortably, especially at its current abysmally low levels of industrial growth.

Nor does it look as it these are going to accelerate any time soon. So it would appear that, even after paying off the RIBs and MIBs India will be left with a surplus of dollars.

Amazingly, as in the case of food stocks, the problem today is of too much, rather than too little. Clearly, all things change. The trick lies in managing that change sensibly.

The easiest way out, of course, would be if the surplus dollars could be sold in the market. But that would lead to an appreciation of the rupee, setting in motion howls of protest from exporters. At a time when exports are so badly down, this option will have to be ruled out.

In fact, an important reason why the reserves built up was that, had not the RBI bought up the dollars that were flowing in, the rupee would have appreciated. It was as much to prevent this as to obtain protection against the sanctions that the reserves built up to such a high level.

The build-up of India’s foreign exchange reserves over most of last year has, in a sense, been involuntary. At the end of March 2001 reserves were nearly $40 billion. About $30 billion would have provided six months of import cover. Another $10 billion could have been put aside for protection against the flight of portfolio investment. The reserves would have provided for servicing India’s $100 billion of external debt without having to resort to borrowing.

During the year the slowdown in non-POL import growth and the decline in oil prices kept the demand for foreign exchange low, while the strong rupee resulted in remittances and capital inflows that maintained the supply of foreign exchange steady.

So despite the poor performance of Indian exports there was an upward pressure on the rupee. Left to the market, the rupee could have appreciated and adversely affected export performance even further. To prevent the rupee from appreciating the RBI bought dollars and thus unwittingly added to reserves which now stand at $53 billion.

Be that is it may, the import bill might come to the rescue by rising quickly. Would that be good or bad? The answer depends on why the bill has risen.

If the increase were to be on account of higher oil prices, it would be bad. Indeed, that is already happening. The budget had assumed a price of between $18 to $20 per barrel, but prices have now shot up to $25 per barrel.

If the Middle East situation hots up further, whether due to Israel’s peculiar policies in Palestine or because the US decides to eject Saddam Hussein, not only would oil prices remain at this level, they may go up further.

The best thing would, of course, be if industrial growth — and therefore industrial demand — pick up so that the non-oil import growth is higher. The available foreign exchange resources would then be used more productively than at present. But given everything, not least confidence in the government abilities, that looks unlikely.

In other words, if the deficit on the current account will not go up adequately, that leaves the capital account. There are two possibilities here.

One is a restriction on inflows; the other is an increase in outflows. The former should not and, fortunately, is not being considered. The latter, as mentioned above, has already been attempted in the Budget.

But a bit more may well be required and possibly by far the most helpful step would be an easing of controls on residents to invest abroad as recommended by the Tarapore committee. Of course, the government would have to be cautious as a rise in oil prices or a pick-up in import growth or a confidence crisis could abruptly draw down reserves. Yet, this may be a good time as any to take some more steps towards capital account convertibility.

In the final analysis, the point to appreciate is that holding reserves entails a cost. This is because the interest earned on them is less than the interest paid out to foreign investors on the softer domestic currency assets. The difference in the interest rates is the cost the country pays for holding forex assets.

Nor is this the only cost. Addition to reserves also expands the monetary base. Over the last one year the RBI reduced its lending to the government to counter the increase in reserve money due to the net addition to foreign currency assets. This was possible because given the low demand for credit, banks were willing to put their money in government securities.

But the RBI may not be able to continue cutting credit to the government especially with a large fiscal deficit. This would result in a higher growth of money supply and eventually inflation. So how much forex reserves should a country hold, especially if there is some sort of an optimal level beyond which a country holds reserves only at additional cost and no particular benefit? A Nobel awaits anyone who can come up with an inter-temporally and inter-spatially valid answer.

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