RBI’s pride, India’s dilemma


Let the market determine how to use excess forex reserves

The UPA government is proposing to use India’s kitty of foreign exchange reserves for infrastructure development. Reports suggest that concrete shape may be given to this idea by creating a subsidiary of the RBI which will lend for infrastructure projects. In this way the government expects to be able to kill two birds with one stone. First, it will be able to get rid of some of the excess reserves that were accumulated by the RBI over the past two years. This would correct the mistakes make by the RBI under the NDA government. And, second, it will be able to provide resources for infrastructure development.

But two wrongs do not make a right. It is true that RBI kept buying dollars and building up its foreign exchange reserves much beyond what it itself declared to be adequate. In April 2002, RBI governor Bimal Jalan, in a speech to international bankers, argued that India’s reserves were adequate by all measures of reserve adequacy. Even the broadest measure, “liquidity at risk”, which took account of almost all possible changes in commodity and oil prices, interest rates, debt conditions, exports and imports, was satisfied when reserves were barely $60 billion. The accumulation of reserves beyond that level was not motivated by a desire to accumulate more reserves, but was a battle against the rising rupee.

In an attempt to maintain the rupee’s peg to the US dollar, the RBI kept on purchasing dollars. This was wrong because the pressure on the rupee had come from a rising current account surplus. It was only later that expectations of appreciation built up and capital inflows came. India’s success on software exports, as well as remittances from Indians employed abroad, increased the flow of dollars to India. If instead of pushing down the price of the rupee, the RBI had allowed it to increase, the purchasing power of the rupee would have been higher. Larger imports would have been possible. These would have gone into various uses including infrastructure. It would also have gone into other uses — the purchase of capital goods, intermediates and raw materials.

Contrary to the erroneous notion that Indians still have a craze for foreign consumer goods, barely 5 per cent of imports are consumer goods, despite the liberalisation of their imports. In general, India’s non-oil imports are largely products that go into production and investment. The allocation of “foreign exchange”, a resource earned by exporting Indian goods, should have been determined on the basis of choices and preferences made by producers and consumers all over the country. The decision not to “use” this resource by letting the price of the rupee move, but to save it for future use, was an arbitrary one made by RBI. The best use of the forex resource would have been to allow the market to decide how the dollars would have been best used. But this is not the place to discuss the costs and benefits of this further. We want to focus on how this “wrong” is now being “corrected”.

The most obvious thing to do is for the RBI to stop buying any more dollars in the market. This has already happened to a good extent. Since the UPA took over, the build-up of foreign exchange reserves has stopped. If no further growth takes place in foreign exchange reserves, at least no further harm is being done. But if the government is clear that the amount of reserves are more than adequate and wants to reduce them, there are two ways in which this can be done. The first is to sell them off in the forex market — that is, to return the USD from where RBI had taken them.

What will be the consequences of selling dollars? The RBI will have less reserves. The rupee will get stronger. The purchasing power of the resident Indian will be greater in terms of what he can buy in foreign markets. A higher consumption of capital goods and raw materials will result. The allocation of the resource — the capacity to purchase foreign goods — will be made according to the choices of millions of households and companies across the country, and not by the government. Imports for infrastructure projects will surely be part of the additional imports that will take place. India will get back to having a current account deficit, and get out of the absurd situation where India has been exporting capital thanks to a manipulated currency market.

Instead, the government is proposing to create a central official body that will allocate resources to firms of its choice. It is assumed that this institution will know what is best for the economy and so it will allocate funds to those it feels will use them best. This fantasy is reminiscent of the socialist paradigm when it was believed that resources should not be allocated by the market. That they are best allocated by a few officers who know best. Despite the failure of central planning models, our policy makers have not got rid of this mentality. The proposal to “use” foreign exchange reserves, in such a manner, will result in a sub-optimal allocation of resources. The government is proposing to create a central official body that will allocate resources to firms of its choice. The idea that the RBI, will be able to do the job of allocating forex resources better than the market is wrong.The government is proposing to create a central official body that will allocate resources to firms of its choice. The idea that the RBI, will be able to do the job of allocating forex resources better than the market is wrong.The government is proposing to create a central official body that will allocate resources to firms of its choice. The idea that the RBI, will be able to do the job of allocating forex resources better than the market is wrong.The government is proposing to create a central official body that will allocate resources to firms of its choice. The idea that the RBI, will be able to do the job of allocating forex resources better than the market is wrong.The government is proposing to create a central official body that will allocate resources to firms of its choice. The idea that the RBI, will be able to do the job of allocating forex resources better than the market is wrong.

India today has to choose from three alternatives. One, RBI can simply stops trading on the currency market. The oversized reserves will look okay when compared with rapidly growing international trade in a few years, and we’ll be okay. Second, RBI can go back into the currency market and sell $10 billion, which will be better. Third, we can create a new frankenstein of a government agency that will meddle with the economy. This is clearly the worst choice of the three.

The $10 billion will be gone in a year or two, but this agency will not go quietly. We will be stuck with a multi-decade battle to close it down. Manmohan Singh and Montek Singh Ahluwalia should concentrate their efforts on closing down the previous frankenstein: the planning commission, not creating new ones.


Ila Patnaik