RBI: Red Brigade of India

Indian Express, 30 March 2006

- Ila Patnaik

In case you thought it was only the JNU Students Union that opposes
globalisation, here is a surprise for you. After the Prime Minister's
statement that India should move towards full capital account
convertibility, the Employees Union of the Reserve Bank of India
issued a statement opposing the move.

What is the RBI staff afraid of? Why should RBI employees be opposed
to India adopting capital account convertiblity? What do they have to
lose? The reasons for the support anti-globalisers have got from this
august body are not too difficult to comprehend. The answer lies in
the annual report of the RBI (2003-04) Table 14.8. It shows that out
of the 24,994 employees of the RBI, the largest number among them --
7,286 employees work in the Department of Currency Management. In
addition, 1,259 employees work in the Foreign Exchange Department.

On paper, the rupee is convertible on the current account and the
exchange rate of the rupee has been a market determined exchange rate
since 1993. But 8,545 people continue to be employed in foreign
exchange management. Today there are a number of controls on capital
flows and foreign exchange movement. Capital account convertibility
will mean dismantling this last bastion of control raj in
India. Bureaucrats in the the ministries of industry and commerce did
not like it when liberalisation eliminated their license-permit
raj. Why should the babus in the RBI like it any better?

The RBI staff would lose work on two fronts. One, they will not be
trading on currency markets as full capital account convertibility can
work properly only if the rupee is allowed to float. Two, households
and firms of India will manage their own assets, with hundreds and
thousands of portfolios scattered across the world, catering to their
own preferences and needs. This will replace the present public sector
framework for risk management done by RBI staff running one giant
foreign currency reserves portfolio.

At a lecture at the Reserve Bank of India on March 24, Harvard
President and former US Treasury Secretary, Larry Summers, noted that
India has excess foreign exchange reserves to the tune of 15 percent
of GDP. The opportunity cost of holding these reserves in low yield
securities, is, according to Summers, more than 1 percent of GDP and
greater than the public spending on health. Last year Planning
Commission Deputy Chairman Montek Singh Ahluwalia had started a public
debate about using India's excess foreign exchange reserves. In mid
2004 when he raised this issue the level of reserves was USD 110
billion. Yet, despite the understanding that the level of reserves was
excessive, more were acquired and today they stand at USD 130
billion. It is clear that for the last 5 years at least, the level of
foreign exchange reserves in India have been far beyond what is
required as 'insurance'. 

Reserve adequacy can be measured in a number of ways. The "Greenspan
Guidotti rule", quoted by Larry Summers, requires reserves to be
enough for a year's requirements taking into account various risks in
the world economy. One can alternatively use months of imports or
short term debt servicing as measures of reserve requirements. India
satified all these requirements many years ago but reserves continued
to grow.

Many people believe that a build up of reserves takes place when
foreign capital comes into the country, or when the country exports
more than it imports. Wrong. It takes place when the RBI buys dollars
in the foreign exchange market. If the RBI does not step forward to
buy dollars, there is no further reserve accumulation. What happens is
a movement in the price of the currency - a movement depending on the
demand and supply of rupees and dollars in the market. The build up of
reserves takes place to the extent that the RBI tries to manipulate
the exchange rate. If it chooses to keep the exchange rate fixed, or
in a band around a chosen level, it buys and sells in the market. In
other words, the costly policy of building reserves is a direct
consequence of the exchange rate policy of the government. There is no
consensus that rupee appreciation is bad, but let us for the moment
assume that that is what the government wants. The question then is
how to achieve it without ending up with costly reserves.

Prime Minister Manmohan Singh's suggestion of putting India on the
path to full capital account convertibility (CAC) will solve two
problems - that of the RBI having to intervene heavily and pile up
reserves if it wants to prevent rupee appreciation, and that of India's
foreign assets earning low returns.

Under CAC, households and firms in India would buy dollars to hold
assets abroad. Instead of the RBI having to enter the market for
foreign exchange and purchase dollars when they start getting cheap
due to capital inflows, millions of investors would see the
opportunity and step in and buy assets abroad. This would reduce the
pressure on the rupee to appreciate. Some recent easing of
restrictions such as allowing households to hold bank deposits of USD
25,000 abroad, pre-payment of external debt, allowing outbound FDI by
Indian companies have been done when the pressure on the rupee to
appreciate was high. Full convertibility will achieve this as
well. How it will be different from what we have today is that there
will be ups and downs in the exchange rate beyond RBI's control.

Second, CAC would address the problem Larry Summers refered to -- of
holding India's foreign assets in low yielding securities. When
millions of firms and households hold assets, they maximise
returns. India's foreign portfolio will contain bonds and shares of
companies and governments all over the world. When RBI holds foreign
exchange reserves these are held mainly in highly liquid securities,
typically low risk, low return government bonds, or as India moves
away towards other currencies, euro and yen denominated bonds.

India got rid of the control raj in industry. India got rid of the
control raj in trade. Both were opposed by vested interests who earned
rents from the controls. It is time for India to get rid of the
control raj on capital flows. 

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