People's Democracy

THE Indian economy is clearly in a peculiar phase at the moment. There is already a large growing surplus of foodgrain stocks held by the public sector, which has become a major embarrassment for the government, and has persisted for far too long already. And now comes evidence of a very substantial – indeed unprecedented – increase in the level of foreign exchange reserves held by the Reserve Bank of India.

By April 2002, official foreign exchange reserves stood at nearly 55 billion dollars, their highest ever level. And this represented an increase of nearly 12 billion dollars just over the financial year April 2001 to March 2002.

Some have seen this increase in reserves as a positive sign, as an indication of the inherent and current strength of the economy. Thus, it is argued that such a build-up of reserves must necessarily reflect substantial surpluses in either the current account or the capital account of the balance of payments, and both are to be welcomed. It is also argued that such large reserves provide protection against capital flight and currency crises, which continue to plague various emerging markets and could also afflict India.

Neither of these arguments is really valid in the current context, as I will argue later. In fact, excess foreign currency holdings reflect an economy operating well below potential, and an enormous slack in terms of the use of resources.

What is behind this tremendous spurt in reserves? Trade flows have contributed to this. Exports over 2001-02 were stagnant, growing at a negligible 0.1 per cent over the previous year.

Meanwhile, imports actually increased slightly, by 1.1 per cent, leading to an increase in the trade deficit by 578 million dollars. So trade flows would have implied falling reserves, not additions to the reserve pool.

Over the past decade, the current account has been kept in check essentially because of invisible payment inflows in the form of large-scale remittances from Indian workers abroad. This process continued well into the first nine months (April-December) of 2001-02, with net invisibles amounting to as much as 8,756 million dollars. So, while the overall current account deficit was much lower in April-December 2001 than in the same period last year, the balance was still negative to the tune of 726 million dollars. So the current account did not contribute to the build-up of reserves, at least over most of the year.

While foreign exchange reserves increased more or less continuously over the months of the financial year 2001-02, the bulk of the increase was in the latter part of the year. In fact, the really large inflows occurred over the last quarter January to March 2002, when the increase in reserves amounted to nearly six billion dollars, more than half the total increase over the year.

Unfortunately, we do not yet have detailed data on the balance of payments flows for the last quarter, January to March 2002. But patterns over the earlier nine months may provide some indication of the broad tendencies. Obviously, going by the ongoing trends, the inflows would have had to come dominantly from the capital account, because the current account has been in deficit, and it is unlikely that the last quarter would have completely reversed this pattern.

There was certainly some increase in foreign investment in April-December 2001, amounting to about 3.5 billion dollars. But this was also counterbalanced by the decline in "loans" by more than one billion dollars. However, what did increase substantially was banking capital inflows, which amounted in the net to 3,8 billion dollars. These are debt-creating flows; indeed, almost 2 billion dollars was in the form of NRI deposits, probably in the Indian Millenium Bonds and similar deposits. Since these deposits bear higher interest than available on domestic deposits or even many international bank deposits, they are really also part of the total external debt.

But even this leaves some part of the increase in reserves even over this period unexplained. Most of this gap can be explained by "errors and omissions", which were more than two billion dollars over this period.

"Errors and omissions" are typically reflective of illegal or irregular capital flows, or "hawala" transactions. Negative amounts for "errors and omissions" would therefore suggest capital flight, while positive amounts indicate inflows. Needless to say, such flows are extra-legal at best, and indicate that resources are coming into the country to finance activities which may be economic, political or even criminal, but are not recorded as part of the economic transactions of the country.

Therefore, such large amounts of inflows - more than one-third of the increase in reserves – being recorded as "errors and omissions" is a source of concern.

There remains the question of whether, in the more open capital account regime, such high levels of reserves are necessary as a precautionary measure against possible capital flight and currency crisis. This is certainly an important consideration, especially given the current political developments in the sub-continent and the likelihood that investors will turn and stay shy of the region at least in the short term.

Unfortunately, however, the experience of numerous crises in emerging markets has made one unpleasant fact quite clear: no level of foreign exchange reserves is enough to ward off a determine speculative capital attack. Most of the countries that have experienced currency crises over the past decade had levels of reserves which were considered comfortable if not excessive, and in all these cases these reserves proved to be totally inadequate to deal with the situation and prevent bleeding outflows of capital.

Indeed, the conclusion is inescapable that large foreign exchange reserves are no substitute for capital account controls in terms of regulating both inflows and outflows and preventing destabilizing movements of capital and volatility in exchange rate movements. Therefore, the currently high level of reserves should not provide any excuse for complacency : the likelihood of these reserves being enough to protect the economy in the event of a genuine collapse in investor confidence and capital flight is extremely small.

Finally, of course, it must be reiterated that at one level these exchange reserves do represent a waste of resources. Essentially, this is an expression of the continuing stagnation of the Indian economy, of the large slack which remains in the system.

While the government could certainly lift the economy out of its current recession through increased productive spending which would also generate more employment and reduce the other evidence of slack (the large foodgrain stocks) so far it has proved to be remarkably inactive on this front. It is not clear whether this reflects lack of enthusiasm for such expansion, or simply incompetence.

But in this context, when the increase in reserves expresses simply an accumulation of unutilised resources, and a large part of them is the result of inflows in the form of debt-creating flows and possibly illegal activities, it is certainly wrong to see in them any cause for celebration.