India’s Dollar Glut: Too Good For Comfort

C P Chandrasekhar

WITH reserves rising well above the record $70 billion mark, the Reserve Bank of India is finding the country’s foreign exchange position a bit too “strong” to be comfortable. For quite some time now, there has been far more foreign exchange flowing into the country than flowing out. And the net inflow of dollars has been accelerating in recent months. Thus, when at the end of year 2002 the foreign exchange reserves crossed the $70 billion mark, this was because of an accretion of as much as $10 billion over the previous four months and another $10 billion in the six months prior to that. As has been noted in the financial media, this trend represents a substantial acceleration of the rate of growth of reserves, which rose from $20 to $30 billion over a period of more than four years ending December 1998 and from there to $40 billion over a two-year period ending December 2000. While a part of the increase in reserves is the result of a revaluation of the dollar value of non-dollar foreign currency holdings, as a result of the depreciation of the dollar against other currencies, especially the Euro and the Yen, it is substantially due to an excess of inflows over outflows. Even an overgenerous estimate suggests that over the period April to September 2002 only about $2.5 billion of the 9 billion dollar reserve accumulation was the result of such revaluation.

Interestingly the acceleration in the pace of reserve accretion occurred despite the fact that the government had in August 1998 and November 2000 issued the Resurgent India Bonds and the India Millennium Bonds respectively, which together resulted in an inflow of close to $9 billion in foreign exchange. Though there has been no similar effort in recent times to mobilise foreign exchange through large scale borrowing against bonds and though there are indications that both the government and the private sector are retiring and reducing past foreign debt, the RBI has been forced to mop up foreign exchange inflows to prevent any undue appreciation of the rupee.

APPRECIATION OF THE RUPEE

The RBI’s efforts notwithstanding the rupee has indeed been appreciating, nudging its way “upwards” from above Rs 49 to the dollar to below Rs 48 to the dollar. This could be seen as reflective of the strength of the rupee and the growing weakness of the dollar. But appreciation of the currency in a country that has not been able to trigger any major export explosion despite ten years of neoliberal economic reform is not necessarily a good sign. At given prices, appreciation of a country’s currency by definition increases the dollar value of its exports and reduces the local currency value of its imports. Inasmuch as this triggers an increase in the dollar value of imports and a decrease in the dollar value of exports, appreciation can be damaging for the balance of trade. And since this occurs in India at a time when oil prices are hardening internationally, the rupee’s appreciation does threaten to widen the balance of trade deficit, or the excess of imports of goods and services over exports of goods and services.

There are two reasons why this has as yet not given cause for worry to the government. First, the most recent figures on exports point to some recovery in India’s export performance. Thus the dollar value of India’s exports rose by 15.7 per cent during the first eight months of the current financial year (April-November), which compares well with the performance during the corresponding period of the previous year. However, while this may dampen concerns about the possible damaging effects of exchange rate appreciation, it cannot be held responsible for the improvement in India’s reserves position. A sharp 21 per cent increase in the dollar value of oil imports and a unexpected 12 per cent increase in the dollar value of non-oil imports have actually increased the size of the trade deficit recorded during the first eight months of this financial year ($6247.65 million) as compared with the corresponding figure for the previous year ($5814.93 million).

The second reason why the rupee’s appreciation has not given the government and the central bank cause for concern is the fact that as a result of a $1.3 billion increase in Private Transfers (largely remittances from workers) and a $1.5 billion increase in net receipts from Miscellaneous Factor Services (which includes software and business services exports), the current account of the balance of payments recorded a surplus of $1.7 billion during April-September 2002-03 as compared with a deficit of $1.5 billion during the corresponding months of 2001-02. That is, the relatively new tendency for the current account of the balance of payments to record a surplus noted over the whole financial years 2001-02, has persisted and gathered strength during the first six months of 2002-03.

But even allowing for this increase in the current account surplus and after taking account of the possible effects of dollar depreciation on value of reserves, there remains around $ 5 billion dollars of reserve accretion that remains to be explained even for the April-November 2002 period. What is more, since the balance of payments statistics indicate that there was a net outflow of $2.2 billion on account of repayment of external assistance and commercial borrowing, we must account for more than $7 billion of inflows on the capital account if reserve accumulation during that period is to be explained. The RBI’s balance of payments statistics suggest that about $1.3 billion of this was on account of foreign investment, another $1.4 billion on account of NRI deposits, around $1 billion on account of Other Banking Capital, $2.1 billion on account of Other Capital and $1.4 billion on account of “errors and omissions”.

AUTONOMOUS CAPITAL INFLOWS

Put simply large “autonomous capital inflows”, occurring at a time when India’s requirements of capital inflows to finance any deficit on the current account have vanished, have played a major role in explaining reserve accumulation. And inasmuch as the easy availability of dollars on account of such inflows have resulted in an appreciation of rupee’s value in India’s liberalized exchange markets, exporters who in the past preferred to delay repatriation of receipts in order to benefit from any depreciation of the rupee have been keen on bringing back their dollar receipts in order not to loose out on the rupee value of receipts because of the appreciation of the domestic currency. Such delayed repatriation of exports receipts get included according the RBI under the “errors and omissions” head.

Thus when we breakdown dollar receipts by source, it becomes clear that the robust balance of payments position as indicated by reserve accumulation and currency appreciation are largely due to autonomous flows from abroad. Those autonomous flows result in a tendency towards currency appreciation, which has a peculiar effect on export receipts. In the short run by encouraging the quick repatriation of past and current export receipts, rupee appreciation increases such receipts. But in the medium and long-term, by raising the dollar value of India’s exports, it affects export revenues adversely.

If any such appreciation-induced worsening of the balance of trade combines with other factors such as an increase in oil prices and a rise in imports on account of buoyancy in the domestic market, a country can be confronted with a situation of rising reserves and an appreciating currency precisely at a time when trade and possibly even current account “fundamentals” are worsening. The process can be especially damaging if foreign investment inflows that involve servicing costs in foreign exchange do not contribute to the country’s foreign exchange earning. This would be true of portfolio flows, of acquisition of domestic companies catering to the domestic market by foreign firms and it is also true of foreign direct investment flows into joint venture companies catering to the domestic market where the existing foreign partner seeks to use the benefits of liberalisation to increase equity share. These are the principal forms of foreign investment flows into India. Despite all this, fortunately, India is still not in such a situation where this has damaged its balance of payments, as we have seen earlier.

CAUSE FOR CONCERN

Yet there is cause for concern for a number of reasons. Virtually pushed by the embarrassingly large level of reserves, and unable to keep acquiring dollars from the market in order to prevent the rupee from appreciating too fast, the central bank has accelerated liberalization of rules relating to availability of foreign exchange for both current account and a growing set of capital account transactions. Access to foreign exchange for investment in stocks and real estate abroad, easier access of foreign exchange for travel, education and the like, slack rules governing use of international credit cards, increase in the limits to which foreign exchange can be used by importers without RBI clearance and changes in rules regarding hedging of foreign exchange transactions are all signs of a process of rapid if imperceptible liberalization. The thrust is clearly in the direction of encouraging use of foreign exchange and liberalizing rules governing cross border movements of goods and capital. In fact, discussion on moving towards full convertibility of the rupee, as recommended by the Tarapore Committee, which had been shelved after the East Asian crises, has once again revived.

Unfortunately, liberalisation can aggravate rather than resolve the problem currently confronting the government. It is to be expected that when a country with a relatively liberalised trading environment experiences currency appreciation, incentives to investors in that country to produce tradable commodities that can be exported or are substitutes for imports decline relative to the incentive to invest in activities involving the generation of non-tradable goods or services. The desire to borrow abroad to invest in infrastructural activities producing non-tradable services, to invest in real estate and construction and to invest in the stock market increase substantially. This most often leads to excess capacity in certain infrastructural areas and even sets off a speculative boom in real estate and stock markets. It also means that there is an inflow of foreign exchange into the country, the costs of which would have to be serviced in time in foreign exchange. Finally, it means that while it increases dependence on foreign capital inflows, it also increases the risk that such flows can dry up and that past inflows are rapidly repatriated. That is, reserve accumulation and currency appreciation of the kind that India is experiencing, the factors that underlie those tendencies and the government’s liberalising response to the tendencies are reminiscent of the process by which countries that were relatively healthy in East Asia and Latin America were pushed into crisis. This curious similarity makes India’s remarkable dollar reserve even more noteworthy than it is being made out to be. It could be the first sign of a crisis that India has managed to stave off thus far.