People's Democracy

The Build-Up Of Foreign Exchange Reserves  

Jayati Ghosh

THE recent unprecedented build-up of external reserves is being seen as a sign of economic strength, but it also contains the seeds of future problems. At one level, India’s external balance of payments appears extremely robust. In the net there is far more foreign exchange flowing into the country than flowing out. As a result, the year 2002 ended with foreign exchange reserves crossing the $70 billion mark.

Between March 2001 and December 2002, external reserves increased by $28 billion.  Most of that increase has in turn been concentrated in the past calendar year alone, which has seen an increase in the level of foreign exchange reserves of more than $22 billion.

Such a dramatic increase is unprecedented in the history of Indian balance of payments. Because of this, Indian policy makers suggest that all is well on the macroeconomic front. Even more significantly, the higher level of foreign reserves is being used to argue that the country’s external accounts are now so healthy, that the economy is ripe for a major dose of capital account liberalisation.

This makes it important to consider the causes of this rapid accumulation of reserves, as well as the future implications of the forces underlying this increase.

CAUSES OF ACCUMULATION OF RESERVES

Most of this increase is because of capital inflows – largely of what can be called “hot money” – which have gone up especially quickly in the last nine months. This may be because India is suddenly being seen as a favoured destination by international capital, or it may be simply because other emerging markets have performed rather poorly over this period. Indeed, many of these markets – in Latin America and elsewhere – are doing badly simply because they were earlier discovered as favourable places for international capital to flow to!

Meanwhile, an important role has been played by remittances from Indian workers abroad as well as service exports mainly software) which have caused the current account of the balance of payments to record a surplus.

So, large “autonomous capital inflows”, occurring at a time when there is no current account deficit to finance, have played a major role in explaining reserve accumulation. This has resulted in an appreciation of the rupee in both nominal and real terms. (It is now at below Rs. 48 to the US dollar.) This rise in the rupee value has got reinforced by the behaviour of exporters, who have been keen on bringing back their dollar receipts in order to ensure that the rupee value of such exports does not fall further.

FUTURE IMPLICATIONS

However, 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. It increases the dollar value of its exports and reduces the local currency value of its imports. If this triggers an increase in the dollar value of imports and a decrease in the dollar value of exports, it 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.

The central government does not appear to be too worried about this. After all, the most recent figures on exports point to some recovery in India’s export performance. But this may not be a good indication of future prospects. It is well known that changes in exchange rates take some time to feed into goods markets and therefore exports and imports. Since the rupee appreciation is still quite recent, it will not yet have fed into changed dollar prices (with corresponding effects on export volumes) or lower margins faced by exporters.

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 the trade balance may be deteriorating.

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 earnings.

This would be true of portfolio flows and of acquisition of domestic companies catering to the domestic market by foreign firms. 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.

A CAUSE FOR CONCERN

Yet there is a cause for concern for a number of reasons. The recent moves towards more capital account liberalisation suggest that there will be even less official control on the types of finance flowing in and out of the country. In November and December 2002, a whole range of measures was announced which liberalised both current and capital account transactions. On January 10, 2003, yet another set of liberalising measures was announced, that has brought the economy even closer to capital account convertibility.

These measures bring the economy much closer to liberal capital account transactions, and make it much more difficult for the government to regulate or even monitor the nature of a range of transactions which may also involve the flow of speculative capital. While the government still retains some degree of control on external commercial borrowing by firms, this is not the only form of mobile finance capital that can cause broader macro-economic problems.

Unfortunately, such 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 desires 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, all increase substantially.

This most often leads to excess capacity in certain infrastructure 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 why it is increasingly recognised across the world that the control and regulation of capital inflows may be even more significant in staving off potential crises, than controls on outflow.

Indeed, 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, and ironically it would have been caused by the very factors that the government is currently celebrating, such as the accumulation of external reserves.