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Tuesday, Jun 11, 2002

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Burgeoning forex reserves: Boon or bane?

C. P. Chandrasekhar
Jayati Ghosh

Foreign exchange reserves held by the RBI rose to unprecedented levels, increasing by nearly $12 billion between April 2001 and March 2002. In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh investigate the increa se in official reserves and consider what it tells us about the current state of the Indian economy.

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, their highest ever level. And this represented an increase of nearly $12 billion just over the financial year April 2001 to March 2002. Chart 1 shows that while such reserves have been growing since 1995-96, the increase last year by $11,825 million was the largest yet, and much more substantial than in previous years. Indeed, only in 1993-94 (the year when financial liberalisation measures led to a sudden inflow of foreign portfolio capital and other such flows) did foreign exchange reserves rise by anything like this amount, but even then it was less at $9.4 billion.

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 completely wrong, but both have limitations, especially in the current context. In fact, the attitude towards reserves build up must be conditioned by an awareness of what has caused such an increase, and by a sense of what is required to limit or prevent currency volatility. In any case, it should be borne in mind that, just as is true in the case of the excess food stocks, excess foreign currency holdings reflect an excess of ex ante savings over ex ante investment. This suggests 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? What is clear is that it is not any development on the trade front which has contributed. Charts 2 and 3 make this quite evident. Exports over 2001-02 were stagnant, growing at a negligible 0.1 per cent over the previous year (which was substantially below even the downscaled target of 4 per cent set by the Commerce Ministry.) Meanwhile, imports actually increased slightly, by 1.1 per cent, leading to an increase in the trade deficit by $ 578 million. So trade flows would have implied falling reserves, not additions to the reserve pool.

Incidentally, it is worth noting the point shown in Chart 3, that this rather minor increase in imports over the past year was really due to the collapse in international oil prices, which brought POL (petroleum and other lubricants) imports down by 12.7 per cent. By contrast, non-POL imports increased by 7 per cent despite the ongoing domestic recession, indicating the continued process of import penetration of domestic markets.

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. Chart 4 shows that 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. (Incidentally, net transfer payments — including remittances — were even higher, at $9,136 million, while net services inflows accounted for $1,639 million. However, fairly large investment income outflows of $4,098 million kept the total invisibles lower.)

From Chart 4 it is clear that, 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. So the current account did not contribute to the build-up of reserves, at least over most of the year.

However, Chart 4 suggests that there have been movements in the capital account — especially increases in foreign investment and banking capital inflows — which could account at least partly for the rise in reserves. These are considered in more detail below. But first, let us examine the pattern of changes in reserves over the year.

Chart 5 shows that 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, as evident from Chart 6, the really large inflows occurred over the last quarter January to March 2002, when the increase in reserves amounted to nearly $6 billion, 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.

Table 1 presents the capital account flows for the period April-December 2000 and 2001. There was certainly some increase in foreign investment in April-December 2001, amounting to about $3.5 billion. But this was also counterbalanced by the decline in "loans" by more than $1 billion. So this would help to explain only about $2.5 billion of the increase in reserves over this period.

However, what did increase substantially was banking capital inflows, which amounted in the net to $3,770 million. This also represents debt-creating flows; indeed, almost $2 billion of this amount 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.

So it appears that in the first nine months of the year, the net increase in capital account inflows was in the form of debt-creating flows of banking capital. However, this leaves some part of the increase in reserves even over this period unexplained.

As Chart 8 shows, the net total capital account flows over April-December 2001 amounted to $ 4,246 million, while the current account was in deficit to the tune of $726 million. But the increase in reserves over this same period was $5,831, which leaves a gap of $2,311 million — not a small amount by any standards. Chart 7 suggests that most of this gap can be explained by "errors and omissions", which were more than $2 billion over this period.

The treatment of "errors and omissions" has always been somewhat of a problem. Analysts have tended to view these as 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 being recorded as "errors and omissions" can be a source of concern. In the period under consideration, that is the first three quarters of the financial year 2001-02, they accounted for 35 per cent of the increase in reserves of the central bank.

Since we do not yet know the composition of the balance of payments flows over the last quarter of the year, we cannot yet say how the additional increase in reserves was distributed. However, if the pattern of the first nine months is a good indication of the subsequent tendency as well, then clearly the build-up of reserves over the past year is the result of several problematic features in the external accounts. The dominant part of capital inflows was probably in the form of debt-creating flows, while a very significant role would have been played by illegal transactions captured under "errors and omissions".

The sale or purchase of US dollars by the RBI (shown in Chart 7), which is another good indicator of net inflows, suggests that a huge amount of the inflows occurred just in March 2002. Subsequent information on the level of official reserves suggests that this very recent tendency has continued: Over April alone, foreign exchange reserves are estimated to have increased by an additional $1 billion.

One interesting feature of the recent trends is that the build-up of reserves appears to have little or no effect on the exchange rate. Usually, such large net inflows and increased reserves over a relatively short time would lead to currency appreciation of quite significant proportions. However, even from 2000, the rupee has continued to depreciate with respect to the major currencies — the US dollar and the euro — as Chart 9 shows. The slight appreciation vis--vis the Japanese yen is reflective of that currency's slide in international currency markets, rather than any greater strength of the rupee.

Of course, the nominal decline over the past few years does not necessarily mean a decline in the real exchange rate. Chart 10 illustrates that the trade-weighted real exchange rate (with respect to five major currencies) actually appreciated slightly in 2000-01 over the previous year.

Chart 11 describes the movement of nominal and real trade-weighted exchange rates over 2001-02. It is clear that over this year, despite the substantial increase in foreign exchange reserves, both the nominal and the real exchange rates have generally depreciated, albeit slightly, over the course of the year. This suggests that the RBI has probably engaged in open market operations that would manage the exchange rate and prevent it from appreciating in a manner that would be harmful for exporters. Of course, there are limits to such market-based intervention: If inflows of the type described above continue to increase, the rupee is likely to appreciate in real terms as well.

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.

While the level of reserves is enormous by conventional standards, amounting to around ten months' value of imports, it is still substantially below (less than two-thirds) the stock of short-term capital in the country. Therefore some could even argue that the level of reserves should be even higher in order to protect against possible capital flight.

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 determined 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 destabilising 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.

Of course, any society may choose deliberately to set aside resources for a precautionary motive, as indicated above, even though in this case this is not likely to be sufficient to protect again possible crises. But the current build-up of reserves does not appear to be such a conscious decision on the part of Indian policy-makers.

Rather, the Government has actually given up its ability to control most balance of payments flows, and therefore this reserve increase must reflect other forces which are shaping the decisions of private agents in the economy.

Essentially, this expression of the excess of ex ante savings over ex ante investment is the result 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.

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