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Harish Damodaran

FEW WOULD dispute that the sizeable build-up of foreign exchange reserves has been the most significant macroeconomic development in the country over the last decade; something that has altered the very face of the economy and profoundly impacted monetary, exchange rate and trade policy.

Reserve accumulation has, in fact, been an enduring phenomenon since the start of the 1990s and there has not been a single year — barring 1995-96 — that has not seen an accretion to India's forex kitty (see Table 1). The total forex reserves have risen from $3.96 billion in March 1990 to $ 66.02 billion as on November 15, 2002. The current fiscal is all set to end with forex reserves upwards of $75 billion.

In terms of adequacy, the existing reserves are sufficient to finance India's import needs for roughly 13 months. Compare this to the reserve cover of below two months in March 1990 (it had plunged to a low of three weeks' level by end-1990).

This article seeks to examine the factors behind this unprecedented reserve accumulation process. How has the transformation taken place, from an economy perennially short of foreign exchange to one where hardly any week passes without the Reserve Bank of India mopping up excess dollars from the market and adding to its swelling coffers? Has the accretion been due to any resurgence in exports or has been facilitated primarily by capital inflows, including foreign investment? What has been the contribution of remittances from migrant workers abroad or, for that matter, export of software and IT-enabled services?

To get an insight into the dynamics of forex reserve movements, Table 2 depicts the aggregate five-yearly Balance of Payments (BoP) statistics for four periods, of which the first two — 1981-82 to 1985-86 and 1986-87 to 1990-91 — pertain to the `pre-reform' period and the last two — 1992-93 to 1996-97 and 1997-98 to 2001-02 — to the `post-reforms' period.

The overall picture that emerges is that there was a drawdown of forex reserves up to $4.5 billion during 1981-91. This, in turn, was attributable to a cumulative current account deficit of $51 billion, which more than offset net capital inflows of $46.5 billion received during this period.

What transpired in the subsequent ten years ending 2001-02 was quite the reverse. The aggregate current account deficit for this period shrank in absolute terms to $34 billion, even as capital inflows, net of repayments, rose to $82 billion. The absolute lowering of current account deficit levels reduced the draft on capital account surpluses, enabling greater deployment of these inflows for beefing up reserves. The end-result was a reserve accumulation of over $48 billion compared to a drawdown of $4.5 billion in the earlier period.

But that does not still explain how current account deficits have come down or what has been the nature of increased capital inflows since the 1990s. Table 2 shows that the reduction in current account deficits has not been on account of any major turnaround on the merchandise trade account front. The cumulative trade deficit actually widened further by 57.5 per cent during 1992-2002 relative to that during 1981-91, as imports continued to surpass earnings from export of goods.

The real impetus has come from the `invisibles' account, which, unlike the `trade' account of the BoP, covers all current forex transactions not involving physical shipment of goods in and out of the country. The aggregate invisibles surplus in 1992-2002 was nearly 250 per cent higher than that during 1981-91. This more than compensated for the 57.5 per cent rise in the trade deficit, while simultaneously bringing down the cumulative current account deficit by $17 billion.

The basic source of buoyancy in invisible receipts has been private transfers (mainly inward remittances from migrant workers), which registered an impressive cumulative growth of 303 per cent. True, remittance figures for recent years also include the gold and silver brought in by returning Indians, following the move in 1992-93 to allow such imports up to 5 kg per person. However, even after netting out for these imports — which totalled $12.3 billion between 1992-93 and 2001-02 — the growth in private transfers works out in excess of 250 per cent.

The underlying reason for this surge has been the rupee's considerable depreciation during the 1990s, leading to a convergence between the official exchange rate and the hawala (parallel market) rate. Since 1990-91, the rupee has fallen from an average of Rs 17.94-to-the-dollar to about Rs 48.25 and this shift from an administered to a market-determined exchange rate regime has eroded the hawala premium, providing the necessary incentive for migrant workers to remit their monies via regular banking channels rather than through unofficial exchange brokers.

There are two related points worth mentioning here. First, remittances have been much more responsive to devaluation than exports. A 62 per cent depreciation in the rupee vis-a-vis the dollar between 1990-91 and 2001-02 produced a near six-fold jump in private transfers, from $2.08 billion to $12.19 billion, even as export earnings went up less than two-and-a-half times, from $18.48 billion to $44.91 billion. The logic for this differential response is simple. Devaluation is not a panacea for exports, if no concurrent action is taken on the `real' front: Removal of infrastructural bottlenecks, simplification of procedures, etc. Remittances, on the other hand, are not bound by such constraints, since the required `supply-side' back-up already exists in the migrant's country of work. The exchange rate incentive, then, makes quite a lot of difference here.

That raises the second issue. What happens to remittances once exchange rate correction runs in course? Official data suggest that after the initial spurt till 1996-97 — when they touched $9.8 billion, net of gold imports — private transfers have stagnated around the $12 billion level in the last three years. Devaluation has clearly had only a one-time salutary effect on remittances, which has petered out. Unless there is a fresh Gulf boom triggering a perceptible jump in manpower exports from India — a remote possibility — private transfers are unlikely to grow the way they did in the past decade.

What about revenues from tourism or software exports? The 1992-2002 period has not been all that benign for tourism, with gross receipts growing by a niggardly 125 per cent. Worse, with Indians themselves turning prolific world travellers, of late — the 353 per cent jump in foreign travel payments bears testimony to this trend — net earnings from tourism have been on the decline. The tourism industry's problems are similar to those burdening exporters: Abysmal infrastructure and lack of concerted marketing efforts, reflected in the hiatus between potential and performance.

Software exports are categorised within invisibles under the sub-head `miscellaneous non-factor services'. These receipts have grown by 292 per cent during 1992-2002 and much of this has to do with the spectacular rise in software exports, from virtually zero till 1992-93 to $7.17 billion in 2001-02. Software exports comprised around 45 per cent of the aggregate miscellaneous non-factor service receipts during 1997-2002.

But what is significant to note is the fact that the 292 per cent growth in miscellaneous non-factor service receipts has been accompanied by a corresponding 297 per cent increase in miscellaneous non-factor service payments. What exactly are these payments and how does one explain their sheer magnitude — some $50.6 billion during 1992-2002, restricting net receipts to just $8.3 billion? Unfortunately, there is no publicly available data giving a detailed break-up of these payments.

And neither do official documents shed much light, apart from containing innocuous generalities such as "the impact of the current account liberalisation is being reflected in rising outgoes in the form of technology-related payments, imports of financial services, management fees payments for official expenses, advertising and other business and commercial services".

All that can be said is that the cushioning impact of software exports on the country's BoP is somewhat overstated at the moment.

While the `knowledge sector' has certainly emerged as a valuable source of foreign exchange, there is need to also recognise that technology is a two-way street, entailing potentially huge expenses on royalties, technical fees and other related payments as well.

Finally, as regards capital inflows, it may be observed from the Table 2 that a large chunk of these flows in the post-reforms period — 54 per cent — has been constituted by foreign investment. Consequently, the reliance on traditional sources of foreign capital (external assistance, Non-Resident Indian deposits, commercial borrowings) has dipped sharply.

And incidentally, not all the foreign investment has been `hot money'. The share of portfolio investment — mainly purchase of shares by foreign institutional investors — in cumulative foreign investment of $44.6 billion during 1992-2002 has been about 52 per cent.

The rest has been direct investment, mostly embodied in plant and machinery and, hence, of a `permanent' nature. Moreover, the profile of such investment has been going up in the last two-three years which is, no doubt, a healthy trend.

In the long run, accumulating reserves on a sustainable basis hinges on a substantial step-up in exports and attracting higher levels of foreign investment. India is probably the only country that has managed to build an impressive foreign currency chest on the back of a measly eight per cent annual growth in exports since 1990-91. That definitely is not sustainable.

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