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V. Anantha Nageswaran

It is a matter of pride that India has moved from being a country that faced a BoP crisis to one that has official foreign exchange reserves of nearly $90 billion. The RBI has done an admirable job of managing the country's external liquidity and debt position, but it cannot behave like a fund manager. That could trigger unwelcome movements and, thus, discretion of the highest order is called for, says V. Anantha Nageswaran.

Is RBI a part of the awakened club alert to the dangers of the unsustainably strong US dollar?

BEFORE making any comments on the management of India's foreign exchange reserves, it is important to acknowledge two important developments: From 1991 to 2003, India has moved from being a country that faced a BoP crisis to one that has official foreign exchange reserves to the tune of nearly $90 billion. It is a matter of pride and a cause for celebration. India is a net creditor nation to the IMF now. It has increased its official development assistance to countries in Africa. Trivial concerns should not be allowed to override the significance of what India has achieved.

The Reserve Bank of India has done an admirable job of managing the country's external liquidity and debt position and its impact on the country's foreign exchange situation. Further, there is no dearth of wisdom within the bank on the implications of rising reserves. Any amount of suggestion and advice or concern cannot ignore this aspect.

The International Monetary Fund (IMF), in its semi-annual World Economic Outlook published in September has argued that Asian countries, collectively, hold reserves well in excess of what they need to, based on their external debt, import requirements, etc and that such `excess' build-up occurred mainly in the course of the year 2002.

Many reasons why 'reserves are excessive'

In general, the accumulation of reserves in excess of what is deemed prudent or desirable has occurred mainly due to the fact that the level of reserves were deemed inadequate during the Asian crisis in 1997-98. Asian countries, stung by the experience of those years and the resulting heightened awareness of their vulnerability, decided to provide themselves substantial cushion against any future eventuality.

Further, China's low-wage competitiveness seriously threatens the export prospects of many Asian nations, India included. Further, China's currency is pegged to the US dollar. Given the relative unit labour costs between China and the rest of the world, estimates of the extent of overvaluation of the Chinese renminbi range from 25 per cent to 50 per cent. Hence, many countries tend to purchase US dollars and sell domestic currency hoping to prevent or delay the erosion of their export competitiveness. This slows the pace of appreciation of their currencies against the depreciating US dollar and boosts their official reserves.

Third, in the light of the tenuous geo-political situation, particularly in the Arab World, it is difficult to predict the future course of oil prices with a modicum of certainty. After the invasion and `liberation' of Iraq, the price of crude oil was widely expected to drop to $20 per barrel. It did not happen. For a long time, the price of crude oil per barrel remained at over $30 per barrel. When it began to slide towards $25, the Organisation of Petroleum Exporting Countries (OPEC) announced an unexpected production cut last month (September). This has pushed the price back above $29 per barrel.

The situation in the Persian Gulf region remains tenuous and further deterioration in the political and security climate in the region in the course of 2004 cannot be ruled out, with its consequent deleterious impact on the crude oil price. Most Asian nations — with a couple of notable exceptions — are oil importers. Hence, they need to build in some cushion for the higher unpredictability of the oil price environment.

These considerations apply mostly to India as well. Hence, larger than usual foreign exchange reserves are to be expected. However, the issue of whether reserves are excessive or adequate is mostly a matter of judgement than theory.

However, India's foreign exchange reserves are now more sustainable

India's growth potential is far widely recognised than it used to be. Back in the 1990s, India used to rely considerably on the inflows of Indian workers' remittances from the Gulf region. Now, happily, the situation is different. Foreign institutional investors alone have pumped in $4 billion into Indian stocks this year. Further, the non-resident Indian community is more widely dispersed now — particularly after the boom in software in the 1990s — and they are beginning to plough back their savings into India.

Further, the reputation gained in the export of software in the 1990s has attracted customers for broader services — call centres, business processes outsourcing, etc., — known as Information Technology Enabled Services (ITES).

India is emerging as a centre for manufacturing as well in some specific niche areas for global companies. All of these hold up the possibility that reserves might continue to stay high and that upward pressure on the rupee in the years ahead is a strong possibility.

If future vulnerability to foreign exchange payments is not high and if inflows could be maintained, should the RBI stop accumulating reserves now?

Not accumulating reserves would mean a sharp rupee appreciation

It would simply mean that the RBI allows the rupee to appreciate as dictated by market movements. While it might satisfy the purists or theorists, practical considerations militate against that. No country in the world could handle too much currency fluctuation (in either direction) in the short-term. Hence, the RBI is correct in managing an orderly appreciation of the Indian rupee against the US dollar.

The recent rupee appreciation against the US dollar has already invited the expected reactions from the industry fearing loss of export competitiveness. In his speech to the National Foreign Exchange Association of India in August, Dr Bimal Jalan correctly pointed out that the export competitiveness of an exchange rate should be seen in the value of the trade-weighted exchange rate rather than in a bilateral exchange rate against the US dollar alone. The rupee has gained far less against the US dollar compared to other currencies and that means that the rupee has gained in competitiveness against them. India's exporters should seek to expand opportunities in those markets where exchange rate movements have given them additional competitive advantage.

Nor is reserve accumulation impeding Indian domestic growth

That brings us to another dimension of reserve accumulation. It is that reserve accumulation occurs primarily because the central bank somehow attaches greater importance to growth through external demand and, to that extent, domestic demand components such as investment spending suffers. There is some merit in that criticism. However, in India, this criticism does not stand empirical scrutiny. Export share of growth in India is relatively small. The country, both in terms of size and population, is a relatively closed and large economy. Hence, domestic demand is central to growth. The criticism, if any, is that the country has paid too little attention to export growth and external orientation in the past. Therefore, it cannot be really argued that India is neglecting or underplaying domestic growth or sacrificing it for the sake of the short-term expedient of export growth. Further, as the former RBI Governor has observed, the RBI has released rupee amounts against the foreign exchange reserves deposited by corporations and others. Hence, whether or not they undertake investment activity is in their hands and it is not up to the RBI. Fair point. Then, the ball is really played to the government. How the government encourages capital spending by the Indian industry is a general macro-economic management issue.

The government knows what needs to be done. Investment spending is a function of the return on capital (business growth potential) and the cost of capital (interest rates). Return on capital is also influenced by the cost of doing business which, in turn, rises or falls with the level of infrastructure support (power, water, roads, and so on), the operating and regulatory environment, labour costs and policy predictability. There is awareness of the desired state and the actual state of affairs and yet the political cycle often comes in the way of the gap between the two being plugged in a timely fashion.

Using reserves to acquire foreign assets including technology

Then, it is up to the government to facilitate the industry `using' the `reserves' to import technology and capital goods and thus scale up productivity. Further, it could also liberalise the release of the foreign exchange for purchase of foreign goods and services by domestic residents. The RBI has been announcing various relaxation measures on the quantum of foreign exchange released for travel, education and overseas health examinations and other services. As for the former, the removal of the cap on the payment of royalties and technology transfer fees is welcome. The government might also consider raising the ceiling on the amount available to Indian corporations for take-over/acquisition of foreign corporations. Foreign exchange reserves should become a useful tool in advancing the cause of Indian multinationals.

Active investment management of reserves is essential in the years ahead

One aspect of the management of foreign exchange reserves that lies with the RBI is the management of reserves as though they are an investible pool of assets. In such a framework, the central bank has to actively manage the risk of foreign exchange rate movement eroding the value of the underlying reserves. For that, the bank needs to form a view on the outlook for various currencies in the years ahead as well as currency substitutes such as gold and other metals and act upon it. In doing so, the RBI would be emulating the practices of investment/fund managers to manage the exchange reserves pool.

Currently, governments in the three major currency blocs — the US dollar, the euro and the yen — seek weaker currencies. However, fundamentals dictate that only the US would be granted that wish in the years ahead. Therefore, for the RBI to hold the reserves predominantly in US dollars without diversification and without active management would be to run the risk of incurring avoidable losses. The International Monetary Fund Annual report of 2003 shows that the share of the US dollar in global official foreign exchange reserves had declined from 67.9 per cent in 1999 to 64.8 per cent in 2002 while the share of Euro has increased from 12.6per cent to 14.6 per cent during the same period. Some of it could be due to the appreciation of the euro against the US dollar. However, if some portion of the increase in the share of the euro is an indication of central banks waking up to the dangers of the unsustainably strong US dollar, one hopes that the RBI is part of that awakened club.

Obviously, the RBI cannot behave like a fund manager totally and actively shuffle its portfolio of currencies and underlying bonds. That would trigger unwelcome movements in exchange rates and nullify the intention of the central bank. Hence, discretion of the highest order would be called for. At the same time, passivity in the light of possible large-scale currency re-alignment and dollar debasement would be a needless waste of precious resources.

(The author is Director, Global Economics and Asset Allocation, Credit Suisse, Asia-Pacific. His views are personal. Please address feedback to anantha@nageswaran.com)

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