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NCAER concern over cost of high forex reserves

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NEW DELHI, Sept. 21

THE National Council of Applied Economic Research (NCAER) has urged the authorities to tackle the cost of keeping the foreign exchange reserves at `high' levels through tight monetary policy, which has resulted in lower economic growth.

In its latest issue of Macrotrack, the Council said the country has never had it so good as far as foreign exchange reserves go, with foreign currency reserves of the banking sector having crossed $60 billion. It said that even if the import bill of the country goes up due to oil prices stiffening in the coming winter, forex reserves are comfortably high.

The Council said the liberalisation of foreign investment as well as attractive interest rate offered to at least some of the debt flows remain the main reason for the capital inflows.

The current account balance turned into a surplus for the first time in 2001-02 since 1977-78. In this sense, current account balance has not been a source of rising forex reserves.

It said the build-up of foreign exchange reserves has been essentially due to improved capital flows. The increase in reserves by nearly $35 billion in the last seven years is the consequence of higher capital flows. Foreign investment accounted for 56 per cent of reserves build-up since 1995-96.

The Council contends that while high forex reserves by themselves need not be a cause for worry, a steady rise in reserves when the economy remains sluggish might imply distortions in capital markets and is likely to have an adverse impact at a future date. It also implies forgone revenues as resources are unused.

It said capital inflows arising out of attractive interest rates should be a matter of concern. India raised high cost funds in times of perceived adverse security milieu. Some of the portfolio inflows are also related to attractive debt issues in the Indian market.

Thus, Indian interest rates are high and returns on investment of funds in debt instruments too are high to the foreign investors. But the high interest rates have kept economic activity "low'', the Council said.

Again, the Council notes that large forex reserves should have led to rising growth of money supply and greater economic activity. That has not happened , as the rising forex reserves have not been allowed to increase money supply proportionately.

"A faster increase in money supply may have led to reduction in real interest rates due to higher inflation rate and the greater liquidity in the markets,'' it said.

While in some segments of the financial markets interest rates have declined with better performing corporations having raised funds at well below the prime lending rate, this is not a uniform feature of the market. The reference PLR of the commercial banks remains nearly at the same level as it was at the inception of 2001-02. These reserves have not been allowed to stimulate growth for fear of increasing inflation rate, even as there is a genuine question whether high reserves could be a likely source of higher inflation rate in the future, the Council quipped.

Yet another implication of high forex reserves is the appreciation of the rupee in forex market. In terms of real effective exchange rate (REER), the rupee has indeed appreciated in 2000-01 and 2001-02, though towards the end of 2001-02 and in the first three months of 2002-03, there are signs of depreciation.

Large forex reserves leading to stronger rupee could stimulate imports, it said adding that this has not happened as the economy is not growing strongly enough.

The Council concluded that if interest rates continue to remain high, forex reserves could be expected to remain high and growth low, as exports would be adversely hit by the appreciating rupee.

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