The Hindu Business Line : Surging forex reserves — Look beyond history and emotions

The foreign exchange reserve, by and large, is in dollars. This means India is extending a $100-billion `interest-free loan' to the US. Worse, since the value of the dollar is falling in the international market, India is possibly earning negative interest.

THE country is rejoicing at the achievement of the foreign exchange reserves crossing the $100 billion mark. Compared to the situation when India's foreign exchange reserves dwindled to a level where the country had to pawn gold outside the country, the present achievement definitely sounds fantastic. However, beyond emotional satisfaction what does it actually mean for the country?

Since the foreign exchange reserve, by and large, is in US dollars, in pure and simple terms, it means that India is extending a $100-billion interest-free loan to the US. Worse, since the value of the US currency is falling in the international market, India is possibly earning a negative interest. Considering that $100 billion is some 20 per cent of GDP, the loss India is incurring is not small. Indeed, it is quite strange that India, home to the largest number of illiterate, poor, unemployed, diseased and hungry, is giving such a huge concession to the richest country.

There is no reason to feel good about the surging reserve because it also does not in any way reflect the strengthening of the external sector. The rupee is gaining against the dollar because the latter itself is performing very poorly in the international market. The rupee has been losing against other major currencies.

There is, of course, good economic logic for maintaining a level of foreign exchange to face challenges of uncertainties.

This is a normal practice, as much for institutions as for individuals. Banks, for example, are not allowed to lend all the money they receive as deposits. A part of the deposits is kept as reserve. However, does India need to maintain a reserve that can finance its imports for two years?

Obviously, India does not need such huge reserves. But the country's managers are doing this presumably to ensure that the rupee does not appreciate.

The concern is that if the rupee appreciates, India's exports will become less competitive, leading to a fall in exports. India cannot allow that because it follows an export-led growth strategy.

But what are the costs of not allowing the rupee to appreciate? Appreciation of the rupee will mean that India's terms of trade will improve as it will be able to receive the same imports for lesser exports.

This will, of course, require that India does not become so uncompetitive that its exports are seriously affected.

Otherwise appreciation of the rupee may not necessarily lead to fall in exports as India will earn more per unit of exports. The overall impact on export revenue will depend on how the demand for the exports in the rest of the world responds to the prices of its goods and services that will be more expensive.

In today's complex world, however, trade is not driven only by comparative advantage. Price is just one of the factors. That is why we find so much of intra-industry trade (meaning a country both exports and imports the same goods).

Moreover, it is likely that even if India allows the rupee to appreciate against the dollar it will not appreciate against other major currencies.

Hence, even if the exports become slightly less competitive in the US market, they will continue to be equally or even more competitive in other markets.

India, however, still prefers to build up reserves and does not allow the rupee to gain against the dollar probably because of its US-centric mindset.

On the import front, however, the goods and services that India gets from abroad will become cheaper if the rupee is allowed to appreciate. Since a huge part of the import is oil whose demand is not very elastic, it will have a good impact on the import bill.

Moreover, cheaper oil and many other raw materials and capital goods that are imported from outside will have a positive impact on export competitiveness.

If a huge influx in imports of finished consumer goods is a concern, the government could probably have avoided the import duty cuts on many goods that it announced recently. This would have been good for the government kitty as well.

It is also questionable if such a policy of not allowing the rupee to appreciate can be pursued in the long run. It obviously creates an expectation that sooner or later it is going to appreciate.

This will lead to foreigners parking their money in India and thereby creating further pressure on the rupee.

The effectiveness of the so-called export-led growth strategy is also quite doubtful in the present global politico-economic situation. It is true that some Asian countries have successfully used this strategy.

The problem is that such a strategy works only when a few countries follow such a strategy. However, the massive neo-liberal propaganda in favour of such a strategy has led to a situation when almost every country is following the strategy. This is nearly a zero-sum game situation.

Every nation is trying to bank on the demand created in other countries while neglecting the demand side at home.

The alternative that India requires is policies that create enough domestic demand and rely more on that rather than foreign demand.

Smaller countries also need to rely on foreign markets as their small domestic market size does not allow them to reap economies of scale. Large economies are not so constrained.

That is why one can see that the US, despite following reasonably open trade policy in most sectors, maintains a relatively low level of trade as a proportion of GDP. The Indian market is reasonably large to offer most of its firms sufficient economies of scale.

The forex reserves issue, thus, needs more rigorous analysis. The RBI, and the Government need to look for answers.

Today's situation is not at all comparable to the times when India had to mortgage gold. At that time the country did not have a flexible exchange rate regime.

In a fixed exchange rate regime if the domestic currency gets overvalued there is then a depletion in the foreign exchange reserve.

Such was the situation then. If today India is maintaining a huge reserve at an enormous cost because of the falling dollar and the over-dependence on the US market, then it is neither an achievement nor a failure but just an unfortunate situation. There is no reason to be happy about it.

(The author is with Consumer Unity and Trust Society — CUTS — Jaipur, a research and advocacy group working on trade and economic issues. The views are personal.)