The Hindu Business Line : India’s external situation — Fallout of the rupee rise cannot be ignored

Discussing some of the points covered in the RBI’s survey on macroeconomic developments, particularly the country’s external investment position, cautions that the adverse effects of the rising rupee on the current account and the country’s net investment position cannot be ignored, and that the sooner ameliorative steps are taken, the better for the health of the economy.

At the time of its annual and half-yearly monetary policy statements, The Reserve Bank of India (RBI) routinely comes out with a competent and elaborate analysis of the macroeconomic developments of the period under reference.

In the excitement and hype that accompany the monetary policy statements, people tend to overlook the RBI document on macroeconomic development, which is a very potentially rich source of analysis and insight on the thinking of the bank. What follows is an analysis of some of the points discussed in the survey, with particular reference to the country’s external investment position.

The rupee has been staging an upward climb in recent months, thanks to increasing capital flows and the RBI’s decision to modulate its intervention policy to keep inflation at bay. The rupee appreciation has been discussed in these columns extensively in recent articles (including one in Business Line, July 23).

The increase of imports and decrease in pace of growth of exports of goods and services worsens the trade account and contributes to a rise in current account deficit.

As for the country’s exports of textiles, manufactured goods in general, as well as services, which do not depend too much on imports, the net impact of appreciation is a decline in current account. This calls for serious consideration by the policy-makers. It is important to bear this trend in mind when discussing the overall macroeconomic situation.

Balancing statistic

In the emphasis over the GDP growth of +9 per cent and foreign reserves in excess of $200 billion, we tend to forget what these reserves are composed of.

Unlike the trillion dollar reserves of China, which are built out of current account surpluses, our reserves are primary, especially in recent years, a resultant of piled up liabilities, external commercial borrowing, foreign direct investment and portfolio inflows into equities mainly. The net investment position is a necessary balancing statistic to bear in mind.

The net investment position, as detailed by the RBI, is the difference between the country’s total external assets, represented by reserves and foreign investments, and the total liabilities, represented by the foreign debt and the value of equity held by foreigners, both as FDI and portfolio holders. The fact that we have reserves of more than $200 billion has to be seen against our total liabilities to our external creditors as well as foreign equity holders in India.

DOUBLE-WHAMMY

The latest RBI report on macroeconomic and monetary development, a first quarter review 2007-08, issued in July, has interesting and instructive data dealing with the country’s net investment position. The position between 2005 and 2007 is shown in the Table.

A few important technical observations on the Table are in order. The valuation of the cumulative total of FDI and portfolio investment is an important variable in determining the real value of the net investment position.

To the extent that the cumulative value of foreign direct investment would have gone up due to the appreciation of the equity of the underlying Indian corporate entities, the liabilities side arising therefrom will rise. The same applies to portfolio investment.

This brings about a double-whammy effect. First, due to the stock market boom, the equity valuation would have gone up. In addition, the appreciation of the rupee would have increased the dollar value. It is not clear how exactly the RBI has calculated the cumulative value. At a minimum, it should have been corrected for the Sensex variations, at least on an average basis estimating the broad break-up of FII and FDI flows. If, as suspected, the valuation is on historical cost basis, the actual net investment position is worse than the document shows in its tabulation.

This raises an important question as to the actual dimension of the cumulative amount of both FDI and FII flows into India, even according to the RBI document. The cumulative amount of FDI flows as at the end of 2006 was indicated to be about $65.3 billion. That of FII flows was put at $73.3 billion.

TWIN FACTORS

In respect of both these investments, as already explained, the twin factors of equity appreciation due to stock market variations and the rupee rise are significant.

On the other side of the coin, India’s investments abroad are denominated in dollars and mostly in debt securities. They rather suffer erosion of value to the depreciation of the dollar.

A suitable amendment would indicate the extent of such erosion in the value of assets as well as the enhancement in the value of liabilities. A broad indication can be given as to how the net investment position will be affected.

The crux of the net external investment position turns on the combined impact of the appreciation of the rupee and the increase in the market value of the FDI/FII liabilities and the erosion of the value of assets on account of the dollar depreciation. This has a real impact on the overall balance of payments.

If the net investment position was $10 billion, it is as good or as bad as a decline in current account by the same order of magnitude, although there is no cash drain immediately. It is analogous to decline in the net worth of a corporate.

Turning to policy implications, I cannot but point out that it is dangerous to ignore the current account implications of the appreciation of the rupee, which affect the net investment position by increasing the liabilities.

A conscious effort to set right these liabilities by increasing export incentives to help exporters of both goods and services has to be taken up.

So, too, with services. It is important not to ignore the fact that the rising rupee has an adverse effect on the current account and therefore on the country’s net investment position.

Let it not be said that by allowing the rupee to rise, the nation ended up owing more and more to the rest of the world with no corresponding assets.

The continuing adverse effects of rupee appreciation are too serious to be ignored.

The RBI and the Government have to take immediate proactive and ameliorative steps. Sooner it is done, the better for the health of the nation’s economy in the longer run.

S. VENKITARAMANAN

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