The Hindu Business Line : India’s ‘external’ economic strength

Forex reserves exceeding $300 billion are quoted as evidence of a significant strengthening of India’s balance of payments.
While the magnitude involved is indeed reassuring, it is necessary to consider where these reserves come from, argue C. P. Chandrasekhar and Jayati Ghosh.

India’s foreign exchange reserves rose by a huge $110.5 billion during financial 2007-08 to touch $309.7 billion as on March 31, 2008. The increase occurred because of a large inflow of foreign currency. Just the foreign currency assets accumulated by the Reserve Bank of India crossed $300 billion in early April, having risen by more than $100 billion over the previous year.

RBI intervention

This was because the central bank was forced to acquire a part of the large inflow of foreign exchange to prevent an excessive appreciation of the rupee. Large and persistent inflows of foreign currency imply that unless the RBI mops up these dollars, euros or yen, through its purchases, the rupee would appreciate with adverse consequences for India’s already beleaguered exporters.

The RBI, therefore, has intervened substantially in forex markets, even if it has not been completely successful in stalling rupee appreciation.

The large increase in foreign reserves in a short period of time has resulted in a new confidence with regard to India’s external economic strength. India too, many have argued, should set up a sovereign wealth fund, to undertake investments of at least a part of these reserves, so as to earn a better return than could be obtained from parking these reserves in more liquid and secure instruments like US Treasury Bills.

This seems warranted because of the differential in returns earned by those who bring in the foreign exchange into the country and by the Reserve Bank on its investments of the reserves it accumulates by purchasing this foreign exchange.

Let us ignore for the moment the argument that it is not the role of the central bank to either bother about returns earned by clipping coupons or to monitor institutions to whom it lends this money for investment in higher-yielding assets. Even then there can be some scepticism about the use of reserves in this manner, unless the sums involved are trivial.

The principal reasons for scepticism would be the implications of such use, given the sources from which the accumulated reserves originate. If the source of reserves is not a reflection of productive strength, risking those reserves on illiquid and/or risky investments may not be appropriate. If reserves can rise by a third in a year, they could decline by the same amount in a similar period. That requires keeping reserves accessible and bearing the cost.

Widening trade deficit

The core issue is that the reserves are not principally a reflection of the country’s ability to earn foreign exchange. In the area of merchandise trade, the deficit on India’s balance of payments is only widening. Figures recently released by the Commerce Ministry indicate that while the value of exports in dollar terms increased by 23 per cent in 2007-08 to touch $155.5 billion, imports rose by a higher 27 per cent. As a result, the trade deficit rose by 35 per cent from $59.3 billion in 2006-07 to $80.4 billion in 2007-08.

Will the trend persist?

Whether this trend would persist in the medium term depends, inter alia, on three factors. First, the likelihood that the price of oil would remain high and global inflationary trends would persist. Second, the possibility that the decline of the dollar and the appreciation of the rupee would continue. And, third, the probability that domestic inflation would force the Government to maintain curbs on exports of commodities such as steel, whose prices are driving inflationary trends.

If these circumstances continue the deficit is only likely to widen, making merchandise trade a drain on, rather a contributor to, foreign exchange reserves.

It is true, however, that India has increased its receipts from the exports of services, whether in the form of export revenues or in the form of remittances from Indian workers abroad. According to balance of payments figures from the RBI, invisible receipts helped cover a substantial share of the deficit on the merchandise trade account recorded during April to December 2007.

Gross invisibles receipts comprising current transfers (that include remittances from Indians overseas), revenues from services exports, and income amounted to $100.2 billion during April to December of 2007. The increase in invisibles receipts was mainly led by remittances from overseas Indians ($13.8 billion) and software services ($27.5 billion). After accounting for outflows net invisible receipts stood at $50.5 billion.

The result of these inflows was that while on a BoP basis the merchandise trade deficit had increased from $50.3 billion during April to December 2006 to $66.5 billion during April to December 2007, or by more than $16 billion, the current account deficit had gone up by just $2 billion from $14 billion to $16 billion.

Given its small size, financing that deficit with capital inflows was not a problem. The problem in fact has turned out to be exactly the opposite: capital inflows have been too large given the size of the current account deficit.

Accretion of reserves

Detailed figures on the sources of accretion of foreign exchange reserves over the period April to December 2007 (Table 1), recently released by the RBI, show that, after allowing for valuation changes, foreign currency reserves with the RBI rose by $76.1 billion between the beginning of April and the end of December of 2007.

Net capital inflows during the first nine months of financial year 2007-08 amounted to $83.2 billion. The three major items accounting for these inflows were portfolio investments ($33 billion), external commercial borrowings ($16.3 billion) and short term credit ($10.8 billion) (Table 2).

To accommodate these and other flows of smaller magnitude, without resulting in a substantial appreciation of the rupee, the central bank had to purchase dollars and increase its reserve holdings (after adjusting for valuation changes) by as much as $76 billion or by an average of around $8.5 billion every month. This trend has only intensified since then with reserves having risen by $33.8 billion between the end of December 2007 and the end of Mach 2008 or by an average of more than $11 billion a month.

Corporate borrowing

Though inflation is now the focus of policy attention in the country, the Government cannot postpone the effort to deal with this problem any further. The first step the Government needs to take is to put a stop to borrowing abroad by Indian corporates, much of which is to finance rupee expenditures. This is a clear form of a carry trade in which loans at lower than domestic interest rates in foreign markets are used to finance domestic investments, some of which may even be speculative, in the hope that the investor concerned cannot merely benefit from differentials in the rates of return but also from the appreciation of the rupee between the time the loan is contracted and repaid.

There is no reason why the Government and the central bank should be left with a macroeconomic muddle just because sections of the private sector are looking for quick returns. A return to a more stringent external borrowing regime with lower ceilings is the obvious option for the Government.

Private placements

Controlling the second of the flows that are resulting in large accretion of foreign exchange reserves, namely, portfolio investment flows, is more difficult. This consists of flows in which the acquisition of shares by a single foreign investor in an Indian company is less than 10 per cent of the aggregate shareholding. This could occur either through the FII route involving purchases of shares in the stock market or the private placement route where share acquisition is ensured through negotiations with the promoters.

Acquisitions through private placements now seem to be as important as acquisitions through the stock market. Thus, while SEBI reports that net FII inflows in the form of equity and debt during April-December 2007 was around $18 billion (Chart 1), the RBI reports that net portfolio investment during the period was $33 billion. Almost as much portfolio investment seems to be coming through the private placement route as is happening through the FII route.

This suits foreign investors, investments by whom would otherwise have been constrained by the volume of free floating shares of listed companies that are available for trading. This is known to be small. Private placements suit Indian promoters as well because they are in a position to sell, at a premium, a small slice of shares, which would not threaten their control over the company.

If these are new shares issued for the purpose and if the premium is large enough, the company obtains a relatively large volume of resources to finance expansion. In return for this investment existing shareholders who now own a part of a larger company need to reward the foreign investors with dividends only when profits are made.

If the promoters had resorted to borrowing instead, interest and amortisation payments would have to be paid irrespective of the profit performance of the company. It is of course true that foreign investors are resorting to such investments in the hope of selling out these shares at a later date at an appreciated price.

If such expectations are realised, the promoters gain because it increases the market valuation of their own shares and therefore their net worth. If these expectations are not realised the promoters anyway benefit from the expansion of the company financed with funds obtained at extremely low cost. Here again, it is the search for significant gains by domestic wealth-holders that is partly driving the large inflow.

The problem is that this search for private profit has economy-wide externalities that are negative. Much has been written about the difficulties the rapid accumulation of reserves creates for the central bank in terms of both exchange rate and monetary management. Rising reserves have as their counterpart increases in money supply, which the RBI wants to rein in given the inflationary conditions prevailing in the economy.

Controlling the flows

But, caught in this quandary, the RBI and, more recently, the Government, have been contemplating the possibility of limiting inflows. But the efficacy of any measures adopted towards that end would depend on the kind of inflows that predominantly account for such accumulation.

As is known, it is far easier for the Government through tax-based or quantitative measures to control capital inflows through the stock market route. Controlling inflows through directly negotiated purchases of equity requires retracting some of the liberalisation of foreign investment rules that have been adopted in recent years.

Thus far, the Government and the nation have borne the costs associated with this form of profit making by foreign and domestic wealth-holders. This may be defensible for some time. But with the inflows persisting, exchange rate and macroeconomic management proving increasingly difficult and instability increasing, it is time to rethink at least some of the liberalisation that has led up to this situation. This is one more area where the dangers of lightly controlled or uncontrolled markets are being driven home. It is better to learn the lessons early rather than be burdened with a crisis whose dimensions are unknown and solutions unclear — as is currently true in the world of finance globally.