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Tuesday, Dec 30, 2003

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$100 billion: Understated, underexplained

Sudhanshu Ranade

A surfeit of dollars, unless taken off the market, automatically raises the price of the rupee on account of the `excess demand'. India, like China, has been trying hard to resist this increase in the `value' of its domestic currency, which has an adverse impact on exports and the profits of exporters.

IT HAS been a rapid journey. Forex reserves have crossed $100 billion. Just 12 years ago, Dr Y. V. Reddy, now the RBI Governor, was stationed in North Block and recalls the difficulties he faced in ensuring that "there was enough cash balance to permit day-to-day forex payments of even a million dollars".

Progress has been significant in recent years. It took 12 years for the reserves to reach $52.5 billion, in May 2002. In less than 18 months from that date, this figure has almost doubled.

Progress, however, willy-nilly brings problems with it, epecially when it comes about so rapidly — and due to factors that are, despite our pretensions, largely beyond our control.

About a year before taking office, Dr Y. V. Reddy, who could then afford to be more candid than the grandeur and constraints of his office will now permit, stated that the `appropriate level of reserves' was determined by the need to be able to intervene in the forex market to check volatility arising out of `mood swings'; to be able to fund imports and service debts, and to ensure against `liquidity risks'.

Somehow, he failed to mention that the `primary', indeed almost the only, reason for acquiring reserves in today's context is to take `surplus' dollars off the forex market, so as to prevent rates of exchange getting determined of their own accord, by the interaction between demand and supply.

A surfeit of dollars, unless it is taken off the market, automatically raises the price of the rupee, on account of the `excess demand'. India, like China, has been trying hard to resist this increase in the `value' of its domestic currency.

A rising rupee has an adverse impact on exports and, perhaps more important from a political point of view, on the profits of exporters.

By increasing the price of a rupee's worth of exported commodity in dollar terms, it tends to price our goods out of the market.

It erodes our `competitive edge', not only vis--vis goods that are produced within the United States (the US accounted for 20 per cent of our exports in 2001/02; compared to the 5 per cent that went to our second largest trading partner, the UK); but also vis--vis goods exported by, say, China which are, for a variety of reasons, better equipped to retain their competitive position in the face of adversity.

It is because of this that the Commerce Minister, Mr Arun Jaitley, publicly called on exporters last Wednesday to take the hardening of the rupee vis--vis the dollar "as a challenge, rather than viewing it as a hurdle". What they needed to do, he said, was to "find ways to cut down costs and increase operational efficiency".

In private, no doubt, exporters were treated to reassurances, by the Finance and Commerce Ministries in conjunction based on steps the government proposes to take to deal with their problem.

Another problem about the inflows is that to the extent the dollar is allowed to fall vis--vis the rupee, it erodes the degree of protection from imports for domestic producers (and employees) in India; which, too, has obvious political ramifications.

However, mopping up surplus dollars in an effort to keep the exchange rate steady involves a corresponding increase in the quantity of rupees in circulation — and therefore raises the spectre of inflation which, apart from the problems it could cause for the economy at large, tends to erode the competitive edge of our exporters, even if the value of the rupee is somehow held steady vis-a-vis the dollar.

One way of restraining this is by urging the stock market onwards. A rise in stock prices (or housing; the generic term used by the IMF is "asset-price inflation") eases the pressure on the prices of domestic goods and services.

It also provides two additional advantages: It increases the value of government holdings in PSUs — up by Rs 150,000 crore in the past eight months; and it helps the growth of GDP — because the increasing `wealth of the nation' stimulates consumption — and hopefully investment in real assets as well.

This, however, is a chancy business, and needs to be supplemented by more reliable mechanisms to trim forex reserves in order to keep domestic prices in check.

When the forex reserves crossed the $100-billion mark a fortnight ago, it was seen as a great success; as if the feat had been brought about by clever planning on our part.

That this is not entirely true is suggested by the fact that, for many years now, the government has been desperately seeking ways of keeping reserves lower than they would otherwise have been. But for these measures, the forex reserves would have crossed the $100-billion mark years ago.

One such step has been to use the pile-up of dollars to retire debt. Other steps include allowing exporters and corporates to retain dollar earnings abroad, and allowing institutional investments abroad.

In 1998-99, 1999-2000, 2000-01 and 2001-02 capital account inflows into the economy of $5.8 billion, $12.2 billion, $14.2 billion and $12.2 billion were to a large extent offset by outflows of $3.6 billion, $7.1 billion, $9.7 billion and $7 billion respectively.

In other words, the outflows in these years accounted for 62 per cent, 58 per cent, 68 per cent and 57 per cent of the inflows.

This phenomenon, incidentally, first surfaced in 1997-98; at about the time the battle to check any further rise in the value of the rupee vis--vis the dollar began in real earnest.

Alongside net forex inflows, the RBI Annual Report for 2002-03 reports `stable inflows'; i.e. "all capital inflows excluding portfolio flows and short-term capital and credits".

Speaking as a layman, these figures seem alarmingly low compared to the total size of net inflows: $67 million, $71 million, $89 million and and $85 million for 1999-2000, 2000-2001, 2001-2002 and 2002-2003 respectively; compared to net forex inflows of $10.4 billion, $10 billion, $10.6 billion and $12.6 billion.

A word of explanation would have been welcome. Second, while it is reassuring that, given the present policy on capital convertibility/repatriability, the RBI has excluded portfolio inflows in the computation of `stable inflows', the fact is that net portfolio inflows over the past decade cumulatively amount to as much as $24 billion — a quarter of the $100-billion reserve.

The (dollar) value of this money in our books seems to have been computed on the basis of its value at the time of entry.

Nowhere in the RBI's Annual Reports or in the Economic Surveys does one find anything to suggest that the government has any reliable mechanism or procedure in place that regularly provides it with some idea of the `value added'; of the amount that could flow out, if the investors decide to de-invest; taking their capital gains (on which tax-based lock-in periods have been greatly relaxed) with them. On this too some sharing of information and thinking would have been welcome.

One last thing. Finance and the Economy are much harder to master than, say, External Affairs and Defence. To manage this portfolio with a modicum of success one needs a certain amount of humility, a sense of humour, and a rough and ready way of putting jargon and gobbledygook (including articles like this one) to the test.

I. G. Patel's report about a 1961 visit by Morarji Desai to a World Bank-IMF meeting in Washington comes to mind. He relates the story thus: "At a dinner at my house, he sat on a sofa gently knocking his head against the wall. After a while he asked what was behind the wall. When I informed him that there was a stair-well, he said: `Thank God. There was so much resonance that I found myself wondering if there was a big vacuum inside my head'".

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