The Hindu Business Line : Forex reserves: After hundred, back to square one?

Moving from debt- to non-debt-creating inflows does not unambiguously signal a change for the better. The latter create liabilities that are hard to quantify and even harder to anticipate and provide for. Large inflows cannot be welcomed blindly without the FII's track record being examined closely.

WHILE switching from debt to non-debt creating inflows of foreign exchange was certainly one objective of the reforms launched in 1991, it was a part of a larger package of objectives that is misleading to view in isolation, or rank in order of importance.

Other objectives included moving slowly away from administered rates of exchange towards a situation in which rates of exchange could, within a reasonable range, be left to the market to work out on its own. Given existing and expected imbalances on the current account, this was expected to jack up the value of the dollar. Imports too were freed from the clutches of administrative control. Licensing was done away with for a large category of imports, and tariffs were lowered with promises of further cuts.

The overall purpose was to raise the Indian economy to higher levels of efficiency by exposing domestic production to international competition; and by using trade to gradually move the economy from a philosophy of being self-sufficient in the supply of basic goods to specialising in lines of production in which it had a comparative advantage. Not everyone felt entirely comfortable with this last proposition 12 years ago. Fortunately, this is still the case.

Given the high cost and poor quality of products and services that we had grown accustomed to living with, moving on to another, higher, trajectory can be accomplished only over the medium term. A short-term jack up in exports was to be expected, but it was imports that were to be allowed to grow more rapidly and in a more sustained fashion.

Consequently, the deficit on the current account was expected to increase a great deal rather than decrease. That it actually shrank from $27 billion over 1985-90 to $24.8 billion over 1995-2000 was solely because of the large, and largely unexpected, increase in invisibles (on account of the dramatic change in the relative importance of tourism and software); the cumulative trade deficit over the period almost doubled, from $39 billon to $73 billion.

The point is that forex reserves were to be left to the capital account to build, as hitherto, albeit on more sober lines. Current account surpluses, or the country's earnings, properly so called, could not be relied on for this purpose.

Once India had committed itself to restructuring the economy, the IMF was more than happy to extend a line of credit to stabilise the balance of payments till these efforts bore fruit or, to be more precise, till they showed sufficient promise to start foreign exchange flowing into the country.

Since the inflow of short or medium portfolio investments was, to begin with, likely to be deterred by the scheduled plunge of the rupee in the years to come (the actual drop was from Rs 24.47 to the dollar over 1991-92, to Rs 30.65, 35.50, 43.33 and 47.69 for 1992-93, 1996-97, 1999-2000 and 2001-02 respectively), most initial flows were expected to take the form of direct foreign investment. But this was not quite the way things turned out. It was foreign portfolio investments that were first off the mark.

For 1993-94, the year after the stock market scam came to light, cumulative inflows amounted to $3.9 billion (compared to $1.1 billion of FDI that year, and an aggregate portfolio inflow of $0.25 billion from 1990 to 1993).

The cumulative total of net portfolio inflows increased steadily thereafter, year after year, to touch $24 billion last March (one quarter of our forex reserves); valued, it would seem, for some strange reason, at the time of entry, rather than `marked to market'.

Inflows seem to have been stimulated rather than put off by the crash of the market in April 1992, when the Sensex dived from its all time high of 4131 to 2190 in July 1993. Then, after key players had, to put it mildly, `survived the fall without a scratch', they began pumping in more and more funds to mop up stocks that people were falling over themselves to sell.

Net portfolio inflows for 1994-95, 1995-96, 1996-97 and 1997-98 amounted to $7.5, $10.1, $13.5 and $15.3 billion respectively (compared to net FDI inflows of $2.5, $4.6, $7.5 and $11 billion).

These inflows did not send the Sensex soaring up, up, up; then and forevermore. Instead, the BSE index kept returning to base every now and then to cash in its chips: The Sensex stood at 3060 in December 1995, 2919 in December 1996; and at 3224 in January 1998, after touching a peak of 4306 in July 1997.

What could these reverses possibly have to do with forex inflows? Or perhaps the more appropriate question is: What had the inflows to do with them? The 30-40 per cent step-up in net FDI inflows since March 2000 (net FDI flows over the three-year period 2000-03, at $76 billion, exceeded net portfolio inflows over the period by $8 billion), is probably attributable to the fact that, according to a cryptic footnote in the RBI's latest Annual Report, the definition of FDI was "expanded" since 2000-01, to "approach international best practices".

In the end, the thing to keep in mind is that moving from debt- to non-debt-creating inflows (which create liabilities that are hard to quantify and even harder to anticipate well in advance and provide for), does not unambiguously signal a change for the better.

Where forex needs are financed by debt, administrators have a far greater degree of control over the liabilities they prospectively incur. It was not debt-financing as such that brought about the crash of 1990-91, but the fact that then, as now, we had been living well beyond our means, on money belonging to someone else; without caring a hoot for the future.

From 1985-86 to 1989-90 we ran up current account deficits averaging more than $5 billion each year, $27.5 billion in all; while simultaneously running up capital account deficits nearly equal in size each year (total over the period: $18.4 billion).

We did manage at the same time to maintain some minimal quantity of reserves in the years preceding the crash — $6-7 billion — but this was made possible only by recourse to skitty hole-in-the-wall-operators (or, to be more precise, under `skitty hole-in-the-wall' conditions), and ultimately by desperate and futile efforts to roll over these short-term loans, physically cart our gold reserves to London in the dark hours of the night to pledge them, and so on.

The crash, when it came, was caused by insolvency, not a crisis of liquidity. It was not because we tried to finance our development needs by running up debts that led to our problems, but the fact that we had nothing to show for other people's money `invested' by us.

The problem this time around has, no doubt, arisen from a different combination of factors. First, our cheerful willingness to welcome large inflows from institutional investors as heaven-sent manna , though their track record clearly calls for close critical scrutiny, and, besides, has got us into a situation where it is the `wrong' market (namely transactions on the capital account) that has been exerting the preponderant influence on market-determined rates of exchange.

Some of the key initiatives in the recent `mini-Budget' represented a desperate effort to urgently right these wrongs, by simply `giving' surplus dollars away. The funds that are now being allowed, encouraged, to gush out for investment abroad will not be easy to quickly lay our hands on when the need arises; as one day in the medium term it certainly will.

Since the problem this time would be one of liquidity, rather than solvency, it will be relatively easy to raise loans to help tide over the mismatch. Still, we are likely to find ourselves on quite a roller-coaster ride, flashing green signals one day, red the next. One wonders what, in the end, is the point of it all.

These huge reserves that so `fortuitously' keep coming our way, long after they have outlived their welcome, end up being deployed like the water gushing out from a fire hydrant for which the only plan ready to hand is to use it to feed the garden hose.

In 1991 at least there was the hope that once a fool is parted from his money it cannot be long before he is parted also from his folly. But today we have money jingling in our pockets. No doubt it is money that belongs to someone else, but, nevertheless, there is nothing anymore to force us to keep focused on the business at hand — namely, issues directly related to the real sector of the economy; GDP, productivity, efficiency, employment and poverty — rather than `wealth'.