The Hindu Business Line : What sets India apart from the ‘Big Five’

The accumulation of forex reserves, rather than being the outcome of a booming export economy, can be a peculiar problem of a rupee rendered increasingly weak at home and strong abroad. Instead of recognising these realities, the academic fashion of making virtue of current account deficits is flawed, says HARISH DAMODARAN.

If one were to single out the most significant macroeconomic development of the country’s post-‘reform’ era, the unprecedented build-up of its foreign exchange reserves would probably emerge a clear winner. Sustained inflows over this period have not merely ushered in a regime of soft interest rates; by making the management of excess liquidity a systemic concern like never before, they have even fundamentally redefined the conduct of monetary and fiscal policy.

Apart from these visible impacts, the accumulation of reserves has been useful for bolstering national self-confidence and the country’s overall international standing (whether these intangible gains have been truly leveraged to the nation’s advantage is beside the point). A far cry, indeed, from the days when the nation’s gold stocks had to be physically pledged with the Bank of England to raise a paltry $405 million!

The Big Five

Since March 1990, India’s forex reserves have mounted from a low of $3.96 billion to $199.18 billion at the end of 2006-07 and $218.96 billion as on July 13. Today, there are only five others with bigger reserve chests — China ($1,333 billion), Japan ($914 billion), Russia ($406 billion), Taiwan ($266 billion) and South Korea ($251 billion).

Table 1 provides a broad picture of the way these Big Five have amassed their fortunes in recent times. China’s reserves zoomed by some $1,300 billion since 1990. Well over half of this has been on account of accumulated current account surpluses, arising from an excess of its exports of goods and services over imports during this period.

The rest has been by way of attracting foreign investment and other capital inflows. Japan offers an even more instructive case, with a cumulative current account surplus of $1,959 billion for 1990-2006 far exceeding its reserve accretion of $835 billion. Thus, its current earnings have flowed over the brim, so much so to make Japan the world’s leading capital exporter.

But whether it is China, Japan, Russia, Taiwan or Korea, there is a simple common thread running through their reserve accumulation process. All of them have, year after year, been exporting much more than what they have been importing. The resultant surpluses have then been ploughed back to expand their forex kitty (or spilt over as capital exports). This process is no different from how companies apportion a part of annual profits after tax to the ‘reserves and surplus’ account of their balance-sheets.

India’s story

The Indian story, on the other hand, follows a marked deviation from the above predictable pattern. Table 2 shows that the country’s export of goods for the entire period from 1990-91 to 2006-07, at $807 billion, was way below its corresponding import bill of $1,109 billion, leaving a cumulative deficit of $302 billion on the merchandise trade account. This deficit was, nevertheless, partially offset by a surplus of $259 billion on the ‘invisibles’ account. The latter term essentially refers to export and import of services, as counterpoised to physical shipment of goods. They encompass items such as software, remittance transfers (from export of ‘labour power’), tourism, insurance, freight, and a host of business, financial, project consultancy and miscellaneous services. Invisible payments further include interest, dividends, royalties and other current outgo on foreign loans and equity investments.

Humongous invisibles

From the Table, it can be seen that the country’s gross invisible receipts, at $617 billion, were quite comparable to revenues from export of goods ($807 billion) over the 17-year period. Roughly 55 per cent of these receipts comprised earnings from remittances, and software exports. This feature of having a humongous invisibles account sets India apart from the Big Five (the only other country with a similarly disproportionate services export profile in its balance of payments is, in fact, the US). But even a $259-billion invisibles surplus has not been enough to neutralise a still wider deficit on the merchandise trade account.

The result is a cumulative current gap of almost $44 billion, which is in stark contrast to the massive surpluses of the Big Five. India represents a unique phenomenon of an economy to have built up its forex reserves exclusively on the basis of capital inflows — something that has never happened before in history on such as grand scale.

Between 1990-91 and 2006-07, net capital inflows were $218 billion, consisting mainly of foreign investments (both portfolio and direct), External Commercial Borrowings and non-resident Indian deposits. Only in three years during this whole period (2001-02, 2002-03 and 2003-04) did the country manage to post current account surpluses. Compare this to China, where there was one exceptional year (1993) through the 1990s and the present decade to have returned a deficit!

What do these trends suggest? The conventional route of reserve accumulation through generation of current account surpluses arguably signifies a more dynamic and virtuous engagement with globalisation.

There is a certain endogenous growth impulse at work here, leading to the enhancement of the economy’s productive base and cost-competitiveness over time. External capital infusions are only supplementary to revenues from exports, built on solid manufacturing foundations and supportive infrastructure. This is unlike in India, where robust exporting capacities are confined to a few sectors such as software, pharmaceutical, auto-ancillaries and light engineering; the bulk of shipments are highly vulnerable to exchange rate fluctuations (textiles, agro-products) or embody low domestic value-addition (gems and jewellery, iron ore).

If Taiwan and China are today the factories of the world, the analogy one could draw for India is of a virtual bank where capital gushes in and out. As the economy’s ability to absorb these inflows is limited, they add to the reserve chest without really contributing to the country’s productive potential. Moreover, by creating currency instability, they further blunt export competitiveness. Alternatively, they are a source of runaway monetary expansion:

When the Reserve Bank of India mops up the surplus dollars to prevent the rupee’s undue appreciation, it releases counterpart domestic currency into the system, stoking inflationary pressures. The accumulation of forex reserves, rather than being the outcome of a booming export economy, becomes symptomatic of a peculiar problem of a rupee rendered increasingly weak at home and strong abroad.

Current account deficits

Instead of recognising these realties, the current academic fashion is to make a virtue of current account deficits. These are considered not just natural but necessary to any developing economy that is savings-constrained and hence requires foreign capital to maintain high rates of investment.

The existence of current account deficits reflects domestic savings-investment gaps, which have to be plugged through external financing. This proposition is then transposed to imply that foreign investment presupposes a country running a current account deficit. Nothing could be farther from such mechanical, if not dubious, theoretical formulations; the examples of China and the East Asian Tigers are proof that it is possible to post current account surpluses and still attract large investments from abroad.

To view current account deficits as a sustainable or even desirable option is akin to believing that a loss-making company will indefinitely receive venture capital funding simply on the basis of the promise for the future. All Ponzi games, at some point, are bound to unravel one way or the other.