India's unique forex reserve accumulation story

On March 31, 1991, India had foreign exchange reserves of $5.83 billion that could finance not even 3.5 months of imports. Twenty years later, on the same day, the reserves stood at $304.82 billion. These sufficed for some nine months' imports, the annual value of which had itself soared from around $ 21 billion to over $380 billion between 1991-92 and 2010-11.

The above numbers capture in a nutshell the sheer distance travelled by the country from the time it had to pledge 47 tonnes of gold from the Reserve Bank of India's (RBI) stocks to raise a paltry $405 million. The fact that this gold was physically airlifted for storing in the vaults of the Bank of England only added to the feeling of humiliation — which the likes of Greece, Portugal and Ireland are today experiencing.

There are only six countries now with larger forex reserve chests than India (see chart).

In the case of the top five — China, Japan, Russia, Saudi Arabia and Taiwan — the reserve accumulation story has followed a predictable plot. All of them have, year after year, been exporting goods and services in excess of their spending on imports and meeting other current foreign obligations.

These current account surpluses have gone to build the forex stockpile of their central banks or even spilled over as capital exports. Japan's cumulative surpluses over 1991-2010, at $2.6 trillion, have been 2.3 times its accumulated reserves. That has led to it becoming the world's No. 1 capital exporter.

India and Brazil, on the other hand, represent unique cases of countries that have amassed huge forex reserves despite running current account deficits (CAD) in most years. As an analogy, imagine a company whose ‘reserves and surplus' account keeps showing an increase even when there are no retained profits that can be taken to its balance-sheet (the ‘company' in this specific instance is actually loss-making!).

What makes the Indian story still more unique is the fact that it has, unlike Brazil, not suffered any currency upheavals. There has been no run on the rupee after 1991 — which cannot be said for the Brazilian Real. The rupee, if anything, has tended to strengthen against other currencies in recent times, the widening CADs notwithstanding.

The mechanics of accumulation

The accompanying table provides a more detailed picture of how India has managed to build its forex kitty since March 31, 1991. During the entire period from 1991-92 to 2010-11, the country's exports of goods were way below its imports, generating a cumulative deficit of $750 billion on the merchandise trade account.

This was, however, partly offset by a surplus of almost $ 590 billion on the ‘invisibles' account.

‘Invisibles' basically refer to export and import of services, as opposed to physical shipment of goods. They cover 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. Invisibles also encompass interest, dividends, royalties and other current receipts/outgo on account of cross-border loans and equity investments.

It can be seen from the table that India's gross invisible receipts of $1,280 billion pretty much matched its revenues from export of goods over the 20-year period, with nearly 60 per cent of the former constituted by two sub-heads — private remittances and software services.

That puts the country in the league of the US, the UK, Spain or Ireland, which have similarly humungous services export profile in their balance of payments (BOP). If one includes remittances, India's services exports would be next only to the US, the UK, Germany and France.

But with the invisibles surplus not large enough to neutralise the still wider merchandise trade deficit, it has yielded a current account gap of $161 billion. This gap has been more than adequately filled by capital inflows of $437 billion.

The resultant excess inflows — in conjunction with the valuation impact arising from the dollar's depreciation vis-à-vis other currencies in the RBI's forex basket — explains the reserve accretion of close to $300 billion between 1991-92 and 2010-11.

This pattern seems to be repeating itself in the current fiscal too, with $10.9 billion being added to the forex reserves during April-June in spite of a $31.6 billion trade deficit.

Sustaining the party

That raises a fundamental question: How long can this story continue? CADs are sustainable to the extent (a) they are within manageable limits and (b) can be financed through capital inflows or running down of reserves.

Till around 2006-07, India's annual CAD hovered below $10 billion or one per cent of GDP, which was perfectly manageable. In 2010-11, the CAD had expanded to $44.28 billion or 2.6 per cent of GDP, only marginally lower than the 3 per cent level crossed in the BoP crisis year of 1990-91

As regards capital flows, they will keep coming in so long as investors perceive the country to be an attractive destination — which means continuing to believe in the India Story.

That obviously is not the most prudent of assumptions to make in the designing of macroeconomic policy. In the long run, there is no escaping from building productive capacity at home and channelising the forex inflows received into projects that would help meet this objective.

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