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Resolving the RBI dilemma
foreign exchange reserves held by the Reserve Bank of India have crossed
the $60-billion mark. They are now sufficient to cover 10 months worth of
imports of goods and services. Since we have almost never accumulated
reserves of this magnitude, they raise some important questions. What led
to this accumulation? Is it desirable? If yes, why and how much more
reserves must we accumulate? If not, why not and what is the best way to
arrest the process?
to these questions are technical but can be understood provided one is
willing to work through some mundane balance-of-payments statistics. These
statistics relate to a country’s international transactions such as
imports, exports, remittances, foreign investment and other capital flows
that give rise to inflows and outflows of foreign exchange (dollars, for
consider the accompanying table, which offers a crude summary of India’s
balance of payments during the year 2001-02. In that year, the excess of
India’s imports of goods and services over exports resulted in a net
outflow of $8.5 billion (imports are associated with an outflow of dollars
and exports with an inflow). Transfers
from abroad (principally remittances by Indians working abroad) led to an
inflow of $12.5 billion while repatriation of the return on investments in
India by foreigners led to an outflow of $2.7 billion.
The net impact of these two transactions was an inflow of $9.8
billion. Together, trade, transfers and investment income, which define
the current account, yielded a net inflow of $1.3 billion.
Table 1: Major Transactions Associated with Foreign Exchange Flows
*A “+” indicates inflow of dollars and “-” outflow.
* *Includes $3.9 billion in foreign direct investment, $2.0 billion in portfolio investment and $2.8 billion in NRI deposits.
Source: Reserve Bank of India
this figure does not take into account the capital-flow transactions. With
relatively strict controls in place, capital outflows from India are
small. Capital inflows, on the other hand, are welcome and come in
significant amounts. In 2001-02, a total of $9.5 billion worth of capital
flowed into the country including $3.9 billion in foreign direct
investment, $2.2 billion in portfolio investment and $2.8 billion in NRI
deposits. Between the current and capital account, RBI thus ended up
adding $10.8 billion to its reserves in 2001-02. It is this essential
process repeating itself over the last decade that led to the current
reserves build-up of $60 billion.
why does RBI need to buy a part of the dollars that flow into the country?
The essential objective behind this exercise is to maintain confidence in
the external value of the rupee. The reserves assure economic agents that
RBI has the necessary resources to prevent the rupee from depreciating
wildly. In turn, this prevents any panic buying of imports or sudden
liquidation of portfolio investment by foreigners.
total import needs worth approximately $75 billion, limited payments due
on the past loans and accumulated stock of portfolio investment at
approximately $25 billion, reserves worth $60 billion are more than
adequate, however, to guarantee a stable external value of the rupee.
As such, the extra benefit from further expansion of reserves is
virtually zero. But the extra cost of the expansion is strictly positive:
the return RBI earns on the reserves is well below the interest the nation
pays on its external debt.
then has RBI continued to accumulate dollar reserves? The short answer is
that it has been doing this to avoid appreciation of the rupee. If RBI
were to leave the excess dollars on the market, the value of the dollar
will fall and that of the rupee rise. In turn, selling goods abroad will
become less attractive and selling at home more attractive. Exports will
decline and imports will rise. The current dilemma of RBI, thus, is to
either accumulate reserves and bear the cost of low return on them or let
the rupee appreciate and risk hurting the producers of exportable and
import-competing goods. It has chosen the lesser of the two evils.
the country as a whole can exercise other options. In the ultimate
analysis, what is needed is the creation of private demand for dollars at
the current exchange rate. At least three options are available.
we could begin relaxing capital controls, allowing individuals to convert
rupees into dollars. Indeed, some piecemeal steps in this direction have
been taken. But in my judgment, this is a risky road. For one thing, the
embrace of convertibility is itself likely to bring more dollars into the
country in the initial phase and add to the existing upward pressure on
the rupee. More importantly, given our current regulatory capacity, such
convertibility runs the risk of a future financial crisis that may scuttle
the growth process as well as reforms.
second solution lies in a temporary discontinuation of external borrowing
and early retirement of the past high-interest-loans. All loans from the
Asian Development Bank and those from the IBRD window of the World Bank
are at near-market interest rates and come with conditionality.
On the other hand, the loans from the IDA window of the World Bank
contain a substantial concessionary element. It will make sense to let IDA
loans flow in but place a lid on the ADB and IBRD loans.
and most importantly, the rising reserves offer us an unusual opportunity
to complete our trade liberalisation programme at a rapid pace. Further
liberalisation will stimulate imports and create the necessary demand for
dollars. Indeed, it may be
argued that slow import expansion has been partially responsible for the
slow export expansion during the past decade.
the absence of this bold approach, the government will face lobbying
pressures for the liberalisation of specific capital-account transactions
from those keen to take their money out. And given the need to unload the
unneeded dollars, the government is also likely to succumb to these
pressures. In contrast, import liberalisation offers the opportunity to
kill two birds with one stone: it promises to relieve the upward pressure
on the rupee and bring the usual efficiency gains.
Economic Times, August 28, 2002