Resolving the RBI dilemma

 Arvind Panagariya

  The 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?

 Answers 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 short).

 Therefore, 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

 But 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.

 But 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.

 With 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.

 Why 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.

 But 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.

 First, 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.

 The 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.

 Finally, 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.

 In 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