The pains and pangs of plenty
India’s foreign exchange reserves continue their inexorable march upwards.
Today, these reserves stand at almost $ 83 billion, enough for fifteen
months of imports. In the last year alone, forex reserves have increased
by a whopping $ 30 billion. Such a pile-up is taking place in some East
Asian countries as well, reflecting in some senses the undervaluation
of their currencies.
Why have India’s forex reserves burgeoned? The Reserve Bank of India
attributes it to three factors: (i) booming software export revenues
and remittances from Indian workers abroad; (ii) timely repatriation
of export earnings back to India by exporters; and (iii) strong inflows
of both foreign direct and institutional investment. Fair enough. India
looks good globally. But there is another factor whose importance can
no longer be brushed aside.
Interest rates in India are at least 3-5 percentage points higher (in
inflation-adjusted or “real” terms) than in the USA and other advanced
countries. Foreign investors, mainly NRIs but also foreign institutional
investors (FIIs) and hedge funds are now taking full advantage of this
differential (engaging in what the pundits call interest rate “arbitrage”)
and pouring money into India. That the RBI itself knows more than it
is revealing is probably borne out by its move on July 17th to fix a
ceiling on interest rates that NRIs would get on their repatriable rupee
deposits. There is an overall cap of $ 1.5 billion for the FII arbitrage.
But this limit is for onshore transactions only. What is happening offshore
is anybody’s guess. Of course, the possibility cannot be ruled out that
a portion of this so-called NRI money is actually money of resident
Indians parked abroad coming back home.
It is tempting to classify “arbitrage” dollars coming into India as
“hot” money-that is, money that can flow out instantaneously as it came
in. But financial crisis has been caused less by such “hot” money than
the savings of domestic residents fleeing. Between one-fourth and one-third
of our forex assets today might fall into the volatile category. The
real distinction is not between “hot” money and “cold” money but between
“flexible” policies and “rigid” policies. If interest rates are attractive,
money is bound to flow in. Under such circumstances, a flexible policy
would be to drop interest rates. That is indeed happened elsewhere but
in India there are other pressures on the government to moderate declines
in interest rates. These pressures arise from the vocal constituency
of provident fund and government-subsidized savings instruments.
Normally, such huge dollar inflows could fuel inflation. But that will
not be allowed to happen here and rightly so. If interest rates cannot
fall freely and if inflation cannot be allowed to rise, how does the
impact of rising forex reserves manifest itself? It will do so in an
“appreciation” of the rupee vis-�-vis the dollar–that is, a dollar
will fetch less rupees. Over the past year, the rupee has appreciated
by almost 5% in relation to the dollar. True, the dollar itself is falling
in global markets because of the huge American current account deficit.
So the rupee’s appreciation is magnified. Normally our exports could
have been hurt but many other competitor currencies have also appreciated.
This appreciation may appease swadeshi sentiment but if it prolongs
it could begin to hit exports, especially since the Chinese yuan is
pegged to the US dollar.
The RBI should never be second-guessed because of its unique access
to data and its formidable analytical capacity. The complexities in
managing an open macroeconomy should also never be minimized. But rather
than become defensive as it appears to have, the RBI must ask itself
as to why there few takers for its assessment. Surely, it also recognizes
that the forex mountain is partly a consequence of sluggish demand for
dollars given depressed economic growth rates in the past three-four
years.
