India’s foreign exchange reserves continue their inexorable march upwards.
Today, these reserves stand at almost $ 84 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. Even other South Asian countries are seeing their
foreign exchange reserves increase considerably. India is therefore
not an exception but the rate of increase in India is most impressive.

Why have India’s forex reserves increased so dramatically? 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. In other words,
what the RBI is saying is that rising foreign exchange reserves reflect
the intrinsic strengths of the Indian economy and successful management
of the external sector. Fair enough. India looks good globally. International
confidence in India is indeed high, especially since most other countries
face severe problems of servicing external debt and do not have the
growth potential and momentum that India has. 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. These accounts were built-up
during the license-quota-permit raj largely by underinvoicing of exports
and overinvoicing of imports. There are no authentic studies or analysis
but some estimates put Indian-held accounts in places like Switzerland
and the Cayman Islands at around $ 100 billion at least.

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. Fortunately, that route is
not open in India because the rupee is not freely convertible to the
dollar for ordinary residents. Between one-fourth and one-third of our
forex assets today might fall into the volatile category. This is not
a dangerous situation as yet but it could turn into one. The real distinction,
however, 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 stunning economic successes of countries
like Japan, China and South Korea have hinged on undervalued or weak
currencies in relation to the US dollar which has been the major export
market. Exchange rate is ultimately an economic price like of any commodity
and has nothing whatsoever to do with national pride.

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
and why most market participants take its analysis with more than the
proverbial pinch of salt. 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. Economic
growth has slowed from an annual average of 6.7%when the Congress was
in power during 1992/93-1996/97 to 5.5% during the BJP-led regimes.
In 2002/03, economic growth rate fell further to just 4.3%. Both industrial
and agricultural growth rates have markedly decelerated. Demand, incidentally,
is one main reason why India has had record stocks of rice and wheat.
If procurement prices are increased and if consumption from ration shops
falls because of sharp price increases, obviously foodgrain stocks will
mount.

Last fortnight, the World Bank released a detailed `117-page report
called “India: Sustaining Reform, Reducing Poverty”. The Union Finance
Ministry reacted sharply and angrily to the report. That came as no
surprise since one of the findings of the World Bank is that ” to the
extent that capital flows into India have been driven by one-off events
since September 11, 2001 including fears of increased scrutiny of accounts
held overseas as part of anti-money laundering drives or the instability
in Iraq more recently, it would be risky to slow fiscal reform on a
gamble that such flows will continue indefinitely”. While foreign exchange
reserves have zoomed, the government’s financial position has worsened.
Fiscal indicators today in India are worse than those prevailing in
1991 when the country faced an unprecedented collapse. This is the reason
why there is hardly any significant growth either in public or private
investment.