In absolute terms they still appear large. India’s foreign reserves at $286 billion are adequate to finance her merchandise imports for over seven months. That is a far cry from the two weeks figure that prevailed at the time of the balance of payments crisis in 1991. Not surprisingly, India’s reserves position is consistently referred to as one indicator of the success of economic reform.
However, things seem to be changing. The week ending June 1 was one more among the many in recent times when reserves have fallen, by as much as $2.4 billion this time. The fall seems reflective of a longer-term tendency. Over the year ending June 1, 2012 reserves had fallen by close to 9 per cent or by $27 billion, with more than half the decline having occurred in the first half of that period. The most two months ending June 1 seem to have witnessed acceleration in the decline, with reserves having fallen by $8.5 billion.
Some of the decline is due to valuation changes or the depreciation of currencies like the euro, in which a part of India’s reserves are held. Since the aggregate value of reserves is converted into and denominated in dollars at current exchange rates, such depreciation erodes the total. This should give no cause for concern, since it reflects changes in the relative value of foreign currencies. However, the cause for concern is that a substantial part of the decline in reserves is not due to valuation changes but because the Reserve Bank of India is being required to sell some of its dollar holdings.
Given India’s liberalised exchange rate regime, the RBI does not do this to directly meet dollar demands to finance imports or meet commitments in foreign exchange. Those needing access to dollars are expected to turn to the many authorised dealers in foreign exchange. But when the demand for dollars in the market is larger (smaller) than the current inflow, the rupee loses (gains) value against the dollar or depreciates (appreciates). In the not too distant past India’s problem was an excess supply of foreign exchange because of a surge in capital inflows. Since the appreciation in the rupee that this resulted in tended to erode the competitiveness of India’s exports, the RBI had to step in on more than one occasion to buy dollars and generate demand for foreign exchange in order to limit the rupee’s appreciation.
This action is not costless. Inasmuch as an increase in the foreign exchange assets of the RBI is matched by an increase in its liabilities in the form of rupees in circulation, the process tends to add liquidity to the system. To absorb a part of this liquidity as part of money supply management, the RBI has had to sell a part of its rupee assets (mainly government securities). The latter tend to fetch better interest than the returns on the secure assets that can be easily sold for cash in which foreign reserves are normally held. That is a loss the RBI has to suffer. So the accumulation of reserves with the RBI was neither all voluntary (since it was required to intervene in the foreign exchange market to manage the rupee) nor costless.
Be that as it may, more reserves in the hands of the central bank in a country that is a recipient of large short term capital flows is definitely positive, since it offers a buffer to deal with the reverse flow of the currency. The difficulty now is not so much a substantial reverse flow, but that flows have dried up considerably while the deficit on the current account of the balance of payments—or the excess of annual outlays on imports over receipts from exports of goods, services and ‘invisibles’ of various kinds—continues to widen. It is the inadequacy of the capital inflow to cover the deficit in the current account that is leading to excess demand for foreign exchange and a depreciation of the rupee. To counter that depreciation the RBI has had to enhance supply and sell foreign exchange in the market by depleting its reserves. This in itself may be warranted. But it is disconcerting that despite the RBI’s effort to run down its reserves to the substantial extent noted earlier, the rupee continues to slide. If current trends continue India may lose a large part of the foreign exchange buffer it had to deal with external shocks or volatile capital flows.
This points to a fundamental weakness in India’s external account that was masked by her accumulating reserves. India’s foreign reserve accumulation was (unlike China’s, for example) not the outcome of its excess earnings of foreign exchange relative to its annual expenditures of foreign currency. Rather it was reflective of the fact that, for many years now, while economic liberalization had not delivered on its promise of generating an export and current account surplus, financial liberalization had resulted in large inflows of foreign capital in the form of portfolio flows and debt. With more capital flowing in than required to finance the deficit, the RBI had to buy up the foreign exchange and accumulate them as reserves. In recent times, however, global developments and the end of the speculative boom in India’s stock markets are resulting in a slackening of such flows and even in small volumes of reverse flows in particular months. Unfortunately for the country, this occurs precisely when the current account deficit is widening. Since that leaves the deficit inadequately financed, the rupee weakens and the RBI has to cautiously deploy its reserves to counter the decline. Obviously, it has not been too successful thus far.
The reasons why the current account widens have been discussed in this column earlier. Oil price increases and a rush into imported gold have been the main culprits behind the increase in the import bill. But underlying the vulnerability to such developments is the fundamental weakness in the form of a persisting current account deficit. And in explaining that deficit the higher import intensity of domestic consumption and investment after liberalisation has an important role to play.
With the crisis in Europe intensifying and talk of contagion within the OECD it is unlikely that India would experience another capital inflow surge. It would need to reduce the deficit on its current account to shore up the rupee and stall further depletion of reserves. However, given the role of geopolitics and speculation, the return to recession in the world economy is only impacting oil prices with a lag and muted intensity. On the other hand, the recession is telling on India’s exports. That is widening the deficit and has triggered the spiral that is taking the sheen off one more indicator of India’s post-liberalisation, economic success. In fact, by creating conditions for the persistence of the fundamental current account weakness noted above and breeding complacence regarding that vulnerability because of large capital flows in good times that financial liberalisation results in, economic reform has partly created the current difficulties.