Boon or bane?

India's fledgling financial services community is in seventh heaven. Share prices are rising on an express elevator, foreign portfolio investment is pouring into the country. Ever myopic, the money market managers are describing the appreciation as a sign of India's economic strength. They could not be more wrong.

The forex inflow is indeed stunning. India's foreign exchange reserves crossed the $88 billion mark at the end of September. Over half of the accumulation has taken place in the past three years. Recently the growth has turned into a millrace. Between 1997 and 2001, India's reserves grew by $4 billion a year. In 2001-02 they grew by $11.8 billion. In 2002-03 they grew by $20.7 billion. In the first six months of this year they have grown by another $13.2 billion.

But this is not an altogether welcome development. Whereas the rise in 2001-02 and 2002 -03 reflected a genuine strengthening in the external account of the country, a good part of the increase during the last six months is being propelled mainly by speculation and is creating some of the same problems that Thailand had experienced before the crash of 1997.

The trigger for the rapid accumulation that began in 2001 was almost without doubt the onset of recession in the U.S. the previous autumn. Facing declining share prices and interest rates at home investors began to look abroad. India looked very good: its inflation rate had fallen to 3 per cent, and its current account balance of payments deficit in 2000-01 was a mere half per cent of GDP. Best of all, the economy was growing at a healthy 5 per cent per annum, and both the economy and the polity were stable.

In the next year (2001-02) India recorded its first current account surplus on the balance of payments in 23 years of $1.35 billion. Last year the BOP surplus rose further to $2.5 billion. As an investment decision India began to look better and better. Portfolio investment and NRI deposits began to flow in, but till recently it was not speculative. For although Indian interest rates were 3 to 4 per cent higher in 2002-03 than the average interest rates in the developing countries, the rupee had depreciated by 4 per cent against the dollar in 2001-02, and 2.1 per cent in 2002-03. This rate of depreciation fully neutralised the higher rate of interest.

All this has changed quite abruptly in 2003, after the last round of interest rate cuts by the Reserve Bank of India and the revival of the share market kicked off by the sale of Maruti Udyog shares. At 6 per cent on three year-deposits, holding money in the bank became decidedly unattractive. The rise in share prices that began took the BSE Sensex from 2900 to 3700 in three months. As if that were not enough good news, exports grew by 19.1 per cent in 2002-03, and the balance of payments surplus rose correspondingly. Not surprisingly, as the dollar depreciated, the rupee failed to keep it company.

Once the rupee stopped depreciating against the dollar, the 4 per cent interest rate differential between India and the main money markets of the world became a magnet for foreign investors. The more money came in the more the rupee appreciated against the dollar. By August it had appreciated by 5.6 per cent. By the end of last week it had risen by 7 per cent over the year. This was a double whammy for foreign investors. The speculative inflow of FIIs that has followed has pushed up the share price index by a thousand points in less than two months.

The appreciation of the rupee is, however, beginning to have its effect on the current account of the country. Export growth has slowed down from 17.8 per cent in 2002-03 to 9 per cent in the first five months of the current year. Even within this period it has registered a further slowdown from 13.5 per cent in May to 4.1 per cent in August. This is happening just when the decline in interest rates and the consequent revival of industry has sent imports shooting up by 22.4 per cent. As a result India has recorded a balance of payments deficit of $1.2 billion in the first quarter of 2003-04 after recording surpluses for six successive quarters.

This is a re-run of the Thai predicament of 1996-97. Exports are slowing down, imports continue to surge, the current account is going into the red, but the only natural corrective — a depreciation of the rupee — is being prevented by a surge in the inflow of foreign exchange on the capital account. India is a long way from an exchange crisis, but there is no room for complacency either.

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