Forex Reserves: What Level Is Enough

Updated: Aug 25 2002, 05:30am hrs
For nearly four decades, foreign exchange was a taboo subject for most Indians. Governments guarded the foreign exchange reserve as if it was a treasure trove. The office of the Chief Controller of Foreign Exchange was a hallowed place and only the privileged few could gain admittance to the sanctum sanctorum. I remember travelling from Chennai to Mumbai to plead with the Chief Controller (a kind man by name Mr Atmarama Rao) my case for an allowance to study abroad and, finally, I got the princely allowance of $7 per day for 10 months in a year!

P Chidambaram
Until recently, we had a law known as the Foreign Exchange (Regulation) Act. Its object was to conserve and augment the forex reserves of the country. The way to hell, it is said, is paved with good intentions. Like many well-intentioned laws, FERA paved the way to disaster. FERA created a flourishing black-market in foreign exchange. It brought into the economic lexicon the word hawala. Illegal forex transactions became the fuel for the growth of crime syndicates with trans-border connections.

FERA also became a tool of oppression. Successive governments persisted with FERA and added COFEPOSA and SAFEMA. International markets do not respect draconian laws that run counter to commonsense. Indias reserves, far from being augmented, dwindled at an alarming rate. By early 1991, they were a little more than a billion US dollars.

Mercifully, FERA was buried finally on May 31, 2002. Indias forex reserves have now crossed $60 billion. We ought to have gained tremendous confidence in the management of the external sector of the economy. Yet, we seem, or pretend to be, as helpless in dealing with the external sector when we have large reserves as we were when the reserves had fallen to $1 billion. It is a story akin to our foodgrain reserves. We were floundering in the 1970s when we lived from ship-to-mouth (the PL 480 days) and we are floundering today when food stocks are of the order of 60 million tonnes.

The sources of foreign exchange inflows are easily identifiable. Official Development Assistance (the name for foreign aid) has dwindled to almost nothing. The principal sources are Foreign Direct Investment (FDI), Foreign Institutional Investment (FII), export earnings, external commercial borrowings, tourism and remittances from Indians working abroad. There are also banking flows which include inter-bank loans and syndicated lending. In recent years, the inflows from these sources have been copious. There was a change of government in 1996-97, yet reserves increased by $ 5.8 billion. Even in the aftermath of the East Asian crisis, reserves increased by $ 3.9 billion in 1997-98. Last year (2001-2002), amidst a worldwide recession, Indias reserves grew by $ 11.8 billion, the highest recorded in a single year.

In my view, there is no reason to believe that these flows will reverse themselves. As long as we adopt sensible and forward-looking economic policies, there is no reason to believe that our reserves will decline or will not be sufficient to meet normal demands. Those who think otherwise must be congenital pessimists or believe that a particularly cruel hand of fate lies over India.

All indications are that India will continue to liberalise the trade sector. We will continue to export more goods and services. True, we will also import more, but the exchange rate mechanism (and tariffs) will act as a restraining factor. All indicators point to a more liberal regime for foreign direct investment. So long as the rate of inflation is under control and there is an interest differential, private remittances will continue to flow into the country. Our corporates have shown a remarkable capacity to access foreign capital. It is a sign of their growing competitiveness and efficiency, and there is reason to believe that more companies will be able to raise both debt and equity abroad.

That leaves tourism. Even with muddled policies and meddling governments, 2.3 million tourists arrive in India. If we can get our act together, this number can be easily raised to, first, 5 million and then to 10 million. Given these objective conditions, I believe that Indias foreign exchange reserves will continue to grow.

A debate has started on the adequacy of our foreign exchange reserves. I recall a seminar on July 5, 1991 when economists of every shade urged Dr Manmohan Singh to concentrate on building reserves. It is most gratifying that 11 years later some economists are asking the question When is enough enough.

The RBIs policy is quite clear and transparent. It is to build a high level of foreign exchange reserves which takes into account not only anticipated current account deficits but also liquidity at risk arising from unanticipated capital movements. Regarding management of the capital account, the policy is short-term banking capital for financing investments and growth has to be avoided, while foreign direct investment and portfolio investment have to be encouraged. There can be no quarrel with these policy pronouncements. They are in line with the exceptional wisdom and ability brought to the office of Governor, RBI, by Dr C Rangarajan and Dr Bimal Jalan.

Still, I would like to ask, Are we not being too cautious I think, by our over-cautious stance, we are missing many opportunities. Let me make three crucial assumptions. First, that governments will keep inflation under control. Second, that the exchange rate will depreciate by about 5 per cent a year. Third, that given the structure of our banking industry, interest rates in India will be higher than interest rates in developed countries, giving rise to an arbitrage opportunity. If these assumptions are correct, a powerful case can be made for adopting a more aggressive stance on liberalisation. Here are some suggestions:

(1) Government could pre-pay, and also allow corporates to pre-pay, high-cost overseas loans;

(2) The time-table for tariff reduction could be shortened;

(3) Government can provide funds to key manufacturing and service industries to explore new markets. Government can extend lines of credit to importing countries to source their products and services from India;

(4) We can re-visit the Tarapore Committee report on capital account convertibility.

Our reserves are adequate if they give us the confidence to leverage that strength. Our reserves will be useless if we continue to treat them as a hoard and believe they will always be inadequate.