The
Indian rupee is on the rise. While its appreciation
vis-à-vis the dollar began in June 2002, when
it had touched a low of more than Rs. 49 to the dollar,
it has been rising vis-à-vis the Euro as well
over the last four months. During these periods of
ascent, it has appreciated by close to 12 per cent
vis-à-vis the dollar in 22 months and by a
significant 9 per cent vis-à-vis the Euro in
a short period of 4 months. Not surprisingly, exporters
have begun to get restive; since a loss of 10 per
cent in the rupee price of their exports can shave
off margins on past fixed-price dollar/euro contracts
and make it difficult to win new orders.
The rise of the rupee is partly attributable to the
depreciation of the other currencies, especially the
dollar against those of its competitors. That this
was true for some time is reflected in the fact that
while the rupee was appreciating against the dollar
for close to two years, it was depreciating vis-à-vis
the euro for much of this period. This is, however,
only small cause for comfort, since most export contracts
are denominated in dollar terms. Moreover, in recent
months, as noted above, the rupee has been appreciating
against the euro as well.
Two factors have influenced this rise of the rupee
vis-à-vis various currencies. First, the excess
supply of foreign currency, relative to demand for
current and capital account transactions from resident
individuals, agencies and institutions, other than
the Reserve Bank of India. Second, the willingness
of the central bank to buy foreign currencies to add
to its reserves and, thereby, increase the demand
for these currencies in the market. The role of market
demand and supply in determining exchange rates and
the consequent shift to market mediated intervention
by the central bank has been the natural outcome of
the adoption of a liberalised exchange rate system
over the 1990s.
The pressure on the rupee leading to its appreciation,
which is affecting export competitiveness adversely,
arises because India, which has recorded a current
account surplus since financial year 2001-02, has
encouraged and attracted large inflows on its capital
account. India's current account surplus, we must
note, is not a reflection of its strong trade performance.
Rather, it is because, net inflows under what is called
the ''invisibles'' head of the current account of
the balance of payments has been more than adequate
to finance a large and recently rising merchandise
trade deficit.
The principal sources of current account inflows have
been buoyant remittance flows and inflows under the
''software services'' head. That is, transfers made
by Indian workers abroad, either on short or long-term
contracts, have helped overcome the adverse balance
of payments consequences of India's lack of competitiveness
reflected in a large trade deficit. Inflows on account
of software services rose from $5.75 billion in 2000-01
to $6.88 billion in 2001-02, $8.86 billion in 2002-03
and $9.09 billion over the first nine months of 2003-04,
while private transfers (mainly remittances) touched
$14.81 billion in 2002-03 and $14.49 billion during
April-December 2003, after having fallen from $12.8
billion to $12.13 billion between 2000-01 and 2001-02.
In an intensification of this trend, during the first
nine months of the recently ended financial year 2003-04,
net inflows on account of invisibles stood at $18.22
billion, well above the $15 billion deficit on the
trade account.
Even while India's current account was relatively
healthy on account of the foreign exchange largesse
of Indian workers abroad, the country's liberalised
capital markets have attracted large inflows of capital
amounting to a net sum of $10.57 billion in 2001-02,
$12.11 billion in 2002-03 and a massive $17.31 billion
during the first nine months of 2003-04. Expectations
are that, because of the huge portfolio capital inflows
during the last three months of 2003-04 encouraged
by the government's privatisation drive, net capital
account inflows during 2003-04 will be in excess of
$20 billion.
There are two issues that arise in this context. The
first relates to the nature of the capital inflows
during these years. The second to the implications
of these inflows for the value of the rupee under
India's liberalised exchange rate management system.
Three kinds of inflows have dominated the capital
account. An early and important source of inflow during
the years of financial liberalisation has been in
the form of NRI deposits in lucrative, repatriable
foreign currency accounts. On a net basis, such inflows
accounted for $2.32 billion, $2.75 billion, $2.98
billion and $3.5 billion respectively in 2000-01,
2000-02, 2002-03 and April-December 2003 respectively.
They reflect the attempt by richer non-residents to
exploit arbitrage opportunities offered by the higher
(relative to international rates) interest rates on
repatriable, non-resident, foreign exchange accounts,
to earn relatively easy surpluses.
A second important source of capital inflows has been
portfolio capital flows, reflecting investments by
foreign bodies, especially foreign institutional investors,
in India's stock and debt markets, encouraged more
recently by the disinvestment of shares in profitable
public sector undertakings. On a net basis, such inflows
had fallen from $2.59 billion in 2000-01 to $1.95
billion in 2001-02 and just $944 million in 2002-03,
but rose sharply to $7.62 billion in the first nine
months of 2003-04. As compared with this, net foreign
direct investment has been relatively stable, at $3.27
billion in 2000-01, $4.74 billion in 2001-02, $3.61
billion in 2002-03 and $2.51 billion during April-December
2003.
The third important source of capital inflows was
a financial liberalisation-induced increase in the
net liabilities of commercial banks (other than in
the form of NRI deposits), which rose from a negative
$1.43 billion in 2000-01 to $2.63 billion in 2001-02,
$5.15 billion in 2002-03 and $2.56 billion during
April-December 2003. This is possibly explained by
the expansion of the operations of international banks
in the country.
In sum, capital inflows that create new capacities
either in manufacturing or in the infrastructural
sectors have been limited. Much of the capital inflow
has consisted of financial investments that expect
to earn higher annual returns than available in international
markets or obtain windfall gains from the appreciation
of the value of such investments, as has recently
been witnessed in India's stock markets.
Given the determination of the exchange rate of the
rupee by supply and demand conditions in the market,
this large inflow of foreign capital in the context
of a current account surplus was bound to exert an
upward pressure on the rupee. When inflows contribute
to an appreciation of the rupee, foreign investors
also gain from the larger pay off in foreign currency
that any given return in rupees involves. This tends
to increase the volume of inflows. The real losers
are exporters, on the one hand, who find that the
foreign exchange prices of their products are rising,
eroding their competitiveness, and domestic producers,
on the other, who find that the prices of competing
imports are falling or rising less that their own
costs of production.
However, this potential loss of competitiveness on
account of surging capital inflows was stalled for
long by the intervention of the central bank. By purchasing
foreign currency from the domestic market and adding
it to its reserves, the Reserve Bank of India increased
the demand for foreign currency and dampened the rise
of the rupee. The foreign exchange assets of the central
bank rose sharply, from $42.3 billion at the end of
March 2001 to 54.1 billion at the end of March 2002,
$75.4 billion at the end of March 2003 and $113 billion
at the end of March 2004. This implies that even after
discounting for the increase in reserves resulting
from the appreciation of the dollar value of the RBI's
Sterling, Yen and Euro reserves, the foreign exchange
assets of the central bank were rising by around $980
million a month in 2001-02, $1.4 billion a month in
2002-03 and $2.5 billion a month during 2003-04. Further,
because of inflows on account of the sale of equity
in companies such as ONGC and ICICI bank, foreign
exchange assets rose to $116.1 billion during the
first nine days of 2004, or by a whopping $3.1 billion.
These magnitudes have two implications. First, they
suggest that the RBI has had to sustain a rapidly
rising rate of acquisition of foreign currency in
order to dampen the rise of the rupee and preserve
export competitiveness. Second, that despite this
sharp rise in the foreign exchange assets of the central
bank the task of managing the rupee's exchange rate
is proving increasingly difficult leading to a rise
in its value.
The task of managing the rupee is daunting because,
when the central bank increases its foreign currency
assets to hold down the value of the local currency,
there would be a corresponding matching increase in
the liabilities of the central bank, amounting to
the rupee resources it releases within the domestic
economy to acquire the foreign exchange assets. If
forced to continuously acquire such assets, the resulting
release of rupee resources would lead to a sharp increase
in money supply, undermining the monetary policy objectives
of the central bank. Since financial liberalisation
implies abjuring direct measures of intervention to
curb credit and money supply increases, the central
bank has sought to neutralise the effects of reserve
accumulation on its asset position, by divesting itself
of domestic securities through sale of government
securities it holds.
This process of ''sterilising'' the effects of foreign
capital inflows through sale of government securities
has, however, proceeded too far. The volume of rupee
securities (including treasury bills) held by the
RBI has fallen from Rs. 150,000 crore at the end of
March 2001 to Rs.140,000 crore at the end of March
2002 and Rs. 115,000 crore at the end of March 2003,
before collapsing to less than Rs.30,000 crore by
the end of March 2004. The possibility of using its
stock of government securities to sterilise the effects
of capital flows on money supply has almost been exhausted.
Foreign investors have made a complete mockery of
the much-trumpeted ''autonomy'' of the central bank
won by curbing the government's borrowing from the
RBI.
In the current context, there are only two options
available with the government for preventing a capital
flow-induced appreciation of the rupee that could
not just reduce India's exports but also deindustrialise
the economy and devastate agriculture by cheapening
imports that are now free. The first is to resort
to measures that could reduce the volume of inflows.
A feeble effort in that direction has been the gradual
reduction in the differential between interest rates
paid on non-resident foreign exchange deposits and
those prevailing in the international market, as reflected
by the LIBOR. The ceiling on interest on non-resident
external deposits had earlier been linked to the LIBOR
and set at 0.25 per cent above it. Now the ceiling
has been set at the LIBOR itself.
But NRI inflows during April-December 2003-04 only
accounted for around a fifth of net capital inflows
into the country, and that ratio is likely to be much
smaller in the subsequent months. Managing the rupee
by controlling capital inflows requires targeting
portfolio flows. That is the signal that the rising
rupee sends out. Unwilling to heed that signal, the
government has decided to encourage outflows on the
current and capital account by removing the few import
controls that remain, reducing duties, easing access
to foreign exchange for current account transactions
like travel, education and health and, most important,
relaxing outflows on the capital account by permitting
firms and individuals to transfer money abroad for
investment purposes.
The dangers of blowing up in this manner the foreign
exchange obtained in the form of volatile capital
flows should be obvious. What is more, it is unclear
whether this would resolve the problem. The process
of liberalisation may, in the short run, make India
an even more favoured destination for foreign investors.
The rupee could appreciate further. Exports could
shrink. Further liberalisation aimed at increasing
foreign exchange outflows could damage the domestic
production system. All of which could finally encourage
investors to walk out on India, in the perennial search
of markets that have not yet been destabilised. That
would deliver an economic scenario that no one would
want to conjure for this country.
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