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On
February 4, the Reserve Bank of India took a major step
forward towards full convertibility of the rupee. It
announced that resident Indians can, with immediate
effect, remit an amount of up to $25,000 per calendar
year for any current or capital account transaction,
or a combination of both. This implies that resident
Indians would not just be able to open and operate foreign
currency accounts outside India, but can use the money
remitted to those accounts to acquire financial or immovable
assets without prior approval from the RBI.
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On the surface, the sum of $25,000 involved may appear
small, especially when compared to net capital inflows
into the country of $12 billion in 2002-03 and $6 billion
in the first quarter (April-June) of 2003-04, and reserve
accumulation of $17 billion during 2002-03, and around
25 billion during April to December 2003. But, looked
at otherwise, if one million Indians, or just 0.1 per
cent of the country's population choose to avail of
the facility in full, the outflow would be adequate
to wipe out the foreign exchange reserves accumulated
during the first three quarters of a year (2003-04)
that has seen record inflows of capital. It is not India's
new and old rich alone who would seek to exploit the
new ‘facility'. The large numbers of middle class households
who have members moving abroad on H1 B visas or for
educational purposes would see some reason for holding
an account, if not making some investment, abroad. A
million may not be a large figure for the number willing
every year to transfer the equivalent of Rs. 11.5 lakh
abroad at current exchange rates. Not surprisingly,
within a day after the new facility was announced, banks
have rushed to press, to advertise their willingness
to manage remittances under this head for interested
clients.
Needless to say, if all or a large part of capital inflows
are consumed in this fashion, it could send out a signal
that the country is losing its ability to meet its repatriation
commitments, either in the form of the returns that
would accrue to foreign investors or in the form of
permission to exit from investments in the country.
This could slow capital inflows or even result in outflows,
leading to a collapse in reserves and a financial crisis.
This is typically the way in which countries that are
temporarily the favourites of foreign investors and
experience a capital inflow surge often find themselves
the victims of outflows that lead to crisis. The "feast-or-famine"
syndrome characteristic of capital flows to emerging
markets has been documented widely. A reading of that
literature does warrant the conclusion that by beginning
the journey to full convertibility, the government has
opened the sluice gates to outflows that can empty its
foreign exchange reserves.
An analysis of the sources of reserve accumulation by
the RBI over a long period points to the important role
of inflows in the form of NRI deposits and foreign institutional
investor investments. Outstanding NRI deposits increased
from US$ 13.7 billion at end-March 1991 to US$ 31.3
billion at end-September 2003. Cumulative net FII investments,
increased from US$ 827 million at end-December 1993
to US$ 19.2 billion at end-September 2003. These kinds
of investments rarely, if ever at all, finance new investments
in the domestic economy. These are also typically inflows
that would be reversed in case of any sign of uncertainty.
Thus, comparisons of likely outflows with the size of
inflows and the extent of reserve accumulation are not
without some basis. Reserve accumulation occurs when
the RBI is forced to intervene in the foreign currency
market and purchase dollars or other foreign currencies.
This it is forced to do when large capital inflows result
in a surplus of foreign exchange in the system, since
the supply of foreign exchange exceeds demand from firms
and individuals for permitted current and capital account
transactions such as imports, private or business travel,
remittance for gifts, donations, study abroad, medical
treatment, investment abroad and so on. When the supply
of foreign exchange exceeds such demand, the rupee tends
to appreciate vis-ŕ-vis foreign currencies under India's
liberalized and market-driven exchange rate regime.
A rising rupee increases the dollar value of India's
exportables and adversely affects her export competitiveness.
It is to prevent such appreciation that the RBI has
been purchasing foreign exchange in the market and enhancing
its reserves.
Beyond a point, however, increasing reserves are a problem
for the central bank. When the foreign exchange assets
of the RBI rise, so do its liabilities, which typically
imply an increase in money supply. Since allowing that
to happen amounts to loosing control of its monetary
policy lever, the central bank chooses to retrench other
assets such as government securities to sterilize inflows.
Unfortunately for the Reserve Bank of India, foreign
capital inflows have in recent months been massive and
unrelenting. The consequent huge and rapid increase
in its reserves, can no more be sterilized easily, since
the central bank has already brought down its holding
of government securities substantially.
Excessive reserve accumulation is a problem also because
of its negative balance of payments implications. Investors
bringing in the capital earn minimum returns of around
7 percent. The maximum would be many multiples of that,
especially from capital gains associated with recent
investments in the stock market. These returns have
to be paid out in foreign exchange. On the other hand,
when the dollar flowing into the country are acquired
by the RBI and invested through central and commercial
banks, the returns are much lower. According to the
RBI, during the year 2002-03 (July-June), the return
on foreign currency assets, excluding capital gains
less depreciation, decreased to 2.8 per cent from 4.1
per cent during 2001-02, because of lower international
interest rates. This implies that the interest associated
with capital inflow and its accretion as reserves involves
little foreign exchange earning but substantial foreign
exchange payouts.
Finally, it is becoming diplomatically increasingly
difficult to accumulate reserves in order to prevent
currency appreciation. India has been identified along
with China as a country whose large reserves prove that
it has an "undervalued" currency that discriminates
against imports from the US. The pressure to allow the
currency to appreciate is therefore on the increase.
For all these reasons, it had become clear to the central
bank and the government that something had to be done
to prevent further rapid reserve accumulation. The choice,
therefore, was either to curb flows or to stimulate
the demand for foreign exchange. Given its unthinking
commitment to liberalization and "reform",
it's the latter route that the government has chosen.
Recent months have, therefore, seen not just irrational
and sometimes bizarre trade liberalisation manoeuvres,
such as across-the-board duty reductions and the license
to bring in laptops duty free as part of baggage, but
the relaxation of ceilings on remittances abroad for
purposes as varied as education, health and investment.
All of these have proved inadequate given the fact that
India has proved to be the flavour of the season for
foreign investors, who have rushed into the country
in herd-like fashion.
It is this set of circumstances, rather than rational
decision-making, that has forced the government to all
on a sudden liberalize controls on capital account outflows.
The sequence has to be noted. First, regulations regarding
purely financial inflows are liberalized to attract
capital into the country so as to finance the outflows
that trade liberalization was expected to result in.
Since the initial response of foreign investors was
lukewarm, further liberalization, in the form of relaxing
ceilings on FII holdings of equity in firms in different
sectors, was resorted to. Suddenly, for reasons extraneous
to the performance of the Indian economy, which has
grown at an indifferent rate for at least three consecutive
years before the current "recovery", inflows
accelerate. Unable to manage those inflows, the government
attempts to encourage foreign exchange profligacy through
liberalization of foreign exchange access for various
current account transactions. When even that proves
inadequate, it opts for capital account convertibility.
The problem is that when
controls on capital account outflows are liberalized,
it is difficult to control the volume of outflows. And
if large outflows raise the threat of depreciation in
the value of the rupee, outflows accelerate and capital
flight out of rupee denominated assets would occur.
Having whetted the appetite of India's rich for a financial
foothold abroad, it would be extremely difficult to
reverse the decision. Moreover, any such reversal would
encourage the flight of financial investors out of the
country. A currency and financial collapse would be
inevitable. In short, the sluice gates have been opened.
It is, therefore, clearly time to prepare for the coming
crisis.
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