If the accumulation of foreign exchange reserves is any indication, India's external balance of payments appears extremely robust. In the net there is far more foreign exchange flowing into the country than flowing out. As a result, the year 2002 ended with foreign exchange reserves crossing the $70 billion mark.
 
This trend represents a substantial acceleration of the rate of growth of reserves, which rose from $20 to $30 billion over a period of more than four years ending December 1998 and from there to $40 billion over a two-year period ending December 2000.
 
Subsequently, the pace of reserves accumulation has been even more pronounced, as Chart 1 indicates. Between March 2001 and December 2002, external reserves increased by $28 billion.  Most of that increase has in turn been concentrated in the past calendar year alone, which has seen an increase in the level of foreign exchange reserves of more than $22 billion.
Chart 1 >>
 
Such a dramatic increase is unprecedented in the history of Indian balance of payments. It has been taken advantage of, by Indian policy makers, to suggest that all is well on the macroeconomic front. Even more significantly, the higher level of foreign reserves is being used to argue that the country's external accounts are now so healthy, that the economy is ripe for a major dose of capital account liberalisation.
 
This makes it important to consider the causes of this rapid accumulation of reserves, as well as the future implications of the forces underlying this increase.

Factors driving the increase in foreign exchange reserves
While a part of the increase in reserves is the result of a revaluation of the dollar value of non-dollar foreign currency holdings, as a result of the depreciation of the dollar against other currencies, especially the Euro and the Yen, it is substantially due to an excess of inflows over outflows. Even an overgenerous estimate suggests that over the period April to September 2002 only about $2.5 billion of the 9 billion dollar reserve accumulation was the result of such revaluation.
 
Interestingly the acceleration in the pace of reserve accretion occurred despite the fact that the government had in August 1998 and November 2000 issued the Resurgent India Bonds and the India Millennium Bonds respectively, which together resulted in an inflow of close to $9 billion in foreign exchange. Despite the lack of any concerted effort in recent times to mobilise foreign exchange through large scale borrowing against bonds and indications that both the government and the private sector are retiring and reducing their holding of high cost foreign debt, the RBI has been forced to mop up foreign exchange inflows to prevent any undue appreciation of the rupee.
 
The RBI's efforts notwithstanding, the rupee has indeed been appreciating, nudging its way "upwards" from above Rs. 49 to the dollar to below Rs. 48 to the dollar. This could be seen as reflective of the strength of the rupee and the growing weakness of the dollar. But appreciation of the currency in a country that has not been able to trigger any major export explosion despite ten years of neoliberal economic reform is not necessarily a good sign. At given prices, appreciation of a country's currency by definition increases the dollar value of its exports and reduces the local currency value of its imports. Inasmuch as this triggers an increase in the dollar value of imports and a decrease in the dollar value of exports, appreciation can be damaging for the balance of trade. And since this occurs in India at a time when oil prices are hardening internationally, the rupee's appreciation does threaten to widen the balance of trade deficit, or the excess of imports of goods and services over exports of goods and services.
 
There are two reasons why this has as yet not given cause for worry to the government. First, the most recent figures on exports point to some recovery in India's export performance. Thus the dollar value of India's exports rose by 15.7 per cent during the first eight months of the current financial year (April-November), which compares well with the performance during the corresponding period of the previous year.
 
This has tended to dampen concerns about the possible damaging effects of exchange rate appreciation, but this may be excessively optimistic. It is well-known that changes in exchange rates take some time to feed into goods markets and therefore exports and imports. Since the rupee appreciation is still quite recent, it will not yet have fed into changed dollar prices (with corresponding effects on export volumes) or lower margins faced by exporters.
 
Further, this improved export performance cannot be held responsible for the improvement in India's reserves position. A sharp 21 per cent increase in the dollar value of oil imports and a unexpected 12 per cent increase in the dollar value of non-oil imports have actually increased the size of the trade deficit recorded during the first eight months of this financial year ($6247.65 million) as compared with the corresponding figure for the previous year ($5814.93 million).
 
The second reason why the rupee's appreciation has not given the government and the central bank cause for concern is the role of invisibles and service payments in easing the current generally. As a result of a $1.3 billion increase in Private Transfers (largely remittances) and a $1.5 billion increase in net receipts from Miscellaneous Factor Services (which includes software and business services exports), the current account of the balance of payments recorded a surplus of $1.7 billion during April-September 2002-03 as compared with a deficit of $1.5 billion during the corresponding months of 2001-02.
 
This means that the relatively new tendency for the current account of the balance of payments to record a surplus noted over the whole financial year 2001-02, has persisted and gathered strength during the first six months of 2002-03. All this is indicated in Chart 2, which shows the recent behaviour of major items of current account balances.
Chart 2 >>
 
But even allowing for this increase in the current account surplus and after taking account of the possible effects of dollar depreciation on value of reserves, there remains around $ 5 billion dollars of reserve accretion that remains to be explained even for the April-November 2002 period. What is more, since the balance of payments statistics indicate that there was a net outflow of $2.2 billion on account of repayment of external assistance and commercial borrowing, we must account for more than $7 billion of inflows on the capital account if reserve accumulation during that period is to be explained.
 
The RBI's Balance of Payments statistics suggest that about $1.3 billion of this is on account of foreign investment, another $1.4 billion on account of NRI deposits, around $1 billion on account of Other Banking Capital, $2.1 billion on account of Other Capital and $1.4 billion on account of "errors and omissions".
 
Considering the period April-September only, it is evident that the more recent period evidenced a slight decline in FDI and portfolio investment flows compared to the same period in the previous year, as Chart 3 shows. However, as Chart 4 indicates, there was a substantial increase in 2001-02 in banking capital flows (especially NRI deposits, largely related to the special schemes for NRIs) that has continued into the subsequent year. The total capital account, therefore, experienced increases in both 2000-01 and 2001-02, as shown in Chart 5.
Chart 3 >> Chart 4 >> Chart 5 >>