Implications of the large capital inflows
What all this suggests is that large "autonomous capital inflows”, occurring at a time when India's requirements of capital inflows to finance any deficit on the current account have vanished, have played a major role in explaining reserve accumulation. And inasmuch as the easy availability of dollars on account of such inflows have resulted in an appreciation of rupee's value in India's liberalized exchange markets, this has also affected the speed with which export earning as being repatriated.
 
Exporters, who in the past preferred to delay repatriation of receipts in order to benefit from any depreciation of the rupee, have been keen on bringing back their dollar receipts in order not to lose out on the rupee value of receipts because of the appreciation of the domestic currency. Such delayed repatriation of exports receipts get included according the RBI under the "errors and omissions" head.
 
Thus when we breakdown dollar receipts by source, it becomes clear that the robust balance of payments position - as indicated by reserve accumulation and currency appreciation - is largely due to autonomous flows from abroad. Those autonomous flows result in a tendency towards currency appreciation, which has a peculiar effect on export receipts. In the short run, by encouraging the quick repatriation of past and current export receipts rupee appreciation increases such receipts. But in the medium and long-term, by raising the dollar value of India's exports it affects export revenues adversely.
 
This is why it is worth bearing in mind the possible implications of the recent appreciation of the real effective exchange rate (for exporters, according to 35-country weights) as described in Chart 6.
Chart 6 >>
 
If any such appreciation-induced worsening of the balance of trade combines with other factors such as an increase in oil prices and a rise in imports on account of buoyancy in the domestic market, a country can be confronted with a situation of rising reserves and an appreciating currency precisely at a time when trade and possibly even current account "fundamentals" are worsening. The process can be especially damaging if foreign investment inflows that involve servicing costs in foreign exchange do not contribute to the country's foreign exchange earnings.
 
This would be true of portfolio flows and of acquisition of domestic companies catering to the domestic market by foreign firms. It is also true of foreign direct investment flows into joint venture companies catering to the domestic market where the existing foreign partner seeks to use the benefits of liberalisation to increase equity share. These are the principal forms of foreign investment flows into India. Despite all this, fortunately, India is still not in such a situation where this has damaged its balance of payments, as we have seen earlier.
 
Yet there is a cause for concern for a number of reasons. Virtually pushed by the embarrassingly large level of reserves, and unable to keep acquiring dollars from the market in order to prevent the rupee from appreciating too fast, the central bank has accelerated liberalization of rules relating to availability of foreign exchange for both current account and a growing set of capital account transactions.
 
Easier access of foreign exchange for travel, education and the like, slack rules governing use of international credit cards, increase in the limits to which foreign exchange can be used by importers without RBI clearance and changes in rules regarding hedging of foreign exchange transactions are all signs of a process of creeping liberalisation. The thrust is clearly in the direction of encouraging use of foreign exchange and liberalizing rules governing cross border movements of goods and capital.
 
In fact, discussion on moving towards full convertibility of the rupee, as recommended by the Tarapore Committee, which had been shelved after the East Asian crises, has once again revived. The most recent changes in policy suggest that full capital account convertibility is not just on the agenda, it is almost completed in terms of the government's own strategy.
 
Consider the policy changes – some of which have far-reaching implications – which have already occurred in the past two months alone. On 1 November 2002, resident Indians were allowed to maintain resident foreign currency accounts in domestic banks. On November 18, the Reserve Bank of India doubled the foreign exchange available under the Basic Travel Quota to resident Indians, from $5,000 per trip to $10,000 per trip.
 
On December 12 another package of measures were announced. These included allowing banks to offer foreign currency-rupee swaps without any limit. Exporters and importers were allowed to book forward contracts up to value of average turnover, without any documents (subject to a limit to $100 million). Banks were allowed to offer forward cover to Non-Resident entities on FDI deployed after 1993. Further, domestic banks were permitted to invest any amount in overseas money market and debt instruments.
 
On January 10, 2003, yet another set of liberalising measures was announced, that has brought the economy even closer to capital account convertibility. These include a general permission granted to companies issuing GDRs and ADRs, to retain the receipts abroad. Up to $1 million can now be remitted abroad for transfer of assets in India. The limit on remittances under of ESOP (which was $20,000) has been removed. Similarly, the limit on trade-related loans and advances by EEFC account holder has been discontinued.
 
There have been further measures easing the ability to export capital. Indian Mutual funds have been allowed to invest $1 billion in companies listed overseas that have at least 10 per cent holding in a locally listed company. Even individuals have been allowed to invest in such overseas companies, with some limits. Companies have been permitted to acquire immovable property overseas for business and staff housing purposes. Listed companies have been allowed to invest in those overseas firms that have at least 10 per cent stake in an India company, with a limit of 10 per cent of net worth of the Indian company, for such investment.
 
These measures bring the economy much closer to liberal capital account transactions, and make it much more difficult for the government to regulate or even monitor the nature of a range of transactions which may also involve the flow of speculative capital. While the government still retains some degree of control on external commercial borrowing by firms, this is not the only form of mobile finance capital that can cause broader macro-economic problems.
 
Unfortunately, such liberalisation can aggravate rather than resolve the problem currently confronting the government. It is to be expected that when a country with a relatively liberalised trading environment experiences currency appreciation, incentives to investors in that country to produce tradable commodities that can be exported or are substitutes for imports decline relative to the incentive to invest in activities involving the generation of non-tradable goods or services. The desires to borrow abroad to invest in infrastructural activities producing non-tradable services, to invest in real estate and construction and to invest in the stock market, all increase substantially.
 
This most often leads to excess capacity in certain infrastructure areas and even sets off a speculative boom in real estate and stock markets. It also means that there is an inflow of foreign exchange into the country, the costs of which would have to be serviced in time in foreign exchange. Finally, it means that while it increases dependence on foreign capital inflows, it also increases the risk that such flows can dry up and that past inflows are rapidly repatriated. That is why it is increasingly recognised across the world that the control and regulation of capital inflows may be even more significant in staving off potential crises, than controls on outflow.
 
Indeed, reserve accumulation and currency appreciation of the kind that India is experiencing, the factors that underlie those tendencies and the government's liberalising response to the tendencies are reminiscent of the process by which countries that were relatively healthy in East Asia and Latin America were pushed into crisis. This curious similarity makes India's remarkable dollar reserve even more noteworthy than it is being made out to be. It could be the first sign of a crisis that India has managed to stave off thus far, and ironically it would have been caused by the very factors that the government is currently celebrating, such as the accumulation of external reserves.