MacroScan (Printable Version) - The Build-Up of Foreign Exchange Reserves

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.



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.



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.







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.



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.



Themes > Features	12.01.2003


The Build-Up of Foreign Exchange Reserves

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. 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. 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. 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. 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.



© MACROSCAN 2003