The Indian economy is clearly in a peculiar phase at the moment. There is already a large growing surplus of foodgrain stocks held by the public sector, which has become a major embarrassment for the government, and has persisted for far too long already. And now comes evidence of a very substantial – indeed unprecedented – increase in the level of foreign exchange reserves held by the Reserve Bank of India.
 
By April 2002, official foreign exchange reserves stood at nearly $ 55 billion, their highest ever level. And this represented an increase of nearly $12 billion just over the financial year April 2001 to March 2002. Chart 1 shows that while such reserves have been growing since 1995-96, the increase last year by $11,825 million was the largest yet, and much more substantial than in previous years. Indeed, only in 1993-94 (the year when financial liberalization measures led to a sudden inflow of foreign portfolio capital and other such flows) did foreign exchange reserves rise by anything like this amount, but even then it was less at $9.4 billion.
Chart 1 >>
  
Some have seen this increase in reserves as a positive sign, as an indication of the inherent and current strength of the economy. Thus, it is argued that such a build-up of reserves must necessarily reflect substantial surpluses in either the current account or the capital account of the balance of payments, and both are to be welcomed. It is also argued that such large reserves provide protection against capital flight and currency crises, which continue to plague various emerging markets and could also afflict India.
 
Neither of these arguments is completely wrong, but both have limitations, especially in the current context. In fact, the attitude towards reserves build up must be conditioned by an awareness of what has caused such an increase, and by a sense of what is required to limit or prevent currency volatility. In any case, it should be borne in mind that, just as is true in the case of the excess food stocks, excess foreign currency holdings reflect an excess of ex ante savings over ex ante investment. This suggests an economy operating well below potential, and an enormous slack in terms of the use of resources.
 
What is behind this tremendous spurt in reserves ? What is clear is that it is not any development on the trade front which has contributed. Charts 2 and 3 make this quite evident. Exports over 2001-02 were stagnant, growing at a negligible 0.1 per cent over the previous year (which was substantially below even the downscaled target of 4 per cent set by the Commerce Ministry.) Meanwhile, imports actually increased slightly, by 1.1 per cent, leading to an increase in the trade deficit by $ 578 million. So trade flows would have implied falling reserves, not additions to the reserve pool.
Chart 2 >> Chart 3  >>
 
Incidentally, it is worth noting the point shown in Chart 3, that this rather minor increase in imports over the past year was really due to the collapse in international oil prices, which brought POL (petroleum and other lubricants) imports down by 12.7 per cent. By contrast, non-POL imports increased by 7 per cent despite the ongoing domestic recession, indicating the continued process of import penetration of domestic markets.
 
Over the past decade, the current account has been kept in check essentially because of invisible payment inflows in the form of large-scale remittances from Indian workers abroad. Chart 4 shows that this process continued well into the first 9 months (April-December) of 2001-02, with net invisibles amounting to as much as $8,756 million. (Incidentally, net transfer payments – including remittances – were even higher, at $9,136 million, while net services inflows accounted for $1,639 million. However, fairly large investment income outflows of $4,098 million kept the total invisibles lower.)
Chart4 >>
  
From Chart 4 it is clear that, while the overall current account deficit was much lower in April-December 2001 than in the same period last year, the balance was still negative to the tune of $ 726 million. So the current account did not contribute to the build-up of reserves, at least over most of the year.
 
However, Chart 4 suggests that there have been movements in the capital account – especially increases in foreign investment and banking capital inflows – which could account at least partly for the rise in reserves. These are considered in more details below. But first, let us examine the pattern of changes in reserves over the year.
 
Chart 5 shows that while foreign exchange reserves increased more or less continuously over the months of the financial year 2001-02, the bulk of the increase was in the latter part of the year. In fact, as evident from Chart 6, the really large inflows occurred over the last quarter January to March 2002, when the increase in reserves amounted to nearly $6 billion, more than half the total increase over the year.
Chart 5 >> Chart 6 >>