Unfortunately, we do not yet have detailed data on the balance of payments flows for the last quarter, January to March 2002. But patterns over the earlier 9 months may provide some indication of the broad tendencies. Obviously, going by the ongoing trends, the inflows would have had to come dominantly from the capital account, because the current account has been in deficit, and it is unlikely that the last quarter would have completely reversed this pattern.
 
Table 1 presents the capital account flows for the period April-December 2000 and 2001. There was certainly some increase in foreign investment in April-December 2001, amounting to about $ 3.5 billion. But this was also counterbalanced by the decline in “loans” by more than $ 1 billion. So this would not help to explain only about $2.5 billion of the increase in reserves over this period.
Table 1 >>
  
However, what did increase substantially was banking capital inflows, which amounted in the net to $3,770 million. This also represents debt-creating flows; indeed, almost $ 2 billion of this amount was in the form of NRI deposits, probably in the Indian Millenium Bonds and similar deposits. Since these  deposits bear higher interest than available on domestic deposits or even many international bank deposits, they are really also part of the total external debt.
 
So it appears that in the first nine months of the year, the net increase in capital account inflows was in the form of debt-creating flows of banking capital. However, this leaves some part of the increase in reserves even over this period unexplained.
 
As Chart 8 shows, the net total capital account flows over April-December 2001 amounted to $ 4246 million, while the current account was in deficit to the tune of $ 726 million. But the increase in reserves over this same period was $5,831, which leaves a gap of $2,311 million – not a small amount by any standards. Chart 7 suggests that most of this gap can be explained by “errors and omissions”, which were more than $ 2 billion over this period.
Chart 8 >>
  
The treatment of “errors and omissions” has always been somewhat of a problem. Analysts have tended to view these as reflective of illegal or irregular capital flows, or “hawala” transactions. Negative amounts for “errors and omissions” would therefore suggest capital flight, while positive amounts indicate inflows. Needless to say, such flows are extra-legal at best, and indicate that resources are coming into the country to finance activities which may be economic, political or even criminal, but are not recorded as part of the economic transactions of the country.
 
Therefore, such large amounts of inflows being recorded as “errors and omissions” can be a source of concern. In the period under consideration, that is the first three quarters of the financial year 2001-02, they accounted for 35 per cent of the increase in reserves of the central bank.
 
Since we do not yet know the composition of the balance of payments flows over the last quarter of the year, we cannot yet say how the additional increase in reserves of nearly 46 billion was distributed. However, if the pattern of the first 9 months is a good indication of the subsequent tendency as well, then clearly the build-up of reserves over the past year is the result of several problematic features in the external accounts. The dominant part of capital inflows was probably in the form of debt-creating flows, while a very significant role would have been played by illegal transactions captured under “errors and omissions”.
 
The sale or purchase of US dollars by the Reserve Bank of India (shown in Chart 7), which is another good indicator of net inflows, suggests that a huge amount of the inflows occurred just in March 2002. Subsequent information on the level of official reserves suggests that this very recent tendency has continued  : over April alone, foreign exchange reserves are estimated to have increased by an additional $ 1 billion.
Chart 7 >>
  
One interesting feature of the recent trends is that the build-up of reserves appears to have little or no effect on the exchange rate. Usually, such large net inflows and increased reserves over a relatively short time would lead to currency appreciation of quite significant proportions. However, even from 2000, the rupee has continued to depreciate with respect to the major currencies the US dollar and the euro, as Chart 9 shows. The slight appreciation vis-à-vis the Japanese yen is reflective of that currency’s slide in international currency markets, rather than any greater strength of the rupee.
Chart 9 >>
  
Of course, the nominal decline over the past few years does not necessarily mean a decline a decline in the real exchange rate. Chart 10 illustrates that the trade-weighted real exchange rate (with respect to five major currencies) actually appreciated slightly in 2000-01 over the previous year.
Chart 10 >>
 
Chart 11 describes the movement of nominal and real trade-weighted exchange rates over 2001-02. It is clear that over this year, despite the substantial increase in foreign exchange reserves, both the nominal and the real exchange rates have generally depreciated, albeit slightly, over the course of the year. This suggests that the RBI has probably engaged in open market operations that would manage the exchange rate and prevent it from appreciating in a manner that would be harmful for exporters. Of course, there are limits to such market-based intervention : if inflows of the type described above continue to increase, the rupee is likely to appreciate in real terms as well.
Chart 11 >>
 
There remains the question of whether, in the more open capital account regime, such high levels of reserves are necessary as a precautionary measure against possible capital flight and currency crisis. This is certainly an important consideration, especially given the current political developments in the sub-continent and the likelihood that investors will turn and stay shy of the region at least in the short term. While the level of  reserves is enormous by conventional standards, amounting to around ten months’ value of imports, it is still substantially below (less than two-thirds) the stock of short-term capital in the country. Therefore some could even argue that the level of reserves should be even higher in order to protect against possible capital flight.
 
Unfortunately, however, the experience of numerous crises in emerging markets has made one unpleasant fact quite clear : no level of foreign exchange reserves is enough to ward off a determine speculative capital attack. Most of the countries that have experienced currency crises over the past decade had levels of reserves which were considered comfortable if not excessive, and in all these cases these reserves proved to be totally inadequate to deal with the situation and prevent bleeding outflows of capital.
 
Indeed, the conclusion is inescapable that large foreign exchange reserves are no substitute for capital account controls in terms of regulating both inflows and outflows and preventing destabilizing movements of capital and volatility in exchange rate movements. Therefore, the currently high level of reserves should not provide any excuse for complacency : the likelihood of these reserves being enough to protect the economy in the event of a genuine collapse in investor confidence and capital flight is extremely small.
 
Finally, of course, it must be reiterated that at one level these exchange reserves do represent a waste of resources. Of course, any society may choose deliberately to set aside resources for a precautionary motive, as indicated above, even though in this case this is not likely to be sufficient to protect again possible crises. But the current build-up of reserves does not appear to be such a conscious decision on the part of Indian policy makers.
 
Rather, the government has actually given up its ability to control most balance of payments flows, and therefore this reserve increase must reflect other forces which are shaping the decisions of private agents in the economy. Essentially, this expression of the excess of ex ante savings over ex ante investment is the result of the continuing stagnation of the Indian economy, of the large slack which remains in the system.
 
While the government could certainly lift the economy out of its current recession through increased productive spending which would also generate more employment and reduce the other evidence of slack (the large foodgrain stocks) so far it has proved to be remarkably inactive on this front. It is not clear whether this reflects lack of enthusiasm for such expansion, or simply incompetence.
 
But in this context, when the increase in reserves expresses simply an accumulation of unutilised resources, and a large part of them is the result of inflows in the form of debt-creating flows and possibly illegal activities, it is certainly wrong to see in them any cause for celebration.