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On
April 23, India's foreign exchange reserves stood close
to $118 billion. This implies that during the first
three weeks or so of financial year 2004-05, reserves
had risen by around $5 billion. This reflects the continuation
of a trend that has been operative for quite sometime
now. The foreign exchange assets of the central bank
rose sharply, from $42.3 billion at the end of March
2001 to 54.1 billion at the end of March 2002, $75.4
billion at the end of March 2003 and $113 billion at
the end of March 2004. This implies that even after
discounting for the increase in reserves resulting from
the appreciation of the dollar value of the RBI's Sterling,
Yen and Euro reserves, the foreign exchange assets of
the central bank were rising by around $980 million
a month in 2001-02, $1.4 billion a month in 2002-03
and $2.5 billion a month during 2003-04.
The process of reserve accumulation is the result of
the pressure on the central bank to purchase foreign
currency in order to shore up demand and dampen the
effects on the rupee of excess supplies of foreign currency.
In India's liberalized foreign exchange markets, excess
supply leads to an appreciation of the rupee, which
in turn undermines the competitiveness of India's exports.
Since improved export competitiveness and an increase
in exports is a leading objective of economic liberalization,
the persistence of a tendency towards rupee appreciation
would imply that the reform process is internally contradictory.
Not surprisingly the RBI and the government have been
keen to dampen, if not stall, appreciation.
The Indian rupee's appreciation vis-à-vis the
dollar began in June 2002, when it had touched a low
of more than Rs. 49 to the dollar. More recently, the
rupee has been rising vis-à-vis the Euro as well
over the last four months. During these periods of ascent,
it has appreciated by close to 12 per cent vis-à-vis
the dollar in 22 months and by a significant 9 per cent
vis-à-vis the Euro in a short period of 4 months.
Not surprisingly, exporters have begun to get restive;
since a loss of 10 per cent in the rupee price of their
exports can shave off margins on past fixed-price dollar/euro
contracts and make it difficult to win new orders.
The rise of the rupee is partly attributable to the
depreciation of the other currencies, especially the
dollar against those of its competitors. That this was
true for some time is reflected in the fact that while
the rupee was appreciating against the dollar for close
to two years, it was depreciating vis-à-vis the
euro for much of this period. This is, however, only
small cause for comfort, since most export contracts
are denominated in dollar terms. Moreover, in recent
months, as noted above, the rupee has been appreciating
against the euro as well.
Since these were periods when the RBI was purchasing
foreign currencies and fattening its reserves, it should
be clear that exchange rate management through currency
market intervention had been crucial in dampening the
rupee's appreciation vis-à-vis the dollar and
relative stability vis-à-vis the Euro. Unfortunately,
the RBI's ability to persist with this policy without
eroding its ability to control domestic money supply
is increasingly under threat.
The task of managing the rupee is daunting because,
when the central bank increases its foreign currency
assets to hold down the value of the local currency,
there would be a corresponding matching increase in
the liabilities of the central bank, amounting to the
rupee resources it releases within the domestic economy
to acquire the foreign exchange assets. If forced to
continuously acquire such assets, the resulting release
of rupee resources would lead to a sharp increase in
money supply, undermining the monetary policy objectives
of the central bank. Since financial liberalization
implies abjuring direct measures of intervention to
curb credit and money supply increases, the central
bank has sought to neutralize the effects of reserve
accumulation on its asset position by divesting itself
of domestic securities through sale of government securities
it holds.
This process of ''sterilizing'' the effects of foreign
capital inflows through sale of government securities
has, however, proceeded too far. The volume of rupee
securities (including treasury bills) held by the RBI
has fallen from Rs. 150,000 crore at the end of March
2001 to Rs.140,000 crore at the end of March 2002 and
Rs. 115,000 crore at the end of March 2003, before collapsing
to less than Rs.30,000 crore by the end of March 2004.
The possibility of using its stock of government securities
to sterilize the effects of capital flows on money supply
has almost been exhausted.
It was possibly this factor which accounted for the
reticence of the central bank to hold back on currency
purchases in recent weeks, resulting in a faster appreciation
of the rupee. Fortunately for the RBI, it was helped
on this front by the uncertainty created by the results
of the exit polls conducted midway through the Parliament
elections. The week ended April 30 witnessed a collapse
in India's stock markets. On Wednesday, April 27, the
Sensex fell by 213 points, wiping clean an estimated
Rs. 55,000 crore of paper ''wealth''. This was the largest
single-day decline in over three years. Over the rest
of the week the markets moved further down, indicating
that ''Black Wednesday'' was possibly not just a stray
blip on the trading screen. With evidence that foreign
institutional investors who were earlier pumping foreign
currency into India's markets were holding back, the
rupee too witnessed a reversal of the rise that excess
dollar supplies had been resulting in.
There is unanimity among ''analysts'' of the factor driving
the downturn: news from the exit polls – the most ''scientific''
of available predictions – that the NDA is unlikely
to win a majority in the elections, which may throw
up a hung Parliament. In the run up to the elections,
India's ''upper crust'' – consisting of ''the markets'',
the media and large sections of the urban middle class
- had convinced itself that the results of the elections
were a forgone conclusion: the NDA would form the government;
only the margin of victory was a matter for debate.
The initial opinion polls only confirmed this belief.
It is therefore not surprising that the results of the
exit polls at the end of two rounds of voting came as
a shock, marginally reversing the rupee's decline.
While this provided the RBI some respite in its increasingly
difficult task of managing the rupee, the development
raises a new spectre. If just the possibility of a fractured
election result could set off a collapse in the market
and a slide in the rupee, the developments that led
to India's strong foreign exchange reserve position
seem to have increased its vulnerability as well. Investor
confidence seems easy to shake and if shaken its effects
could be dramatic.
What
is noteworthy is the quick response to the exit poll
results of the market, which declared its displeasure
with actions that not only erode the wealth of its own
constituents but, through their impact on credit and
foreign exchange markets, threaten a crisis in India's
liberalized financial sector. Market developments over
the week ended April 30th cannot be explained by the
stray action of a few unhappy and/or nervous investors.
The herd instinct, so typical of financial markets and
especially of foreign institutional investors, has resulted
in concerted action that threatens a sharp decline.
And in India's markets, which are neither wide nor deep,
a small herd can make a big difference.
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