A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 5 - External Sector - Capital Account, External Debt and
Exchange Rate: Approach, Development & Issues

Foreign Exchange Reserves: Approach, Developments and Issues

Capital Inflows, Foreign Exchange Reserves and Growth

The coexistence of slowdown in the growth rate of the Indian economy in the recent period and the sharp build-up of foreign exchange reserves, has fuelled the debate on their possible inter-relationship and has called into question, in some quarters, the extant policy of reserve accretion. A recent study for example, has contended that India could have attained a higher growth trajectory had capital inflows been allowed to be absorbed by the economy (instead of accumulating them as foreign exchange reserves of the central bank) and had fiscal deficits not been incurred. According to the study, the entire foreign capital can be absorbed by allowing the real exchange rate to appreciate. The real appreciation could be engendered either by allowing the nominal exchange rate to appreciate or by allowing prices to increase (i.e., non-sterilised reserve build-up which will increase the money supply and thereby give rise to both higher inflation and lower interest rates - both of which can increase absorption). An econometric exercise shows that the growth rate could have been higher by about 1 to 6 per cent in different years in the 1990s. The study makes the following policy recommendations:

1. the reserve management policy should be replaced by appropriate monetary and exchange rate policies that could boost growth;

2. have a tighter fiscal policy (to contain the crowding out effect) and an easier monetary policy (by non-sterilisation of reserves - that could increase prices and lower interest rates);

high reserves and low domestic inflation provide the right environment against which the Rupee can be made fully convertible on the capital account; and

3. replace on the managed exchange rate regime by full float.

The above results and policy prescriptions, however, need to be viewed with a great deal of circumspection. First, it needs to be recognised that high reserves reflect the lack of absorption/demand, and prescribing real appreciation as a means to raise domestic absorption completely disregards the importance of the trade-off between growth and stability and the role of a central bank in ensuring stability as a means to higher growth.

Second, the experience of the emerging market crises in the last decade shows that with low reserves and appreciated real exchange rate, India would have also faced a similar (or even more severe) crisis. On an average, the crisis years witnessed a sizeable growth reversal of the order of 6 to 7 per cent in all the crisis affected countries which could have offset the perceived ‘first round’ gains to the growth rate.

Third, it also needs to be recognised that even if REER appreciation is allowed to ensure full absorption of foreign capital, it is important to examine whether the full absorption (i.e. higher current account deficit) would result from an increase in imports or a major fall in exports. Given the asymmetric response of exports and imports to price changes brought about by REER appreciation, it is possible that a higher CAD would be attained more by a fall in exports than an increase in imports. It needs no emphasis that the external sector sustainability hinges critically on the performance of the export sector, and in the face of zero incremental reserves resulting from full absorption, weak export growth could be a strong source of vulnerability to crisis. On the other hand, even if imports increase in response to exchange rate appreciation, it is possible that import demand may just replace domestic demand, and as a result aggregate demand may remain unaltered. In other words, when imports are not driven by overall demand conditions (as is the case now) but are encouraged through a policy of exchange rate appreciation, imports may only compete with domestic supply and in the face of no increase in aggregate demand, the higher absorption through cheaper imports could displace some of the domestic manufacturers and thereby lower growth. Thus, growth gained through full absorption could be offset by lower growth resulting from displacement of domestic producers.

Fourth, the contention that full absorption of capital flows would significantly reduce the extent of crowding out by allowing a larger part of the fiscal deficit to be monetised, ignores the possibility of ‘crowding in’ effects by certain types of government expenditure which at times may dominate the crowding-out effects.

Finally, it needs to be recognised that foreign capital should not be allowed either to give rise to excessive consumption or excessive investment just to ensure full absorption. When foreign capital finances consumption demand (as in Mexico) or sustains an investment driven overheating (as in South East Asia), higher growth can be obtained only at the cost of a severe financial crisis. High reserves, a flexible exchange rate regime, and cautious liberalisation of the capital account, together aim at preventing a crisis. Sterilisation is a strong instrument to regain monetary independence that allows a policy of reserve build-up without any adverse monetary implications. Sterilisation has been used successfully so far in India and limits to sterilisation are yet to be reached.

The need for raising domestic absorption is well recognised and the Tenth Plan document already envisages a current account deficit of 2.8 per cent of GDP to attain a growth target of about 8 per cent. In the context of the Tenth Plan requirements, current levels of reserves and capital flows appear to be inadequate. Even if large capital flows materialise in future to meet the financing gap of 2.8 per cent of GDP as envisaged in the Tenth Plan document, the flows need to be regulated so that the CAD does not expand beyond the sustainable level. Hence, even though expanding absorption of foreign capital is a major policy challenge in the short-run, the overall medium to long-run policy strategy demands that the CAD be necessarily maintained within the sustainable level. This has been the most important lesson from the balance of payments crisis in 1991. Rather than engendering real appreciation, other counter-cyclical policies can be applied to revive aggregate demand, which in turn can improve absorption of foreign capital.

Monetary policy has already been eased to attain the objective of business cycle stabilisation without sacrificing the overriding inflation objective. The degree of manoeuvrability in fiscal policy is not very high because of the extent of fiscal imbalances prevailing today in India. During the phase of global slowdown, exchange rate appreciation could weaken exports and thereby have implication for external sector sustainability. The ‘Dutch disease’ problem is at best a very distant reality for India. Real appreciation has been prevented both through reserves build-up and sterilisation (the former preventing nominal appreciation and the latter preventing higher inflation). Excessive consumption/investment has been prevented by maintaining the CAD within sustainable levels. Thus, both the channels through which the ‘Dutch disease’ can spread, have been effectively regulated and their impact on the economy has been contained. With stronger recovery in demand, the surplus condition created by strong growth in remittances and software exports as well as capital flows would be absorbed automatically, reducing the scope for any Dutch disease effect and the need for any larger than desirable level of reserve build-up.