The Hindu : A LANDMARK WITH CHALLENGES

Online edition of India's National Newspaper
Friday, Dec 26, 2003

Opinion

Opinion - Editorials

A LANDMARK WITH CHALLENGES

THE ACCUMULATION OF foreign exchange reserves of $100 billion is a landmark event that symbolises a sea change from an era when India had to live a hand-to-mouth existence in the external sector of its economy. During much of the first four decades after Independence, India had to worry about the availability of dollar resources to pay for imports. Today the country has the sixth largest reserves in the world. In December 1990, at the height of a balance of payments crisis, reserves could pay for only three weeks of imports. Today India's dollar holdings provide import cover for as many as 15 months. It can be said without any exaggeration that the country no longer faces a foreign exchange constraint. Much of the credit for this transformation should go to the Reserve Bank of India, which has been following a judicious approach in managing the balance of payments since the early 1990s. The RBI has overseen the maintenance of more than adequate reserves, ensured a reasonable level of stability in the exchange rate, and has successfully warded off potentially major threats like the fallout of the East Asian crisis of 1997-98.

In a world of unpredictable financial crisis, developing countries are obliged to protect themselves against the "herd" mentality that influences the behaviour of foreign investors. The only protection possible is a bank of a large stock of liquid resources in global currencies; India now possesses that kind of security. But there is a risk in, and a cost to, the holding of large reserves. The risk is in attracting potentially volatile capital and the cost is in tying up substantial resources in low-yielding investment. During the past decade, a variety of inflows on the current and capital account have contributed to the accretion of India's dollar holdings. Over the past two years, however, capital receipts have become more important. A substantial proportion of these inflows has been driven by arbitrage and the prospect of a further appreciation of the rupee. While some of the avenues for interest arbitrage have been plugged in recent months, the flood of capital has not receded. Foreign institutional investment in the stock market has become the single largest source of foreign capital. The risk is that any sign of volatility in currency rates (especially a rupee depreciation) will precipitate a drying up of inflows and an outflow of capital. All this puts additional pressure on the RBI — which has to make major purchases of foreign currency as it attempts to balance the interests of both exporters and importers, hold the rupee steady, and simultaneously remove excess rupee liquidity from the economy.

The dollar resources of the RBI are mainly invested in U.S. Government securities. The cost of such investment, in terms of low yields, has prompted calls to make the rupee fully convertible so that the reserves can be brought down substantially. The central bank has been taking a number of small steps to facilitate a freer movement of capital, but has wisely stopped short of full convertibility. The most important lesson of the many financial crises of the 1990s is that full convertibility in a developing country can cause more problems than provide tangible benefits. Finally, crossing the milestone of $100 billion means that a new challenge awaits India in the global arena. The U.S. has been exerting pressure on Japan and China — the countries with the largest reserves — to let their currencies appreciate so that it can bring down its trade deficit. India can now expect to face similar demands on the rupee. All this underlines the need for a coordinated Asian strategy.

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