Reserves And Exchange Rate Management
One of the bright spots of the Indian economy is the management of the external sector. This is no flash in the pan and the track record has been the envy of many other emerging economies. While caution has been the watch word, there is a need for a periodic reassessment. The macro economic review, released with the statement on the monetary policy, explores a number of analytical and policy issues but is rather scanty on the external sector. This is, however, more than made up by the elaborate write-up in the policy statement.
According to the policy statement the adequacy of reserves cannot be merely in relation to the quantum of imports or the size of the current account deficit. In view of the importance of capital flows, and the associated volatility of such flows, the composition of capital flows, particularly short-term liabilities, have to be taken into account; furthermore, contingencies have to be provided for to take into account unanticipated increases in commodity prices and asset prices.
The policy document emphasises that during a crisis, an emerging economy is largely on its own and cannot expect to be bailed out. Accordingly, the Indian reserves management policy is judiciously built on a host of factors (apart from the size of the current account deficit) such as short term liabilities including current repayment obligations on long-term loans, variability of portfolio investments, repartriable non-resident deposits and unanticipated external shocks. Undue volatility in asset prices in equity/bond markets can also create disproportionate pressures in forex markets. In this context the policy document rightly stresses that it is essential to continue with the pursuit of realistic and credible exchange rate policies. Thus, the quantum of reserves needs to be consistent with the growth of the economy and the size of risk-adjusted capital flows.
While one should not read more than what is said in the policy document, the stress by the authorities on all these factors, while considering the adequacy of reserves, should be of great comfort.
The foreign exchange reserves of US$ 38 billion do not appear to be excessive when viewed against the volatile/short-term liabilities. The non-resident deposits (excluding non-repatriable deposits) amount to $16 billion while net portfolio flows total a little over $17 billion. The amortisation of loans amount to about $12 billion per annum and as such the total of these liabilities is around $45 billion. There are, in addition, some trade credits and other short-term liabilities, but even excluding these the liabilities would be 118 per cent of the reserves. It would be totally erroneous to argue that all these liabilities could be encashed simultaneously, and as such there is no need whatsoever, for any alarm. All that needs to be appreciated at this stage is that the reserves are by no means large and we need to steadily keep building up these reserves. Without explicitly saying so the policy document puts paid to the scatter-brain viewpoint that the reserves are far too high and that we can comfortably go back to the days when we had only $5-6 billion of reserves. There is, nonetheless, a pressing need to have a good grasp over the size of the liabilities. It is unfortunate that the data on portfolio investment are in terms of net inflows rather than outstanding liabilities. The outstanding portfolio investments could be significantly lower than the figure of $17 billion derived from the net inflows. It is unfortunate that neither SEBI nor RBI has attempted to value the portfolio investments outstandings, in rupees, on say March 31, of each year, converted into dollars at the current exchange rate to derive the outstanding liabilities.
Another way of assessing the adequacy of reserves is the net foreign exchange assets - currency ratio (NFA-C ratio). The NFA-C ratio at the end of March 2000 was 84 per cent which should give great comfort to foreign investors. But the RBI appears to fight shy of focusing attention on this ratio. We should not delude ourselves into believing that this ratio is not relevant. Any sensible foreign institutional investor (FII) would derive comfort from a ratio of 84 per cent and per contra exit if the Indian authorities passively let this ratio fall below 40 per cent without any visible policy action. Many FIIs monitor this ratio hawk-like and the RBI needs to shed its intellectual aversion for this simple barometer.
On the question of the exchange rate the policy document makes a characteristic statement that the primary objective "...continues to be the maintenance of orderly conditions in the foreign exchange market, meeting temporary supply-demand gaps which may arise due to uncertainties or other reasons, and curbing destabilising and self-fulfilling speculative activities." Now what does one make of this policy pronouncement? On this issue I am afraid I must reiterate my earlier assessment that the actual operation of the exchange rate policy is nonpareil, yet its articulation is extremely poor. In the recent period there have been screaming headlines saying that the rupee has fallen to its lowest level in 20 months. In fact one should be relieved that this is so! In the absence of the correction the real effective exchange rate (REER) of the rupee could appreciate to the point wherein it would give great discomfort to both market players and the authorities. The REER, as of February 2000, on the 36 country model shows an appreciation of 6.9 per cent over March 1993, but with the recent movements it would be somewhat smaller. The 5 country model with base 1993-94 shows a depreciation of a little less than 2 per cent. With the depreciation in the second week of May 2000, the REER depreciation on the 5 country model would be slightly higher. Given the problem of base and coverage, the indices would not reflect any serious problem on the exchange rate at the present time.
As one looks to the immediate future, of say the financial year 2000-2001, the area of discomfort is probably not the exchange rate per se, but interest rates. With interest rates rising in the major industrial countries Indian interest rates would be clearly far too low and by the second half of the financial year 2000-2001, if not earlier, Indian interest rates should be on their northward journey. While the Indian authorities wish to drive a wedge between the money and exchange markets, the markets will not obey; all that would happen is that the market activity will move off-shore. Inflation rate differentials should be reflected in interest rate differentials which in turn should show up in the forward exchange rates. The Indian authorities need to take cognisance of this. In this context the exchange rate of the rupee would show some downward movement in the current financial year. Lest punters go haywire let me emphasise that the kind of downward movement which the fundamentals indicate would be of the order of 3-5 per cent per annum which market operators can easily take into their stride. What the
authorities need to ensure is that such moderate adjustments are smoother than hitherto. There is some merit in gentler landings.