The Hindu Business Line : To fight common problems... <br> Create a regional forex corpus

Over the last year India's forex reserves have grown to a staggering $123 billion, and rising. Other Asian countries too hold large reserves in relation to their GDP. But such a large forex corpus has its costs too. Perhaps the solution to holding excessive reserves lies in evolving a regional mechanism with neighbouring countries that would enable their central banks fight jointly any crisis involving one or more member countries.

PERHAPS the solution to the holding of excessive foreign exchange reserves lies in India evolving a regional mechanism that would bring together the central banks of countries of the region to fight a crisis that any one or more of its members may face. When such an arrangement is in place the countries can make do with a smaller volume of reserves and put the surplus to better use.

A remarkable development in recent years has been the steady and steep rise in forex reserves. The reserves, which stood at $5.8 billion in early 1991, rose to $91 billion as on September 2003. Within the last year, the reserves have grown to over a staggering $123 billion and are continuing to rise unabated.

The major sources contributing to this swelling of reserves are foreign investment, banking capital, short-term credit and other capital inflows.

The rise may not entirely be attributable to money flows alone; part of it may be due to revaluation as the dollar has been depreciating against other currencies. This phenomenon is not unique to India. Countries such as China, Japan, Taiwan, Singapore and Malaysia now hold very large reserves in relation to their GDP. India occupies sixth position in Asia in terms of reserves, which are equivalent to about 20 per cent of GDP.

The rise in reserves is partly due to the intervention by the Reserve Bank of India to mop up inflows from foreign investors, remittances from Indians working overseas and trade flows. This intervention is mainly to mop up the excess liquidity to prevent excessive rise in the rupee and the blunting of the country's export competitiveness. Apart from these, there is need to preserve the long-term value of the reserves in terms of purchasing power and to minimise risk and volatility in returns.

Forex reserves are a bulwark against international risk. They also serve to quicken the momentum towards development of the economy. They also increase the foreign investors' confidence in the country. This rising trend will continue, with the economy becoming more global, the market opening up steadily in a variety of sectors, and exports also going up correspondingly.

Further, India's primacy in the information technology area will only bring more foreign exchange, including through IT-enabled services. The reserves now represent almost 20 months imports, against the traditional three months. The question now arises whether India should continue to accumulate the reserves and what level is considered sufficient for the economy to be able to absorb external shocks.

The RBI has in its report mentioned that "with the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable".

The Tarapore Committee on Capital Account Convertibility had suggested alternative measures of adequacy of reserves in addition to trade- , money- and debt-based indicators. The RBI, it appears, has done several exercises to calculate the country's foreign exchange liquidity position under "a range of possible outcomes for relevant financial variables, such as exchange rates, commodity prices, credit spreads, etc".

It is gratifying to note that "at end-September 2003, the import cover of reserves was of 15.6 months. The ratio of short-term debt to foreign exchange reserves declined from 146.5 per cent at end-March 1991 to 6.1 per cent at end-March 2003 and the ratio of volatile capital flows to reserves declined from 146.6 per cent as at end-March 1991 to 38.2 per cent as at end-March 2003.

As said earlier, the RBI intervenes by buying foreign currency in excess of demand and, at the same time, resorts to sale of securities to mop up the excess liquidity to keep the prices under control. This is done to prevent the fall of exchange rate of dollar vis-à-vis the rupee and also keep the inflationary tendency under control. The currency appreciation would limit the cost-push inflation and would also slow down the accumulation of forex reserves.

The exporting community is already raising a hue and cry about the appreciation of the rupee against the dollar and its adverse impact. It would be in India's interest to keep its exports competitive and growing to bridge the trade deficit. But the central bank has to choose between allowing the rupee to appreciate and raising the bank rate. Any increase in rate would have an adverse impact on credit growth and would invite more reserves. Contrarily, currency appreciation would lead to slower growth of foreign exchange reserves and create more space for credit growth.

It is learnt that about 75 per cent of capital inflows are being sterilised by the RBI. Is there an unbounded capacity for the central bank to conduct open market operations and, if not, what other regulatory measures are available to it? One way could be to discourage deposits from NRIs. The problem of plenty without weakening our export initiatives appears challenging. In the event of an interest rate hike by the US Federal Reserve, which appears possible, the scenario will change dramatically and the flow of forex may be reversed. But it is still in the realm of speculation.

The RBI invests foreign exchange reserves accumulated through such sterilisation process in multi-currency, multi-market portfolios, such as securities, other central banks and BIS, and deposits in foreign commercial banks. The yields on such investment are naturally low, raising the question whether after deducting the high-interest foreign loans, the reserves in excess of whatever is deemed as appropriate can be used for basic health, eradication of illiteracy, social security system, rural infrastructure, and the like. In the euphoria over the burgeoning foreign reserves we may tend to forget the cost of having large reserves. The dollars that we hold as reserves represent the money that cannot be spent on the vital areas mentioned above, such as health facilities, education, and rural infrastructure, which can bring about an economic and social transformation in the villages.

It is against this background the Planning Commission's proposal to use a portion of the country's foreign exchange reserves is welcome. Building India's infrastructure requires mammoth investments, which are not available with the government. Besides the efforts to woo the domestic private sector and foreign direct investment to invest in infrastructure, using of a portion of the ballooning forex reserves is a move in the right direction.

The RBI Governor has rightly struck a note of caution by stating that several aspects, such as the possible direct and indirect impact on the fiscal and monetary conditions, including financial stability, should be considered carefully before embarking upon this. A transparent policy paper on management of forex reserves is called for.

Taking into account all economic factors and the rupee not being fully convertible, the size of the forex reserves should necessarily be high. But how big it should be must be decided keeping our peculiar needs in mind. It is good to remember that the retention of forex reserves after all seeks mainly to guarantee a balance of international payments and safeguard the security of the economy as a whole. But there are more things to the economy than these.

Perhaps the solution to holding excessive reserves also lies in consultation with neighbouring countries and in evolving a regional mechanism that would bring together their central banks to fight as one any crisis involving one or more member countries.

Given its stature, India may be able to persuade the other countries in the region that such an arrangement would benefit all members. The IMF, with its conditionalities and tardy response to requests for loans, cannot be of much help in times of crisis as much as a system of the kind described above.

Such regional cooperation could eventually extend to larger area of mutual trade. And when such an arrangement is in place, countries in the region can make do with smaller volume of reserves and deploy the surplus resources for better uses.

(The author is a Chennai-based freelance writer.)