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Foreign exchange: Handle with care - Views on News from Equitymaster
 
 
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  • Jul 13, 2002

    Foreign exchange: Handle with care

    During the pre liberalization era forex reserves were one of the biggest concerns for the country. (In fact a balance of payment crisis forced the government to open its doors to the outside world). Now nearly eleven years post liberalization the country’s forex reserves have reached such a high that the government is being accused of mismanaging by holding too much. Thus, the article reviews the various views presented by economists as to how much is enough.

    To buy imported goods, oil for example in India’s case, countries need foreign currency. Forex reserves are important for any country as they act as a cushion against any adverse eventuality. For example in case of any adversity (like war or slowdown of exports) that will reduce a countries earnings in foreign exchange, the forex reserves will ensure that the country is in a position to buy imported goods. The amount of reserves will decide how long the imports can be sustained. Indian forex reserves are at an all time high of nearly $57 bn and they are sufficient to sustain imports for nearly 11 months since the monthly import amounts to US$ 5 bn

    The mop-up in reserves has been mainly due to a significant spurt in NRI remittances. Other sources of forex income are exporters remittances and FDI inflows. What is worth noticing is that while the forex flows in to the country have increased considerably the Indian Rupee has devalued consistently over the same period. This is contrary what would be expected. Ideally the Rupee value should appreciate. As the increased supply should have made the dollar cheaper. The digression is not difficult to understand. The RBI has been consistently mopping up US dollars from the forex market in order to devalue the Rupee to give further incentives to exporters. A weak rupee makes exports cheaper in the foreign markets. Thus, due to RBIs intervention forex reserves have gone up considerably.

    The first though that comes to the mind is more forex reserves better it is, as exports are secure for a greater period of time. However, holding too much for forex reserves has negatives also. The value of the rupee for purposes of trade is calculated by way of the Real Effective Exchange Rate or REER. The REER gives the value of the rupee relative to a basket of currencies like the British pound, the French Frank, the German Marks, the US Dollars and the Japanese Yen. According to the REER the Indian rupee is overvalued and needs to be devalued in order to make Indian exports more competitive. By this rational the forex reserves are likely to go up further as the RBI will intervene in the market in order to devalue the Rupee. The rationale of a weak rupee is justified only if the ends justify the means. In the Indian scenario while the devaluation of the rupee has lead to significant rise in exports over the past few years last year saw no significant change in exports, Indian exports have recorded a marginal increase of 2% YoY in FY02.

    India has achieved a current account surplus after nearly 26 years, delving deeper we find that the surplus is a result of a considerable slowing down of imports and not due to a higher exports growth.

    India’s imports can be divided into oil and non-oil imports. While a part of the decline imports stems for low oil prices, the cause of concern is the fact that non-oil imports have also shown a decline. Historically a major part of non-crude imports have been capital goods, which was a result of investments i.e. setting up production capacities. A decline in non-crude imports could, therefore imply a decline in imports of capital goods. This is bad news since could signal decline in setting up of new production capacity.

    The whole rationale of a weak rupee can help only to a certain extent. What is required is that the government and the industry have to work together to identify demand and sell value added products that cater to specific consumer needs. The devalued currency should acts as a means not as an end. The government can manage the forex flows better by boosting investments and by encouraging industries to invest in capital goods to manufacture value added products rather than manufacturing products that are just cheap.

    Rising forex reserves have other implications as well. A significant part of Indian forex reserves (nearly $ 10 bn) have been generated out of the India Millennium Deposits (IMD) in 2001 and the Resurgent India Bonds (RIB) in 1998. These forex inflows are debt creating carrying a high cost. The Indian government is paying a high price in order to maintain such high forex reserves, and it will be safe to assume that this cost is in part borne by the tax paying public of India. After all how long will the government be able to pay investors returns close to 8% on their investments when the government itself is running such a high rate of fiscal deficit? What is even more disturbing is that these deposits mobilized at such a high cost, are lying idle with the government. Thus the government instead of earning of the deposits is losing money.

    If the inflow of foreign exchange continues at the same rate it will become very difficult to devalue the Rupee consistently moreover the real effective exchange rate (REER) of the rupee is likely to go up in spite of controls. A testimony to this is the fact that the rupee gained nearly 26 paise post the December 11th attack on the Indian parliament. An economy with a strengthening currency, a low rate of imports implying slower growth in production capacity and lagging exports is definitely a cause of concern. Forex Deposit mobilization at very high rates should be avoided. And if possible existing cost on this account should be cut. . It is high time that these concerns are addressed so that forex reserves are used to our advantage rather than being a burden on the government.

     

     

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