The problem with foreign capital is that in capital-scarce countries, it adds to the money supply, raises expenditure and pushes up the local currency, raising prices and affecting exports. Most emerging economies, and certainly India, have approached liberalisation wanting to export more, get more FDI (and other capital flows) but not seeking to import more. These are inconsistent objectives unless the central bank decides to mop up the extra forex flows. So if the RBI, which has always firmly sided with the political mantra that inflation is the worst sin in a democracy, does not buy the excess dollars and hold the rupee, it will appreciate and fell governments. The BoP worry, war threat or oil price rise, etc, are all of secondary importance.
What if the RBI hadn't been "sterilising" the flows? In a situation of a floating exchange rate, this would have led to a nominal appreciation of the real exchange rate, made tradeables (what can be imported) cheaper and increased imports. Even in our managed regime, had the RBI allowed such flexibility, we'd have larger imports (which would boost revenues), hurting import-competing producers. Would the CII-FICCI brigade have allowed that in a slowdown? Instead, the exchange rate policy regime conspires to keep the cost of non-tradeables (housing, roads, infrastructure, etc) high, and probably helps deepen the slowdown, says Deepak Lal, James S. Coleman Professor of International Development Studies at UCLA. "Sterilising of inflows is making the economy operate at a much lower level and potential than it's capable of," says Lal, adding that the time is ripe for a full float of the rupee. Unfortunately for Lal and other liberals like him, all the ballooning forex position has produced is two measly budget measures relaxing repatriation by NRIs.
Critics go further to say that even the RBI's sterilisation policy hasn't been much of a success—it has managed to absorb about half of the flows. It also implies that the exchange of monetary assets (creation of NRI schemes, RBI securities, etc) has helped keep the interest rate high. A better picture will emerge once we go into why reserves have grown so strongly and will continue to grow.
Reserves began to climb up since '97-98 (see chart). One reason was improved earnings on invisibles account, which led to better current account balance than before. (The current account is the net amount of goods and services, including software, exported minus imports of goods and services.) Two, the very costly India bonds, a clear panic reaction to the sanctions and added straight to the public debt (banks).Three, the beginning of a growth slowdown. Says Shashanka Bhide, chief economist, NCAER: "Slower growth meant weak imports and the forex inflows could not be used for imports. So, accumulation was both by design (external borrowing) and default (slower economic activity)." The industrial recession has many causes, prominent among which is the cost of capital. Paradoxically, this high cost of capital (or better interest rates) ends up attracting foreign capital on the one hand, while on the other, large forex reserves serve to keep short-term interest rates high courtesy RBI's firefighting.
Clearly, the RBI's present reserves accumulation policy is unsustainable because of its long-term costs on the economy—external debt servicing and high interest, directly, and public debt and infrastructure development, indirectly. Says Arvind Panagariya, professor, University of Maryland: "We probably earn less than 2 per cent on the reserves but pay 8 or 9 per cent on our external debt. Unless one can justify such a large reserve on a possible security crisis, the extra payments on the debt are hard to defend."
India will probably end 2001-02 with a 0.5 per cent current account surplus (first since '76-77, the Emergency year when GDP also grew 10 per cent!). Plus there are large inflows of portfolio investment ($2.5 billion-odd last year) and FDI (about $3.3 billion), plus external assistance (small) and NRI deposits—all of which add up to a large positive BoP. According to Moody's, unrequited transfers have averaged $12-13 billion over the past five years. So why does the RBI still feel insecure?
According to Basu, Japan right now is in the same boat: it has massive foreign reserves, but also an unsustainable fiscal deficit (as its public debt is rising by about 8 per cent of GDP a year, and GDP has been stagnant). India is better off—the ratio of public debt to GDP has been stable, but that's only because real GDP has continued to grow at 5-7 per cent. What happens when GDP growth continues to hover at 5 per cent? What happens if the fragility of the banking system makes it impossible to refinance public debt anymore and the capital flows out? Maybe the RBI knows something we have only begun to guess. And till the time the NRI eposits are not paid back, as Lal says, "precious foreign capital will end up straight into the vaults of the RBI".