Embarrassing riches

Union finance minister Jaswant Singh has done well to deflate the enthusiasm of those who advocate early full capital account convertibilit...

Union finance minister Jaswant Singh has done well to deflate the enthusiasm of those who advocate early full capital account convertibility in the light of burgeoning foreign exchange reserves that crossed the US100 billion mark last week. While these unprecedented volumes of forex have buttressed the feel-good factor, hasty capital account liberalisation could present other problems. To begin with, a counter-intuitive consequence of further external liberalisation could well be a further accretion to reserves rather than their drawing down. This has indeed been the experience of the past decade. The more liberal the external account the higher have reserves been because the assurance of being able to take money out of India easily has brought money into India!

While not addressing the problem of rising reserves, capital account convertibility could induce greater instability in the financial markets and contribute to exchange rate volatility. Given that India8217;s exchange rate policy has been marked by stability in the past decade, no government would like to willingly buy trouble unless there was assurance of greater stability. In fact, recent trends in the global economy warrant prudence in dealing with exchange rate liberalisation till growth picks up at home and abroad. One of the problems created by rising forex reserves is that it fuels money supply at home and could generate inflationary pressures apart from creating other problems. To examine these issues, the RBI had set up a working group to come up with new ideas to deal with the challenge of rising reserves. An important idea that the RBI has come up with is for the Union government to create a Market Stabilisation Fund, that could be used to issue market stabilisation bills/ bonds for mopping up excess money supply. This is an eminently sensible idea that would contribute to the health of the banking sector and would also be fiscally transparent. These are, however, temporary measures that enable a management of a surge in inflows. In the medium term there have to be more productive ways of using forex.

Increased trade liberalisation would generate import demand and this could help partly use up the reserves. Of course, if exports also increase then trade liberalisation does not automatically reduce the reserves. To the extent India will remain a net absorber of technology and capital, trade liberalisation could help make better use of forex reserves. However, for reserves to be put to good use via the trade side, investment demand must increase. Thus, investment-led growth can help absorb some of the reserves. As former RBI governor Bimal Jalan famously declared, there is no longer an external constraint to growth in India. The challenge is entirely at home.