Strong India, strong rupee

The NRI deposits carry an interest cost higher than what these reserves could fetch when invested by the RBI. The reserves may also have inflows on account of external commercial borrowings. These have to be repaid with interest.

In any case the cost of holding such huge reserves is not something that can be taken lightly. The debt service ratio was estimated at 14.7 per cent of the current receipts at the end of 2002-03 RBI Annual Report.

While this ratio has been declining on account of falling interest rates, it is still sizeable. After all, our reserve build up is not a consequence of mounting trade surpluses, as in the case of China, Japan or Taiwan.

If reserves pile up due to continuing trade surpluses, the problems will be on the trade front. Countries having adverse balances will exert pressure for either currency appreciation or other trade-related measures.

But the bulk of our reserves is due to NRI deposits 31 billion and portfolio flows 5.3 billion in the current year till September 30.

As such our policy on reserve accumulation will be driven only by domestic considerations 8212; to have a safe import cover, to instill confidence about India8217;s ability to meet its international debt and other payment obligations and to have a safe margin of forex assets for an emergency.

All these criteria are more than adequately met by the current level of reserves. What next?

There is no denying that the accumulation of reserves is largely on account of the difference in interest rates. Deposit rates in the US are around one per cent. Indian banks offer over five per cent and some NBFCs go as high as 13 per cent for longterm investments.

Those Indians who can have deposits in India and abroad have no more incentives to keep money outside. The rupee has stopped depreciating. Interest rates are more attractive than elsewhere. Even exporters, who found it advantageous to keep export earnings outside, have lost the reason to do so. Similar is the case with NRI remittances.

Foreign investment in Indian debt securities was around 13 billion. Indian debt securities have interest rates much higher than government bonds elsewhere. There could be more inflows in this area.

Therefore the flow of foreign exchange into India is unlikely to stop. It may at best slow down, depending on the policy the RBI adopts.

This leaves the RBI on the horns of a dilemma. If it keeps away from buying dollars, the Indian rupee will appreciate fast and exporters will raise a hue and cry. If it makes largescale purchases in the market, as it has been doing hitherto, money supply will increase causing inflationary pressures. This is evident now with inflation crossing five per cent.

While this will have a dampen the appreciation of the rupee, given current rates of interest, bank deposits will give negative returns. If, either to check inflation or make savings more attractive, the RBI increases the interest rate, it will lead to a greater inflow of foreign funds!

The RBI could of course resort to sterilisation operations to mop up excess flow of rupee resources by issuing bonds. If the government does not want these resources, the cost of sterilisation will fall on the RBI, adding to the cost of holding the reserves.

In the mid-1990s, when Indian reserves started building up, the RBI had a choice of allowing the rupee to appreciate gently 8212; so that when the rupee started depreciating during the south-east Asian crisis, the steep fall could have been avoided. The upswings and downswings in the value of the rupee could have been gentler.

No economist has been able to categorically state what forces determine the value of a currency and to what extent. Purchasing power of the currencies in their respective local markets, interest rate differentials, inflation level, rate of economic growth, structure of the economy, political and economic stability, exchange controls, stability of the banking system and fiscal deficit are the most common factors taken into account.

Empirical evidence does not support one theory or the other. But interest rate differentials have been found to influence the flow of funds from one country to another. This does affect the value of a currency at any given point, in the absence of central bank intervention.

The RBI has been credited with excellent reserve management by the IMF. It has also been transparent in regularly reporting the country8217;s reserves and their composition. It is time for the RBI to look at the situation holistically.

We also have to take a hard look at our GDP statistics. These do not capture large chunks of income. After the revision in February 1998, the government seem to have stopped examining this issue even though it is acknowledged India8217;s GDP is grossly underestimated.

India8217;s GDP has grown at an average of around six per cent in the past decade, almost twice the rate of most developed countries. Our inflation is well under control. The structure of our economy has undergone a change in the past few years. There is no reason why we should be afraid of the rupee appreciating to a reasonable extent.

China8217;s currency remained stable all these years, when other currencies in the region depreciated. But this did not affect China8217;s export growth.

While the value of the currency has a role in export growth, exporters must remember it is productivity and the quality of products that determine cost. Ability to deliver as per the importer8217;s demand is more important than the value of the rupee.

Statistics relating to how much of our exports are quoted in Indian rupees are not readily available. By and large these should be in dollars and therefore a gentle appreciation of the Indian rupee should not unduly worry exporters.

So the least bothersome option for the RBI seems to be to not aggressively intervene in the market to purchase dollars 8212; and to allow an appreciation of the rupee till inflation is again brought down to at least four per cent. This will make current interest rates viable for depositors.

The author is former revenue secretary, government of India, and former executive director, International Monetary Fund, Washington DC