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Forex: From here to uncertainty

Shyamal Majumdar

Forex is not a subject that readily lends itself to levity - especially not in India where the crisis of 1991 is fresh in public memory.

But former Finance minister P Chidambaram did find cause for amusement at the intense and sometimes acrimonious exchanges ten days ago at the India International Centre.

Y V Reddy, the RBI deputy governor who is shortly headed for an executive directorship at the IMF, had just finished a lecture on India's forex reserves and faced a barrage of criticism from the audience. Why had the central bank let the forex kitty grow so large, people asked, and shouldn't it be put to productive use?

Chidambaram was amused because these criticisms stood in stark contrast to a seminar he had attended on the same subject at the same venue 11 years ago. The speaker was S Venkitaramanan, then RBI governor, who was pilloried for not taking enough steps to boost the country's forex reserves.

"It's a discovery for me and it only shows the distance we have covered in the last 11 years," Chidambaram commented at the end of the question-and-answer session.

For the past few months, these extreme positions have been manifesting themselves in a debate among economists, businessmen, bankers and the RBI over whether India has enough forex reserves. The sub-text to this is the argument over whether the reserves are being handled optimally or not.

On one point, however, everyone agrees. It certainly has been a spectacular journey from the shock of 1991 when the central bank struggled to find enough reserves to permit day-to-day forex payments of even $1 million.

From agony to comfort

Consider the milestones on this journey "from agony to comfort, if not ecstasy," as Reddy puts it.

• The import cover, which is 12 times the ratio of reserves to merchandise imports, stood at three weeks of imports at the end of December 1990. At the end of March 2002, it stood at roughly 11.5 months.

• In July 1991, the RBI had to temporarily pledge gold to raise loans, and the level of forex reserves at the end of March 1991 was $5.8 billion.

• In May 2002, the kitty crossed $55 billion, of which around $53 billion comprises foreign currency assets and the rest is accounted for by gold. Reserves are now pushing

• $56 billion.

• The proportion of short-term debt to forex reserves has dipped from a level of 147 per cent in March-end, 1991 to a comfortable 8 per cent in March 2001.

• The proportion of volatile capital flows (that is, the cumulative portfolio inflows and short-term debt to reserves) has dipped from 147 per cent to 58.5 per cent over the same period.

Comfortable forex reserves

India is clearly back in the comfort zone as far as forex is concerned. But that's precisely where the problem lies. Economists think that India's reserves are comfortable and that inflation is low enough for the rupee to be made fully convertible on the capital account.

"The economy is robust and the forex kitty is overflowing. Go for it now," says Surjit Bhalla of Oxus Research.

Others think that the RBI should use these assets to pay off the high-cost external debt of $108 billion.

Reddy says that the RBI is being prudent, especially after the crisis in south-east Asia, when reserves vanished almost overnight as panicky fund managers pulled out. He suggests that in global markets, the rules for developing countries differ from those for developed countries.

That is why developing countries needed to be more risk-averse and maintain a high level of reserves as insurance.

Some economists argue that the central bank is using the south-east Asian crisis as an alibi. "The RBI cannot go on harping on the south-east Asian crisis. That crisis is history. It's time to look forward," says Bhalla.

The pro-changers point to the huge leaps in living standards in outward-oriented and capital-friendly south-east Asia, which has long since surpassed India on these parameters.

In 1996, before the economic whirlwind hit, the people of Hong Kong enjoyed a standard of living 16.2 times higher than that of their Indian counterparts. Even if Hong Kong's economy contracts, its standard of living will still be 15.4 times higher than India's. In South Korea, even after the sharp contraction, per capita GDP will remain more than eight times higher than India's.

Japan, for example, now suffering from $1 trillion in bad bank loans, has only made a bad situation worse for the region by hesitating to implement reform.

Can India absorb the risk of instability?

A related issue is whether the system can absorb the risk of instability that comes with faster growth. Deepak Lal, the James S Coleman professor of international development studies at the University of California, suggests that this is better than what he calls the "stability of death".

Lal argues that the RBI has no reason to look to high reserves as a cushion against future crises. "Such caution can only be termed a deflationary policy. If the growth rate falls, there could be huge problems about the sustainability of India's debt," he says.

The broader argument that economists put forward is that in the global economy, free-flowing capital disciplines governments, inducing them to follow more rational policies.

Had exchange rates in Asia or any of the other crisis-hit countries of the developing world been determined by free markets, policy mistakes would not have accumulated as disastrously.

And India, with its different debt profile (low levels of short term capital), bulging foreign exchange reserves and higher quality bank assets, may not be vulnerable to the kind of crisis that south-east Asia faced.

Full capital account convertibility has many advantages. It will allow Indians to hold an internationally diversified portfolio that reduces the vulnerability to domestic income streams and wealth, lowers funding costs for borrowers and creates prospects of higher yield for those who save.

Financial integration also provides the impetus for domestic tax regimes to rationalise and converge into international tax structures. This removes the inducement for tax evasion and capital flight.

Surprisingly, there is a large lobby that supports the RBI's cautious approach. The Confederation of Indian Industry, for example, feels that capital account convertibility could be risky because it would probably witness a sharp rise in capital inflows in the short term.

As the realisation sets in that the government's finances (the fiscal deficit is still worryingly high) and financial systems are not sustainable, the CII's argument goes, there would be an equally quick panic-driven outflow.

There is also the argument (though not made by the RBI) that the forex should be used to meet the redemption pressures of the Resurgent India Bonds and India Millennium Bonds. The first matures in 2003 and the latter in 2005.

There is, however, some scepticism over whether these redemptions will make a dent in the forex kitty.

First, forex reserves are expected to go up. A government status report on external debt states that the burden could be mitigated as a significant part of these bonds could be transferred to Indian residents or reinvested as NRI deposits.

Second, the government may opt for fresh borrowings to meet redemption costs, since international funds are now relatively cheap.

How much forex is enough

The debate over whether the RBI is "hoarding" or not basically boils down to the question of how much forex is enough. That is a tough question, and Reddy was not inclined to put a number to it.

"I wish I knew when enough is enough," he said. The chart "In the comfort zone?" suggests that India still lags behind several south-east Asian economies on this count.

But Bhalla says that putting a number to the reserves is a pointless exercise. "Some may say $75 billion is the cut-off point, some would say $100 billion while some others might feel $200 billion is the safe benchmark. Enough is enough for this kind of numbers game. The RBI must stop looking at the past," he says.

Various measures have been employed in India thus far to judge reserve adequacy. A 1993 committee under C Rangarajan, former RBI governor, recommended that the target level should be determined in terms of payment obligations in addition to the traditional measure of import cover of three to four months.

A 1997 committee under S S Tarapore, former RBI deputy governor, on capital account convertibility suggested four alternative measures:

• Import cover of not less than six months;

• Reserves should not be less than three months of imports plus 50 per cent of annual debt service payments plus one month's imports and exports;

• A ceiling of 60 per cent in the ratio of short-term debt; and

• A portfolio stock-to-reserves and a net foreign exchange assets-to-currency ratio of not less than 40 per cent.

In recent times, the concept of reserve adequacy has been influenced by the former Argentine Deputy Finance Minister Pablo Guidotti, who suggested that countries should manage their external assets and liabilities in such a way that they are always able to live without new foreign borrowing for up to one year.

This concept received support from the US Federal Reserve chairman Alan Greenspan, who suggested a liquidity-at-risk rule that would also take into account the foreseeable risks that a country could face.

The bottom line is that there is no infallible rule for determining what constitutes adequate forex reserves for a country. Each country must develop its own approach. This means that the current debate is likely to last longer.

Five years on, Chidambaram may find himself with more cause for amusement.

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