Dilemma in use of foreign exchange reserves

INTEREST rate and foreign exchange (forex) reserves are the two important issues under discussion in the business media and among economists in the academia. Quite a few media commentators are arguing in favour of full utilisation of the huge forex reserves for what they see as serving of a dual purpose.

By From Kumaresh Chakravarty In New Delhi

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Published: Mon 11 Aug 2003, 12:01 PM

Last updated: Wed 1 Apr 2015, 7:47 PM

Here is a brief explanation of the two purposes connected with two respective problems. First, rising reserves have been pushing up the exchange rate of the rupee. A stronger currency is supposed to affect exports because the exporter gets a smaller amount of domestic currency from the same amount of foreign money, dollar in this case. Imports on the other are supposed to be cheaper since a dollar is now exchanged for a smaller sum of rupees. Until some time back many believed that a higher rupee would not affect exports at least up to a certain extent. They had anticipated that the level of forex reserves would not keep rising beyond a certain limit and therefore, the rupee would not be rising after that limit is reached. That has not proved true.

Reserves have touched $84 billion, which is enough to pay for 18 months imports. And, the rupee has been on the rise. Some exporters have started complaining about falling profit margin due to smaller rupee realisation for the dollars they have been getting. But there is a limit beyond which the Reserve Bank of India (RBI) cannot resist a further rise of the rupee. So, different ways and means are being sought for using the dollar stock so that reserves do not keep rising. But, for that one needs to be certain that at least so much dollar will not be repatriated within such and such time. For that, in turn, one needs to ascertain the sources of inflow. If foreign financial investors are a major source, then it is clear that they have brought their money here only for earning a higher rate of return interest, dividend, or capital gain in the stock market. A good part of the funds brought in by non-resident Indians also belong to the same category. A part of the extra funds is money owned by Indians but not brought in earlier, when it was earned. As regards the actual quantities, one report says that about 40 per cent of $84 billion are from financial investors and another 15 per cent belongs to NRIs. These two together thus come to about $46 billion, and this is the amount which can be called "hot money," willing to move away on a short notice as soon as another country appears to deliver better returns. Will it then be safe to spend this money for absorbing the forex reserve in a more fruitful way? Besides, how exactly does one utilise the money?

That is where the second issue, rate of interest, comes in. If the domestic rates come down, and inflation rate also remains constant or falls, then the real interest rate will see a significant decline. If the financial investor finds a higher real return elsewhere, he will move away. So, one way of using the money is to increase the money supply by the amount equivalent to the used portion of forex reserve. This extra money, some argue can flow towards the capital market, or as bank money to be used for consumer lending for housing, and purchase of durables. Thus, more money can be used as funds for investment, and as consumption loan. The first will create investment demand while the second will create extra consumption demand. And, both will boost output growth. But, can more money be on demand at current interest rates? Or should the RBI cut the interest rate along with increasing money supply? Experience shows that the economy is already saddled with excess liquidity, since even after lowering lending rates by six percentage points in three years, the demand for money falls miserably short of its supply. Besides, businessmen, large firms in particular, have been borrowing much cheaper than the average firm or individual, but not using the borrowed fund for productive investment. They have been using it for earning a higher interest, or investing in stocks. That is how their income from financial operations, called "other income" has gone up to occupy a higher share of total profit.

This is one of the ways in which firms are making use of cheap money, while interest income of households has severely declined. Those who argue in favour of lowering interest rates do not take this into account. As regards lowering real interest rates, inflation rate has to be in step with the changed nominal interest rate. That is a matter of conjuncture, since there is no instrument in the hands of authorities which can be used with a guaranteed result. Even going by recent experience can be risky, since some inflation-inducing factors can occur without any prior indication.

Cheaper imports can be helpful in controlling inflation, but less so in an economy like India in which import does not constitute more than 10 to 12 per cent of GDP. In sum, there is no absolutely risk-free way of utilising a substantial portion of the present level of forex reserves. In fact, lowering interest rates can prove counterproductive. If, as discussed above, the foreigner decides to look for an alternate country to invest, because of lower interest rate in India, with or without a simultaneous depreciation of the rupee, then the cushion that is now available with a high forex reserve, may disappear overnight. Once such a process sets in, a chain reaction may trigger off a balance-of-payments problem once again. Nobody will be willing to invite that even if the current cost of forex reserves is not entirely to India's advantage.

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