Ever since India's forex reserves started reaching unprecedented levels ($107 billion plus at the last count), the nation's policymakers have been confronted with a dilemma of a different kind. How to cope with this embarrassment of riches?
A lot of people have started arguing that rather than allowing the reserves to idle away in low interest earning dollar deposits, it would be prudent to use those reserves in a manner that would help in the overall development of the economy.
Therefore, what should be the ideal level of reserves (to withstand shocks such as the rise in oil prices or sudden capital flight), and what part of the reserves should be put to proper use? Let's try and find out.
Forex reserves are mainly held by a country to maintain the balance between the demand and supply of money, help the central bank to intervene in the market during crises and also to preserve confidence in the ability of an economy to meet its external obligations.
In order to perform all these functions, the economy requires a certain level of reserves and the thumb rule that is usually followed is that the reserves should be adequate to meet the import bill of the country for a certain number of months.
The Rangarajan Committee set up for this purpose recommended that the reserves should be adequate to meet the import bill for three months. But that was 1993 and a lot of changes have taken place in the markets since then.
Prominent among these is the fact that in addition to trade flows and economic growth, capital flows have also emerged as one of the major determinants of exchange rate.
As has been proved by the East Asian economic crisis, these capital flows can be taken out of the economy at very short notice and this can trigger a series of events, which can put the currency of a country at serious risk. Therefore, in order to avoid any such risk, some cushion in the form of reserves, over and above that required to meet the import bill should be set aside to prevent any volatility in the capital flows.
To make things simpler, if we assume this figure to be equivalent to say around three months of import bill then the total reserve requirement would stand at around six months of import bill (three months for actual import plus three months to account for capital flow risk).
At current levels, India can easily finance its import for 16 months. But does it really make sense for a developing country like India to hold such a high level of reserves and invest it in foreign currency bonds where interest rates are at an all-time low.
India is a developing economy with a relatively low savings rate as compared to other developing economies, like China, and as a result has to rely on capital from abroad for its investment needs. We are living in an age of financial integration where developing economies compete against each other for funds, so that they can achieve a higher growth rate by making profitable investments.
These funds are most likely to flow from developed world where there is a surplus of capital. The capital surplus economies would only be interested in an economy if the return on their investment were greater than what they get anywhere else in the world.
There are primarily three ways in which capital can flow into the economy. These are the external commercial borrowings from overseas banks (short term and long term), investment in capital markets and foreign direct investment in the form of plant and machinery.
Out of the three forms, it is believed that investment in plant and machinery and other physical assets is the best indicator of faith that the overseas investor has in the long-term prospects of the economy. Therefore, developing nations should try and tap this form of capital investments if they really want to grow in the real sense.
This is where our excess reserves can be put to good use. Given the poor infrastructure level in the country, the reserves can be used to invest in certain key infrastructure areas like road and power. This infrastructure along with our cheap and skilled manpower and also the enormous growth potential in the economy will definitely attract more foreign capital in the country.
The comfortable position of India's forex reserves is making a lot of people to proclaim that the capital account convertibility process should be hastened. Capital account convertibility is nothing but giving someone unrestricted freedom to convert his assets from one currency to another. Although full convertibility of the rupee has still not seen the light of the day, there has been a notable progress on the issue.
Companies have been allowed to retire overseas debt ahead of schedule. They have a lot more freedom in acquiring foreign companies. Banks in India have been asked to confer convertibility status on a significant portion of their non-resident deposits. Very recently, fungibility of shares listed in Indian stock markets has become a reality.
A Non-Resident Indian shareholder can easily shift his investments between instruments listed in India and the underlying ADR/GDR listed abroad. Thus it would be fair to say that as far as conveniences on the personal and business front are concerned, the rupee is for all practical purposes convertible.
However, there should be restrictions on short-term external commercial borrowings and also on the freedom given to domestic residents to convert their domestic bank deposits and idle assets in response to market developments as these can make an economy extremely vulnerable and emerging markets like India can find it difficult to come to terms with it in a volatile scenario.
Despite these avenues, the government seems circumspect of employing these reserves just yet. Probably, policy makers are looking a little for sustainable trend on the forex inflows front before they go in for an alternate policy on gainful employment of forex reserves.
Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.
