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The Challenges of Dr. Reddy Omkar Goswami
Spurred by an inflow of over $1 billion in a single week, India’s foreign exchange reserves on 2 April 2004 swelled to $112.69 billion. There was a net inflow of foreign exchange of $9.5 billion in the first quarter of this calendar year; and a staggering $37 billion have rolled in during the last twelve months. Dr. Y. Venugopal Reddy, the affable Governor of the Reserve Bank of India ought to be delighted. But is he? Central bank chiefs have to be inscrutable. That’s an attribute that they are paid to have. So, you won’t get a heart-to-heart stuff from Dr. Reddy. Yet, being a good economist and central banker that he is, I suspect that he isn’t over the moon with this veritable tsunami of dollars that is crashing on to Indian shores. Through a simple example, let’s try to to understand why. Suppose you earned a million dollars from an export order. You will immediately credit the cheque or pay order to your company’s bank account, which will be richer by Rs.43.5 million at the present exchange rate. The bank, which has far less to do with dollars than with rupees, will then present $1 million to the RBI. If the RBI purchases these at the prevailing exchange rate, the bank will get Rs.43.5 million, and the RBI’s foreign exchange reserve will have increased by $1 million. Here lies Dr. Reddy’s first problem. For buying $1 million, the RBI gave Rs.43.5 million to the commercial bank — an act which would increase money supply. There are limits to which you can increase money supply without risking inflation. So, if there are too many dollars flowing in to India, and if the RBI continues purchasing them from commercial banks at prevailing exchange rates, it would create a growth in the supply of rupees that would be excessive in relation with the level and growth of economic activity of the country. India’s foreign exchange coffer has swollen by $37 billion in the last one year. Assuming an average exchange rate of Rs.45.89 for the period 2 April 2003 to 2 April 2004, that would translate to Rs.137,673 crore! Forget the number. The point I am try to make is that there has been a huge accretion of rupees because of the massive inflow of dollars. And despite 8.1 per cent GDP growth in 2003-04, the economy would have been in no position to absorb an extra Rs.137,673 crore without risking severe inflation. Therefore, the RBI had to step in — as it always has in situations of excess liquidity — to mop up the extra rupees. The tool for doing this is through selling of government securities. Instead of keeping the extra rupees in their coffers as an expensive liability, banks purchase the Government of India’s treasury bills through RBI’s ‘repo’ auctions, and thus earn a modest yield on the funds. Here lies Dr. Reddy’s first problem. Today, the central bank just doesn’t have enough government securities to sell in order to mop up this incessant inflow of dollars. Just to give you an example: on 4 April 2003, the RBI had Rs.98,611 crore of government securities in its coffers; on 2 April 2004, it had Rs.22,664. The difference must have gone somewhere. And I’m betting that much of it went to mop up the surplus liquidity on account of dollar inflows. To put it bluntly, the rupee equivalent of the dollars that have come to India in the last year has been greater than the Central Government’s borrowing programme to finance its fiscal deficit. Given that the centre is no paragon of fiscal prudence, you can get a sense of the extent to which India has been awash with the American moolah. I suspect that this may have been one of the reasons why the RBI chose not to intervene and buy dollars in the last week of March 2004 — which led to the rupee appreciating by 3.9 per cent in just one week. That brings me to Dr. Reddy’s second problem. Hypothetically, he could say, “I won’t buy dollars on demand”. However, given the power that the RBI has in the foreign exchange market, this would result in the exchange rate appreciating at an alarming rate — as it was did in the last days of March. There are limits to letting the exchange rate go, because it risks the wrath of Indian manufacturers and exporters. That’s something that Dr. Reddy’s boss may not want to deal with at this stage. Of course, much of Dr. Reddy’s angst would be a thing of the past if the economy could dramatically increase its imports. Pundits say that as infrastructure spends increase and corporates roll out their investment programmes, India will see a major growth in import demand. That hasn’t happened yet — and what may happen in the future is hardly any succour to Dr. Reddy’s pains of the present. The RBI can also further widen capital account convertibility. However, capital account convertibility per se can’t be the panacea to Dr. Reddy’s worries. As long as the supply of dollars exceeds the demand, the price of dollars will fall and that of the rupee will rise. Capital account convertibility can mitigate the problem; not eliminate it. Faced with a deluge of dollars, RBI’s intervention can only reduce the rate of appreciation, but not the appreciation itself. And the cost of intervention is getting higher with every passing day, as more and more billions come into the country. How much easier it was to be an RBI Governor in the times of scarcity. Through multiple fiats, you could ration the scarce foreign exchange; you could virtually order any intermediary to do what you wanted; you didn’t have to be very adroit to manage scarcity. In the latter part of his stint, Dr. Jalan had to manage a bit of plenty. However, that is nothing compared to what faces Dr. Reddy — who will preside over a veritable cornucopia of plenty. He will have manage this growing bounty without risking inflation or any politically unsustainable appreciation of the exchange rate. The challenges of dealing with abundance are far more difficult than with scarcity — and nobody knows this better than Dr. Reddy. His innings has now well and truly begun.
Published: Financial Express, April 2004
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