Drowning under the forex pile

At last count, India's foreign exchange reserves were close to $219 billion (Rs 8,97,900 crore). In the second week of July alone, there was an addition of over $4 billion (Rs 16,400 crore) to the kitty. This is in line with trend across emerging markets which are seeing gargantuan inflows of foreign funds. "The global availability of cheap money is leading to the flow of funds from developed countries into high growth emerging economies where returns on capital have exceeded 20 per cent," says Rishi Sahai, Director, IndusView Advisors, a cross-border transaction and financial services advisory firm. According to a recent RBI report, the main sources of accretion in 2006-07 were external commercial borrowings, foreign investments and short-term credit.

In the normal course of events, high reserves should not be a problem. Like any growing economy, India has significant import requirements and also foreign currency debt payment obligations, among other things. But what is causing problems is the relative magnitude of the flows. "Capital inflows in 2006-07 were five times greater than the current account deficit (which is at 1 per cent of GDP)," says a recent report by the Economic Advisory Council (EAC) to the Prime Minister. This is increasing the supply of money in the economy, and, in turn, leading to a host of downstream macro-economic problems.

So what can policymakers do? The first option, of allowing the rupee to appreciate, has already been used. The rupee has risen about 8 per cent against the dollar this financial year. The headroom available to exercise this option seems expended already (witness the havoc that the hardening rupee played with the first quarter results and the forward guidance of several software majors).

Given this limitation, another option is that of increasing the cash reserve ratio (CRR) for banks. However, as CRR is often seen as a tax on the banking system, it is only a limited option. Yet another option is to hike the limit under the Market Stabilisation Scheme (mss), which is currently at Rs 1,10,000 crore. This scheme was introduced to mop up excess liquidity. However, excessive use of mss bonds may well affect the government's borrowing programme.

Then, RBI can curtail the huge external commercial borrowings (ECBs) being mobilised by India Inc. Ajay Mahajan, Group President, yes Bank, articulates the expectation within the industry for a redefined and more stringent ECB policy. "What is very possible is that the blanket permissions will become subject to some pre-conditions. Those conditions could ensure that the foreign currency is kept offshore," Mahajan says.

For example, Indian companies could be encouraged to buy assets overseas. Indian companies are already helping by investing overseas. The value of 121 outbound cross-border deals in the first six months of the current year is around $28 billion (Rs 1,14,800 crore).

A gradual loosening of controls for individuals, too, will help. "Though the limits on individual investments have gradually been scaled up to $100,000 (Rs 41 lakh), no bank is clear on the exact process of doing so," says Mahajan. And the setting up of a sovereign investment fund on the model of the Singapore government's Temasek is another option that the government is considering.

So, it seems "at this juncture, a judicious blend of all options is needed," says M. Govind Rao, Member, Economic Advisory Committee to the Prime Minister.

More of the same and something more...

The government is taking the following measures to tackle the massive inflows of foreign exchange.  

OPTION	IMPACT and LIMITATIONS
Rupee appreciation	Huge appreciation needed to match CAD size; exports to be hit
MSS bonds*	Part of the hike in reserves will be monetised; may affect GOI borrowing
CRR hike	Beyond a point, profitability of banks could be affected
Inbound flows	Curb the short-term debt route
Outbound flows	Indian companies have started acquiring aggressively overseas. Relaxation in individual overseas investments ought to be a precursor to capital account convertibility. The government itself is planning an overseas investment arm.