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The great Indian war chest

In a Manila seminar in early December 2001, some international finance men commented on the large foreign reserves being maintained and further built up by the Asian economies, particularly China and India.

These "war chests" provide ammunition and supplies for a rainy day, when markets are in turmoil, foreign creditors and investors are shy, and people are betting against the rupee or the yuan for no substantive reason.

Some doubted, however, whether China needed the $212 billion of foreign currency reserves that it had, or India its $45 billion.

With representatives of international rating agencies present at the meeting, I could not help pointing out that the war chests were taken rather seriously in the rating exercises, and at least a part of the incentive for maintaining and building them came from the rating agencies themselves.

Our foreign currency reserves have gone up by almost another $7.5 billion from end-2001 to $52.5 billion on May 10, 2002.

In a recent public lecture, former Finance Minister P Chidambaram said that crisis of 1991, because of insufficient foreign exchange reserves, was "burnt into our consciousness," and the war chest partly reflected this experience.

India certainly knows the utility of generous foreign exchange reserves, yet defining when our reserves have reached the desirable or optimum level remains a matter of much debate.

The "enough is enough" school would say that while we have gone through hard patches in the past, we have now acquired a war chest with a vengeance. Why go for more? Like the 60 million tonnes of food-grains in FCI warehouses, our nearly $60 billion of reserves is enough.

One must remember, however, the experience of the late 1970s.

Total reserves, had gone up steadily from $1.4 billion in 1974-75 to an impressive $7.3 billion in 1978-79.

Policy makers were worrying over what to do with the lush reserves, and the late L K Jha, in a lecture at the Delhi School of Economics, mentioned that with many imports still under quantitative restrictions, one possibility was to import luxury cars, sell them at a huge premium to the rich, and use the proceeds to fund development projects for the poor.

Sadly enough, our worries of excess wealth proved entirely without merit. Reserves stopped growing in 1979-80, and actually fell in the next two years to reach the figure of $4.4 billion in 1980-81.

The embarrassment of riches quickly turned into a shortage, and India soon required exceptional balance of payments support from the International Monetary Fund.

The utility of the war chest depends largely upon the effectiveness of RBI intervention in the foreign exchange markets, and this may depend on one's economic perspective.

Many prescribe a view described as "Adam Smith unadulterated": leave it to the market, and the currency will find its own equilibrium. Failed interventions, such as in Thailand in 1997 and in Argentina today, show that only the market will decide in the end.

Intervention distorts the relative price of tradeables (like shoes and potatoes) and non-tradeables (like road transportation and haircuts), and induces inefficiency in resource allocation.

For this reason, if, for example, there is excess demand for dollar vis-à-vis the rupee, the rupee should be allowed to depreciate.

On the other hand, if there is excess supply of dollars vis-à-vis the rupee and the RBI intervenes by buying up dollars and adding further to the war chest, it prevents the exchange rate from moving to its equilibrium. In any case, the RBI will lose the battle in the long run, but in the process it will unnecessarily distort the economy, increase inefficiency, and thus hamper growth.

The proponents of this view assign little value to the war chest, for its use, they would claim, is ineffective at best and harmful at worst.

This group, however, overlooks problems as overshooting of the exchange rate, when, for example, the rupee in the process of adjusting from Rs 49 per dollar first goes to Rs 55 per dollar before settling down at Rs 52 per dollar.

Other problems, such as speculative bubbles formed by self-fulfilling expectations of price change, are also dismissed by the advocates of unadulterated Adam Smith.

Yet delayed adjustments and adjustment costs in markets in transition from one equilibrium to another can be a great problem, and certainly more pressing a concern than trying to "fix" the exchange rate at a "wrong" level, as the Malaysian experience of managing their currency after the 1997 crisis shows.

This school might like to solve the ongoing Argentinean crisis by simply letting the peso go through a free fall, but there are many who would disagree.

The existing policy of the RBI recognises that economic security is essential for national security, and the war chest of foreign exchange does give us some flexibility.

For example, our much larger reserves relative to Pakistan's $3½ billion must be a source of some satisfaction to our security strategists. The RBI's policy is one of not having any officially announced target exchange rate, and intervening only to maintain "orderly market conditions".

If tensions continue to escalate along the Indo-Pakistan border, the economic repercussions of the political situation might be cushioned by utilising our burgeoning war chest.

Some people worry that RBI intervention is one-sided, yet the figures show that the RBI clearly sells as well as buys foreign exchange.

In 1996, for example, the RBI ended up selling foreign exchange and depleting its war chest in three months out of twelve.

In the next three years, the number of months in which it used its war chest was five, four, and three, respectively.

The sale of foreign exchange from the war chest was fairly heavy in certain months like November 1997 and June 1998, when it was $2.1 billion and $1.6 billion, respectively.

The critical question, however, may not be the absolute size of our reserves but whether the rupee is undervalued.

If so, the war chest will keep growing as long as the undervaluation persists. The Japanese yen, for example, was 350 per dollar in 1971 and had appreciated to 108 in 2000, and the undervaluation of the yen led to the accumulation of Japanese reserves of $354 billion by the end of that period.

While the undervaluation of the rupee can have traces of a mercantilist mindset, it may be a prudent Asian way of better being safe than sorry.

Currencies are fragile animals; especially, it seems, in the Indian climate.

If the foreign exchange worries of 1981 and 1991 have seared anything into our economic consciousness, it is a faith in festina lente.

Perhaps old Adam Smith has useful wisdom for the RBI, but it may not be applicable at this particular moment.

We might maintain the war chest, and continue to debate its utility, without compromising long-term ideas of how big or small our reserves, or how active or detached our RBI, should eventually be.

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