Shankar Acharya: A new BOP paradigm?

A PIECE OF MY MIND

Over the past year or so there has been a lively debate on a set of inter-linked issues, including the surge in foreign capital inflows, the growing mountain of forex reserves (and how to deploy them productively) and the appropriate monetary, fiscal, and exchange rate policies in response to these developments.

Much of the attention has been focused on inflows from foreign institutional investors (FIIs), who invested $11 billion net in the Indian capital market in 2003/4 and a comparable amount in the present fiscal year as of mid February.

In much of the discussion there has been an explicit or implicit presumption that "foreign capital surge" is the major new phenomenon, which our macroeconomic policies are having to contend with.

In fact, is capital surge the only "new" development in our external finances? Or even the most important one? It's time to look at a few numbers.

The table compares key elements of India's balance of payments (BOP) for the first three years after the crisis year of 1991/92 versus the three most recent years for which full BOP data are available. For each triennium, ratios to GDP have been computed and annual averages taken. Several trends are noteworthy. 
 

Balance of payments (All entries are as % of GDP at current market prices)
	Average of 1992/93- 1994/95	Average of 2001/02- 2003/04
Exports, f.o.b.	8	10
Imports, c.i.f.	10.2	12.7
Trade Balance	-2.2	-2.7
Invisibles, Net	1.1	3.5
of which:
(Private Remittances)	-2	-2.9
(Software Exports)	-0.1	-1.8
Current Account Balance	-1.1	0.8
Capital Account Balance	2.7	2.9
Of which:
(Foreign Direct Investment)	-0.3	-1
(Foreign Portfolio Investment)	-0.9	-0.8
(External Assistance)	-0.6	(-0.2)
("Other Capital")*	-0.7	-1.1
Reserves Increase	1.7	3.7
* Consists mainly of banking capital flows (other than NRI deposits) and 'Leads' and 'Lags' in payments and receipts for imports and exports. Source: Reserve Bank of India

First, the share of both exports and imports in GDP has increased, partly reflecting the rupee's depreciation over the intervening decade.

Second, there has been a small increase in the merchandise trade deficit to 2.7 per cent of GDP (actually it was running even higher in the period 1995/96 to 1999/2000, reaching a peak of 4 per cent in the latter year).

Third, and far more significantly, the balance on the "invisibles" account has more than tripled from 1.1 per cent of GDP in the early 1990s to 3.5 per cent in the recent period. About two-thirds of this massive increase is attributable to the rapid growth of software exports from negligible levels to over $12 billion in 2003/4.

The other third is accounted for by the continuing growth of private transfers or remittances from NRIs; these amounted to over $19 billion in 2003/4.

As a result of the sustained surge in "net invisibles", India's long-standing, "structural" deficit in the current account of the BOP has swung into surplus in recent years. This is a much more significant development than the surge in capital inflows.

Indeed, comparing 2001-4 with 1992-95, the data don't reveal a jump in the capital account balance, even though the composition of capital flows has changed. There isn't even a pronounced rise in FII inflows, partly because the earlier period also included a temporary surge in such flows.

Finally, powered by the turnaround in the current account and continued buoyancy in capital account inflows, the average rate of forex reserve accretion has quadrupled over the decade from around $5 billion per year in the early 1990s to about $20 billion per year in recent years.

We can summarise the evolution in India's BOP as follows. In the first part of the 1990s a merchandise trade deficit of over 2 per cent of GDP was partially offset by an invisibles surplus of about half that magnitude, leaving a current account deficit of around 1 per cent of GDP. Set against net capital inflows in the order of 2.5 to 3 per cent of GDP, this led to an overall BOP balance (broadly equivalent to forex reserve accretion) in the range of 1.5 to 2 per cent of GDP.

Over the ensuing decade, the tripling in net invisibles has transformed the picture and brought about a swing (from negative to positive) of about 2 per cent of GDP in the current account balance. With capital inflows almost constant (as a ratio to GDP), this means that the annual rate of forex reserve accretion has risen sharply to average close to 4 per cent of GDP.

Thus, it is the surges in software exports and private remittances that are the main new contributors to the embarrassment of forex riches, with FII inflows playing only an amplifying role in particular years like 2003 and 2004.

What are the implications of this diagnosis for policy? At one level, the challenge posed by "excessive" reserve accretion for macroeconomic policy remains the same, irrespective of whether the increased flows are coming from the current or capital account.

The RBI's basic options continue to be three: allow the exchange rate to appreciate, augment forex reserves without "sterilising" them (that is, without compensatory reduction of the RBI's domestic assets), or add to reserves and sterilise the monetary consequences. Or, of course, some combination of these three.

Of the three primary options, unsterilised intervention is generally the least preferred because of the high (and politically unacceptable) risks of accelerated inflation.

In judging the appropriate policy response one key issue is the durability of the "excess" flows or new trends. If the flows are temporary, then there is a strong case for buying them into reserves (without disturbing the exchange rate) and sterilising the monetary consequences. This has been the RBI's preferred response over the past three or four years.

However, as everyone knows, sterilised intervention has growing fiscal costs since low return forex assets are substituted for higher-earning government bonds. These fiscal penalties have to be compared with more nebulous but real costs of allowing exchange rate appreciation, including, primarily, the reduction in international competitiveness.

It could be argued that the growth of remittances and software exports in the past decade is likely to be more durable than occasional surges in FII flows.

In that case the RBI's (and the government's) dilemma of choosing between rupee appreciation and fiscal costs of sterilisation acquires a sharper edge. The dilemma becomes even worse if the rise in capital inflows is also sustained.

The best resolution of the dilemma would be through an increase in the rate of investment (especially productive private investment). Anything that the government can do to improve the investment climate and thereby trigger higher investment (relative to savings) would help move the current account in the BOP towards deficit and thereby relieve the pressure to acquire more forex reserves.

The list of investment-promoting reforms is well known. So, unfortunately, is the government's apparent incapacity to deliver on them. The import-promoting option of reducing peak import duties is more feasible and can be engineered in a revenue-neutral way.

An incremental enhancement of capital account convertibility is a third option, which the RBI has pursued, but it is limited by the vulnerability of the domestic fiscal situation and the financial system.

Pumping up public investment is another alternative but that runs the real risk of even higher fiscal deficits and its various associated costs, including damping of private investment. An even worse option is to stoke government current expenditure and reduce public savings.

Which of these options will the government pursue? My guess is all of them, including, regrettably, the last. The only saving grace is that the more economically unsound is the mix of options, the quicker will be the reversal in the recently burgeoning FII inflows.

That will lessen the RBI's forex management problem but it could also dent the current bull market and the ongoing recovery in industrial activity and investment. These are interesting times for macroeconomic management. Let's hope the government's economic policies are equal to the challenge.

(The author is a Professor at ICRIER and former Chief Economic Adviser to the Government of India. The views expressed are personal)