Step jump in value?

When the country's foreign exchange reserves crossed $50 billion a couple of years ago, it sparked debate among policy makers about the costs and benefits of maintaining such a high level of reserves. Since then the dollars have kept pouring in, the Reserve Bank still keeps mopping them up, and consequently the country's foreign exchange reserves continue to go up by leaps and bounds.

Forex reserves have already crossed $110 billion, and, according to reports, one assessment is that they will touch the stratospheric level of $150 billion by the year-end. This is certain to sharpen the debate about the costs of maintaining such a high level of reserves, the dampening of economic growth as a consequence, and the policy choices before the government.

The first question of course is whether the country should expect a $40-billion increase in reserves over nine months. On current reckoning, the chances seem slim. One of the reasons for the rise in reserves last year was the decline in the value of the dollar, which led to revaluation gains.

For the period April to December 2003, for instance, these revaluation gains were responsible for $5.4 billion out of the total rise in reserves of $26.4 billion during the period. If the dollar is now stronger in international markets, the "dollar depreciation reserves" may not grow this year.

The main sources of forex inflows are remittances into the country, services exports, portfolio investments, and NRI deposits -- in that order. FII and NRI inflows are volatile, but the other sources of accretion to foreign exchange reserves have been stable. While remittance inflows have been steady, the prospects for increased service exports are good, thanks to the growth of information technology and BPO outsourcing.

And the recent spate of disinvestments has shown that foreign appetite for Indian public sector assets is healthy, and such sell-offs could easily attract substantial capital inflows. Add to that the recent relaxation in the norms for external borrowings, and the country could see a substantial increase in foreign exchange inflows and a corresponding rise in reserves. So, even if the level does not reach $150 billion by December, a substantial increase in reserves is on the cards.

What should the government do? The stabilisation bonds that the government intends to issue have a cap of Rs 60,000 crore, or about $14 billion. This limit may conceivably be exhausted in the course of the year. What then? Clearly, the government needs other policy responses, not temporary palliatives, and it may be time to recognise that the productivity gains that the Indian economy has achieved over the past few years now warrants a further improvement in the rupee's external value.

While precise levels are impossible to predict, the argument for allowing the rupee to gain further ground gets momentum when one looks ahead at the likely trade flows, the continued growth of software exports and BPO, and the new momentum that textile exports will acquire next year. The problem is that most of the market has figured out as much, and so the RBI is close to giving the market a one-way bet on the rupee.

This is avoidable, and there could be merit in arguing for a step jump in the value of the rupee so as to make speculators wary of taking large positions.