Subir Gokarn: Orthodoxy on reserves

To deal with forex inflows, it is best to effect a structural change in domestic demand for forex

Since the idea of using some proportion of the country's forex reserves was mooted, I have been asked for my opinion on it on a number of occasions. The substance of my thinking on the issue is as follows. The reserves are the assets of the Reserve Bank of India (RBI) and are reflected as such on its balance sheet.

To the extent that the RBI itself belongs to the government of India, it could claim effective ownership of the reserves. However, the convention has been to keep the assets of the central bank (which constitute the monetary base and hence determine the supply of money in the economy) from those of the government.

Following this convention, if the government wanted access to the reserves, for whatever purpose, it would have to buy them by paying rupees to the RBI. It could do this by squeezing its current expenditures or, more realistically, by issuing fresh debt in the domestic market and using the proceeds to buy forex.

This is fine, but the reserves are actually incidental to the whole story. It is tantamount to debt-financed public investment in infrastructure; if there is a forex requirement, the reserves ensure that, unlike in the past, investments will not be constrained.

The immediate macroeconomic impact of this, assuming no change in the RBI's monetary stance, will be upward pressure on domestic interest rates, because the government's increased borrowing requirements add a new source of demand for funds.

But, that is not how the plan is envisaged. Simply put, it requires that 5 per cent of the reserves is "monetised", i.e. money supply is allowed to expand by this magnitude, instead of being "sterilised" by keeping money supply constant, as is essentially happening now.

This increase in liquidity, rather than being allowed to pass generally and indiscriminately through the economy, will be lent specifically to infrastructure projects, which, presumably, will have qualified on the basis of some stringent project evaluation criteria.

For many economists, myself included, the increase in liquidity intrinsic to this scheme is a red flag; when it happens, we tend to see a higher rate of inflation somewhere down the line. To be fair, the plan, as it has been publicly articulated, does anticipate this concern.

However, it believes that the inflationary threat will be averted by the fact that the bulk of requirements for the projects financed by the scheme will be imported, using the forex. This will not exert the kind of pressure on domestic capacity, which is the main reason for the inflationary threat in the first place.

However, realistically, any large project, and there are going to be several of them going on simultaneously, will involve a mix of domestic and foreign inputs.

To the extent that higher demand for domestic inputs puts pressure on capacity utilisation (surely a real possibility in our current situation), some inflationary pressure is inevitable.

In speaking to the press last week, the Prime Minister was asked about the developments on the plan, to which he replied that "orthodox" economists had reservations about it and all viewpoints would have to be given due consideration before acting.

I was asked to comment, and I put forward my basic idea that the macroeconomics of the plan did suggest either interest rate or inflationary consequences.

In his column in this newspaper last week, Mr Sudhir Mulji ("The bullionist controversy," December 2) used my comments as broadly representing the "orthodoxy" on the issue of the macroeconomic consequences of monetising forex reserves.

Citing the historical evolution of monetary theory, he makes a distinction between the consequences of increasing the supply of currency on a fixed base and accommodating a structural change in the nature of the base itself.

Against this backdrop, he poses a question to the orthodoxy: what would it propose to do if foreign inflows continue at their present level?

This is an important question and as a member of the orthodoxy, I feel obligated to answer it. Assuming that there is structural change in India's ability to attract forex inflows, and I believe there are good reasons to do so, the most fundamental impact is on the exchange rate""we should expect to see a permanent appreciation of the rupee.

The issue of mounting reserves is a derivative one; the reason why reserves are growing to these unprecedented levels is that the RBI has been buying up the inflows in order to prevent (or slow down) the appreciation.

This is common practice amongst emerging markets, many of which compete with India in global export markets. Every country feels that it will lose in terms of export competitiveness if it doesn't protect its currency, given that all its competitors are doing it.

This partly explains why, despite the rupee's significant appreciation against the dollar all through 2003 and up until March 2004, our export growth did not slow appreciably. The rupee basically did not appreciate in the net against the currencies of our competitors.

But, even if one concedes that appreciation does hurt competitiveness""and this is by no means a consensus view within the orthodoxy""it is not necessarily incumbent on the central bank to prevent it. The reason it feels the need to do so is that other sources of demand for forex within the economy are laggard.

The best way to deal with a structural increase in forex inflows is to effect a structural change in the domestic demand for forex. In a sense, this is what the reserves-for-infrastructure plan attempts to do, but it unnecessarily restricts the scope of expansion.

The right approach to this is to simultaneously reduce tariff rates, so that the demand for imports increases""our much promised convergence to ASEAN rates""and expand the opportunities for Indians to invest in foreign assets""capital account convertibility.

Over the last couple of years, there has been significant progress on the capital account. But, it is really the government's decision on how much further it is willing to go on this, keeping in mind the real risks of capital flight.

When both these regimes are in place, the exchange rate may still appreciate relative to where it was before, but it would now be part of a new macroeconomic equilibrium in which the RBI can focus predominantly on price stability.

Expanding infrastructure investment requires a clear and predictable policy and regulatory framework. The only role that forex reserves have in the process is that they remove a tight constraint that used to hurt us in the past. There are two distinct problems requiring two distinct solutions. We simply cannot kill both birds with one stone.

(The author is chief economist, Crisil. The views expressed are his own)