Sterilisation blues

For the past year or so, the Reserve Bank of India (RBI) has been dealing with the flood of forex inflows with determined resistance "" not against the inflows themselves, but against the impact they might have had on the value of the rupee.

It has tried its best to prevent the rupee from appreciating by buying up the foreign exchange, which has seen the country's reserves shoot up to over a $ 100 billion worth.

Such a large accretion to the RBI's assets would normally translate into an explosion of domestic liquidity. Not wanting to let this happen, for fear of inflation and other evils, the RBI has done what is known in the central banking trade as 'sterilisation'.

While mopping up dollars, it has simultaneously sold government securities to offset the increase in liquidity.

As a consequence, according to a recent paper by Crisil, it has seen its portfolio of government securities shrink from over Rs 140,000 crore in January 2002 to about Rs 35,000 crore in January 2004.

This dramatic decline was highlighted in Deputy Governor Rakesh Mohan's comment last November, when he said that the RBI was fast running out of securities to persist with sterilisation.

In light of this, the RBI proposed the introduction of a special purpose security "" a stabilisation bond "" which it would issue to continue sterilising its accumulation of reserves.

The money raised from selling these bonds would be put in escrow, so the government could not use it for financing its activities.

International experience shows that such special purpose instruments have been used on a number of occasions by countries dealing with large inflows. Korea, Malaysia, Philippines and Mexico have all been down this road.

Ultimately, the decision to continue sterilising in the face of dwindling central bank holdings of government securities must be based on the relative costs of sterilisation versus currency appreciation.

Given the plans to issue upto Rs 60,000 crore worth of stabilisation bonds in the coming year, the Crisil paper estimates the direct and indirect fiscal costs to be of the order of Rs 2,700 crore "" about 2 per cent of the government's total interest liability for the year. This does not appear all that large in absolute terms.

However, it has to be set off against the possible decline in export earnings resulting from persistent appreciation.

That is far more difficult to estimate, but given strong export-employment linkages, the impact on jobs in a variety of export-intensive sectors could be quite significant.

The costs of sterilisation may, therefore, turn out to be small relative to its benefits. However, it must be kept in mind that the reason why the RBI needs to keep buying up the incoming dollars is because private entities "" individuals and corporates "" are not allowed to in an unfettered way.

The bond may be a relatively low-cost short-term measure to keep the rupee from appreciating, but, if the inflows are sustainable, there is no substitute for unshackling private demand, through tariff reductions and capital convertibility. Some progress has been made, but apparently not enough.