Understanding India's Foreign exchange Reserves

 

The Rupee's Exchange Rate and Declining Dollar Reserves

 

The malaise that drove down the rupee

V. SRIDHAR in the hindu

  

 

Desperate attempts to woo foreign capital by boosting investor sentiment is unlikely to result in a lasting solution to India’s currency travails

The recovery of the rupee and the euphoric rebound of the markets in the last few days would appear to suggest that the economy is back on track again. Nothing could be more wrong. The flurry of policy announcements in recent weeks is based on the diagnosis that the relentless slide of the rupee, attributed to the widening Current Account Deficit (CAD), can be arrested if and when capital inflows — as investments or borrowings — fill the gap.

Reserve Bank of India governor Raghuram Rajan’s recent announcement allowing banks to borrow from global capital markets at a time when interest rates are rising because of the expected reversal of the United States Federal Reserve’s easy money policy is tailored to this logic. Indian banks can now borrow up to 100 per cent of their combined net worth and long term borrowings from the international market (compared to 50 per cent earlier) and then “swap” them with the central bank. This is expected to augment the supply of foreign exchange by an estimated $30 billion, which is about one-tenth of Indian foreign exchange reserves. The markets reacted euphorically, but the risks of the country borrowing its way out of trouble have been much less appreciated.

The two-track policy — of making India more attractive to foreign investors by deepening “reforms” and of borrowing more — is fraught with serious consequences. The policy response suggests that the ongoing crisis is only a temporary blip in the Great Indian Growth Story. But it appears that the seeds of the crisis were sown in that very story.

THE GREAT CREDIT BINGE

A striking feature of the story is that Indian corporates borrowed like there was no tomorrow — from not only Indian banks but also from overseas capital markets. Consider this: between 2003-04 and 2010-11 the Indian corporate sector’s share of net bank credit increased from 31 per cent of Gross Domestic Product (GDP) to over 37 per cent. In fact, since 2006-07, their share has been consistently higher than net bank credit to the government.

Infrastructure companies’ (power, roads and telecom) share in total bank credit increased from about 9 per cent in 2003 to more than 33 per cent in 2011. The spectacular increase is responsible for the mounting burden of non-performing assets in the Indian banking sector today. According to an oft-cited report in the media, prepared by the Credit Suisse Group in 2012, the debt of 10 Indian corporate groups whose interests range from oil and gas and steel to infrastructure increased from about Rs. one lakh crores in 2006-07 to Rs. 5.4 lakh crores in 2011-12 — a compounded annual rate of 40 per cent.

ASSET BUBBLE

The fact that private fixed investment did not increase at the same pace is perhaps because a large portion of the credit was diverted by Indian companies to what would appear to be an asset bubble — in land, shares in companies and other speculative assets. The clamour by corporate lobbies that interest rates be lowered has no respect for economic logic, given the state of the country’s external balances. They fail to appreciate that the era of cheap-credit fuelled growth is well and truly over.

But this increase in domestic credit was dwarfed by the remarkable increase in the inflows of foreign capital following the global economic meltdown in 2008.

The share of capital inflows — external borrowings, foreign direct investment (FDI) and foreign institutional investors (FII) — increased from about 5-6 per cent of GDP to about 9 per cent in 2011. The share of costlier short-term borrowings (almost entirely by private companies) in overall borrowings increased from 4.5 per cent in 2002-03 to 25 per cent in 2012-13. Companies, lulled into borrowing at illusorily low interest rates, have been surprised by sharp increase in the rupee-denominated value of their loans.

FDI ILLUSION

Inflows of FDI registered a spectacular rise — from $9 billion in 2005-06 to $33 billion in 2010-11. Popular understanding is that while FII investments are volatile, FDI is much more stable, long term in nature and contributes to improving the competitiveness of recipient nations. However, the story of India’s dalliance with FDI is shockingly different and raises serious doubts about whether the ongoing attempts to woo investors is sustainable or even desirable.

A study co-authored by Biswajit Dhar, Director General, Research and Information Systems for Developing Countries, based on a painstaking dissection of every FDI project entailing an investment of $5 million and more between 2004 and 2009, provides shocking insights that prove that a large proportion of FDI is just as volatile and transitory as portfolio capital. The study that considered 2,748 projects, which accounted for almost 90 per cent of all FDI in the 2004-2009 period, found that the lowering of norms prescribing the minimum level of equity stake in an “FDI invested” project — from 40 per cent to 10 per cent — offered perverse incentives to capital flowing in the garb of FDI.

Less than half of the investment was actually FDI; private equity, venture capital and hedge funds, which are volatile and normally associated with short investment horizons, accounted for 27 per cent; and about 10 per cent was actually portfolio investment. Over 10 per cent of the “investment” was round tripping by Indian entities, which funnelled money back through tax havens in order to take advantage of tax concessions and other inducements available to FDI projects.

A large proportion of the investment was by entities masquerading as investors committed to the long haul or investments that enhanced the productive capacity. Indeed, manufacturing, which advocates of FDI said would be a key beneficiary, received only one-fifth of the investment; but even in this case portfolio and other short-horizon investors accounted for almost 40 per cent of the total investment. Interestingly, while much attention has been focussed on the rising import of oil and gold, little attention has been paid to the fact that the trade deficit in manufactured goods has widened from $1.5 billion in 2004-05 to $45.5 billion in 2011-12 (about 2.5 per cent of GDP).

If there is any truth in the old cliché that a crisis is also an opportunity, surely this is a time to rebalance the Indian economy on a more sustainable path that allows policymakers to use levers that are more easily within their control. Of course, this would require import curbs and other measures suited to these hard times. But rebalancing would also require the use of measures such as the fiscal deficit, which have been for far too long a strict no-no in the policymakers’ handbook.

THE FISCAL DEFICIT OBSESSION

The stubborn opposition to the good old-fashioned Keynesian logic of using a fiscal deficit to get the economy back on its feet is grounded in the apparently intuitive logic that equates a government deficit with a household deficit. A classic example of such misguided thinking is evident in the loud opposition to the Food Security Bill. Quite apart from the fact that such a measure would provide a measure of security to the poor, the implementation of the legislation promises economy-wide benefits.

First, the guarantee of subsidised food grains, which constitutes a significant proportion of the consumption basket for most people, will have the immediate effect of increasing their disposable income. This is not trivial, given that the growth of consumption expenditure has halved between 2009 and 2012.

Second, the provision can play the role of an economic stabiliser because food prices determine the floor wage level, which is why they are termed a wage good. The guarantee would thus not only help in controlling food prices but also stabilise wages. Indeed, it is perplexing that industry lobbies are attacking the provision of an enhanced social wage, from which they stand to benefit significantly.

Third, if the fiscal deficit is run in an imaginative way, even more can be achieved. For instance, coupling the food guarantee to the MGNREGA can help in the construction of a countrywide network of godowns for the Food Corporation of India.

Of course, a cash transfer scheme would negate much of the potential economy-wide benefits that would accrue from the implementation of the food security legislation.

Why the rupee can keep falling

S A Aiyer in Times of India

People ask me, will the exchange rate go to Rs 70 to the dollar? I reply, why not Rs 80?

Indian analysts are in denial. They don’t dare face up to the full consequences of the global financial hurricane originating in the US. This will keep blowing for 12-18 months.

To revive the US economy, the Federal Reserve has been pumping out $85 billion of cash per month (called quantitative easing). With the US economy recovering, the Fed plans to reduce this cash bonanza in stages to zero. Emerging markets like India have long enjoyed a slice of this $85 b/month. Not only will fresh flows stop, older flows will reverse to the US, a net turnaround of hundreds of billions.

This storm has knocked the rupee down almost 25% in two months. It is the first of many storms that will hit not just India but the whole developing world, with every tightening of the money tap by the Fed.

Expect a second Asian Financial Crisis. This will cause much less damage than the earlier one in 1997-99. Then, Asian countries had low forex reserves, excessively high debt, and semi-fixed exchange rates. Learning from 1997, Asian countries (including India) now have large forex reserves, less debt, and floating exchange rates. This makes them far more resilient, so they will not collapse as in 1997. But they will suffer substantial damage. Countries with large current account deficits like India will suffer the most. But even Malaysia, which runs a surplus, has seen its currency crash 10%.

A crashing currency raises the prices of all items that can be imported or exported. This erodes people’s purchasing power — by maybe 2.5 to 3% of GDP in India’s case. That is hugely recessionary, as is already evident in the latest data showing falling production of services as well as manufactures.

Such a recession can, in theory, be combated by monetary and fiscal stimuli, as in 2008. But today money must be kept tight to check inflation, so no monetary stimulus is possible. Finance Minister P Chidambaram has sworn to limit the fiscal deficit to 4.8% of GDP, so no fiscal stimulus is possible either. With GDP growth and revenues falling far below budgeted numbers, and oil and fertiliser subsidies rising, he will have to slash Plan investment to meet his fiscal target.

The breach will not be filled by private investment — few businessmen will invest when domestic demand is collapsing. So, the economy will spiral downwards.

One theoretical solution is use a depreciated currency to stimulate export-led growth. If exports grow 20% per year for two years, that will help weather the storm. However, as we found in 1997, when all developing countries are hit, all cannot suddenly increase exports at the same time: the West lacks enough absorption capacity. Besides, India’s investment climate is terrible — files just don’t move, with or without bribes. Many Indian companies would rather invest abroad. Politicians are more focused on distributing goodies before the election than on slashing red tape.

Finance ministry analysts say the equilibrium exchange rate is Rs 58-60 per dollar. They say irrational panic has caused overshooting, and economic fundamentals will soon force the dollar’s value back to Rs 60.

Warning: similar things were said when Asian currencies began to slide in 1997. Far from recovering, they crashed further. The Indonesian rupiah went from 2,500 per dollar all the way to 18,000.

Why so? Because when a currency crashes, that itself changes the economy’s fundamentals. Domestic purchasing power falls, causing a recession. Prices shoot up, negating the positive effects on exports. Corporations that have borrowed abroad heavily go bust. Banks that have lent to such borrowers (and others hit by recession) cannot recover their loans. International rating agencies downgrade such economies, inducing further capital flight.

India’s fundamentals have already changed. GDP growth in the first quarter is down to 4.4%. It could fall to 3.5-4% over the full fiscal year. A slowing economy will help reduce the current account deficit, but hit the fiscal deficit. Wholesale prices had been falling but are accelerating again, dampening purchasing power. All industries face slowing revenues and rising costs, eroding profits. Tax revenue may grow by hardly half the budgeted estimate of 19%.

Disinvestment can happen only at throwaway prices. Chidambaram is a determined disciplinarian, but may be powerless to stop global hurricanes. The threat of a credit downgrade has become very real.

Right now, there is a lull in the financial storm, and the rupee has regained some ground. But this storm will blow, off and on, for 12-18 months. Gird your loins.

Practise swadeshi, save the rupee

By Kingshuk Nag in the Times of India

The only way to save the rupee and to prevent its free fall is to start practising swadeshi all over again. Yes, you read it correctly. As a nation we are living beyond our means and you can’t continue doing so unless we want India to crash (and not the rupee alone). That is exactly what is happening: the crash of the rupee is a symptom of the problems that ail the economy. Although sarkari economists et al are trying to explain away the problem by changes in the Fed rates in the US and a revival in the US economy this is a very shallow explanation. Just because the Indonesian rupiah, the South African rand and the Brazilian real have been competing with the rupee in depreciating against the US dollar, there is no reason to wish away our problems.

------
Also read

Gresham’s Law in Present day India

-----

Next time you bite corn produced in Australia, oranges raised in California and apples from god knows where, think deeply whether as a nation we can afford this. Maybe middle class and upper middle class consumers can afford these imported fruits at an individual level, but certainly not as a nation. When India’s foreign exchange earnings are not enough to cover our imports, it is a no-brainer that we cannot. Stopping such imports and also of other edibles like cheese is not going to make any one worse off. The question that we should ask ourselves is: cannot good quality fruits be grown in the country that we have to spend precious foreign exchange to import them?

In the good old days, students used to travel abroad for higher studies after they completed their MA to take admission in PhD and other such programs in top universities. The learning in these top universities would be far superior to what could be had in high institutions in the country. But things have changed in the last two decades: these days you can find  parents sending their children abroad to do their undergraduate degrees. Why? This is possibly because it has become a fad to send children abroad. Parents say that they have the money so they will send their children abroad. While this may be true, the fact of the matter is that as a nation we cannot afford precious foreign exchange to spend on children studying at the undergraduate level and doing basic technical courses. A pertinent question to ask is whether the education infrastructure is so poor that there are no colleges in the country to impart a basic degree. So the issue is why this fad for a foreign education?  

However you would not have seen any economist or politician who waxes eloquent on TV holding forth on the rupee speak anything about all this. Most of their conversation revolves around the tight monetary policy of the RBI and the decline in growth impetus, etc This misses the real issue. The fact of the matter is that the process of liberalization that was kick-started in 1991 is so lopsided that it promoted the culture of consumption without any breaks. (Editor's comment - i.e. the Kerala model, but Kerala has the advantage of foreign remittances to pay for the consumption culture.) True, before liberalization the economy was in shackles and the consumption in the country was artificially restricted. This was by way of import curbs and by the process of licensing. Thus things like washing machines were treated as luxuries although in reality it was a great boon for families especially those with working women. 

Liberalization provided a great opportunity to break the shackles and set up a modern, efficient manufacturing base in India. Well that really did not happen adequately. Had that happened India would have become a major exporter of manufactured goods that would have been enough to take care of India’s import requirements (of which oil imports is a major component). But India continued to be an exporter of raw material. For example till the ban in exports of iron ore, the country was exporting iron ore to China. A country which is focused on its growth (like China is) would have instead tried to manufacture steel from this iron ore which could have been exported instead. This would have resulted in more foreign exchange earnings. But India had no such strategy in place.

Instead of exporting manufactured goods, India has become an importer of raw materials. A good example is coal that is imported into the country for fuelling thermal power stations. This is in spite of the fact that India sits on reserves of billions of tons of coal reserves. India spent $18 billion in coal imports in the last fiscal year 2012-13. This is by no account a small sum.

But while exports did not go up, imports of not only coal and petroleum products (valued at $169.25 billion in the last fiscal year) but other consumer goods also went up.

World class manufacturing facilities did not come up in India due to many reasons. But primarily the culprit is the policy paralysis in the country for many years that resulted in inadequate infrastructural facilities whether it was electricity generation, port facilities or proper roads. Bureaucratic hassles and widespread corruption in granting permissions played a none-too-insignificant role in this process. 

Entrepreneurs finding a bleak scenario soon realized that realty was a booming sector where large profits could be made without much hassles. As a result entrepreneurs of all hues and colors turned to realty. This includes top names in the Indian corporate sector. Even many IT companies started dabbling in real estate. With politicians joining in the game, realty became the name of the game. Thus the high growth evidenced in the country in the period 2000-2009 and especially between the years 2005-2008, is nothing but an indication of the rapid growth in the real estate sector that led to bourgeoning cities (never mind the poor infrastructure). But the increase in the growth of the realty sector is an artificial growth that may add to national income yet doing nothing to increase India’s exports. A huge middle class, which has earned moolah through direct speculation in realty or by working in companies whose profits have soared due to their investments in real estate, started feeling empowered. And this empowerment was reflected through increased consumption. This has led to spiralling imports. It may not be out of place that India’s savings rate has plummeted in the last five years. From 36.9 per cent in fiscal year 2007-08, it tumbled to 30.8 in 2012-13 and is expected to go down to 30 per cent by the end of fiscal year 2013-14.

The rupee may have tumbled in the last two weeks, but the signals were there for anybody to see for the last few months. In the last fiscal year India’s imports of gold soared to $50 billion. This was not due to the proclivity of the Indian consumers to own the yellow metal. Rather it was a signal from the market that the rupee could not be trusted to hold its value. Gold was being imported, because people preferred to hold their savings in the form of the yellow metal than in the form of the Indian rupee in banks or investments.

Whether it is an individual, household or a nation, nobody can live beyond their means. You have to cut the coat according to the cloth that you have. Thus there is no other way for India and as Indians we have to learn to live within our means. The time has come to reduce to zero the imports of inessentials and restrict the imports to the essentials. The control raj came with a lot of ills, but independence also comes with responsibilities. From 1991 to 2013, the pendulum has swung from one extreme to the other. It is time to restore balance in our lives, think in terms of age old concepts like import substitution and check the rampant spread of this consumerist culture. Otherwise doomsday is not far away.

India's FDI Reforms - A risky strategy, born of panic

SIDDHARTH VARADARAJAN

SHARE  ·   COMMENT   ·   PRINT   ·   T+  

TOPICS

macro economicsinflation and deflation
investments
politicsnational politics

Building ‘capitalism with Indian characteristics’ means decisions cannot ignore concerns of voters and communities

As the economy slows down and the rupee wilts, Manmohan Singh has bitten the ‘reforms’ bullet with both eyes on the credit rating agencies whose negative reports have done much to dampen the ‘animal spirits’ of investors, foreign and native.

Last November, when the Congress party made a push to introduce foreign direct investment in multi-brand retail, protests in Parliament forced the government to back off. Pranab Mukherjee, who was Union Finance Minister at the time, said the FDI plan was being put on hold until a political consensus emerges.

I asked a senior member of the Prime Minister’s Cabinet what had changed between November 2011 and September 2012. There is still no consensus on FDI in retail, yet a decision has been taken to go full steam ahead. “What has changed is the value of the rupee,” the Minister replied. Every rupee that the dollar gains adds Rs 8,000 crore to India’s annualised oil import bill. “Of course, Manmohan admitted to us that not even one dollar may flow into retail or airlines right now”, he said. But this decision to open the sector and raise diesel prices has to be taken in order to stop the rupee from going into free fall.

SELF-SERVING AND DECEPTIVE

Signalling is not an unknown tactic, both in economics and in war. Signals can radiate strength and resolve, but they can also connote weakness. How will those whose ‘animal spirits’ are being propitiated look at the petard the UPA has just pinned upon the door of small retail across India? Dr. Singh must not be fooled by the applause he has garnered from editorialists, TV anchors and corporate leaders for being “tough” and “decisive”. These perfumed words may wash the stain of the Washington Post’s ink on his hands — a recent article in the American paper about his indecisiveness seems to have particularly stung the PMO — but they are self-serving and deceptive. From their vantage point in the White House or on Wall Street, the champions of American finance and enterprise see an Indian Prime Minister who is not tough but vulnerable: a man who believes the only way he can revive the economy and save the rupee is by doing what it takes to pull in foreign institutional investors and even hot money.

There is no doubt that foreign capital inflows, including FII monies, have played a big role in India’s success story over the past decade. But the problem with the Manmohan Singh strategy today is three-fold. First, it leaves untouched the very structural imbalances in the Indian economy that are responsible for the onset of the slowdown and, worse, stagflation. Second, by pinning all hopes on the revival of foreign inflows, those imbalances will most likely get exacerbated. Today, instead of being used for productive investment, capital is getting locked up in property, gold and other ‘safe’ outlets. A revival of the Sensex on the back of renewed FII interest may breathe some life into the stock market. But the risk is that this may trigger speculative demand and have no impact on the real economy. The third problem with the Prime Minister’s current approach is that the appetite of finance capital will not be sated so easily. One concession must necessarily beget another in order for the foreign investor to keep the faith in the India story.

A few weeks ago, we were told that the dilution and postponement of the General Anti-Avoidance Rules (GAAR) on tax — an important initiative taken by Mr. Mukherjee in the last budget — is necessary so as not to scare off investment. The same reason was cited to argue against the ‘Mauritius route’ of inbound investment being shut down. Today it is said that the bait of FDI in retail must be thrown to the rating agencies, or else the rupee will sink. Sure, the rupee has recovered against the dollar by around Rs 1.50 in the past few days but what happens if and when these gains get eroded again by structural factors? Foreign investors will demand more liberalised norms for entry into banking, insurance and pension funds. They will demand a friendlier patent regime for drugs so that generics can be blocked in the name of “incremental innovation.” They will rail against the ‘wasteful’ subsidies on food and employment going to India’s poor.

MISMANAGEMENT

The slowdown of the Indian economy today is essentially due to manufacturing. This, in turn, is largely the product of poor governance and mismanagement by the Central and State governments and their systematic neglect of basic infrastructure like roads and power over a long period of time. It is also the product of corruption and rent-seeking. The sub-optimal utilisation of the railways and coastal shipping — under the influence of one private lobby or another — raises the cost of long-haul cargo and increases the inflationary impact of any diesel price hike. Thanks to poor monitoring of contractor works, road projects remain unfinished for years on end, even after the land acquisition process is over. Industry is plagued by chronic electricity shortages even as would-be power producers find it more profitable to squat on their allocated coal or gas blocks.

Why is it that the Prime Minister didn’t think about being tough and decisive when it came to allocating coal blocks through a transparent auction? Why weren’t such auctions seen as a way of plugging the fiscal deficit? And we haven’t even begun talking about the allocation of bauxite, iron ore, granite, sand and water. How much revenue is the state continuing to forego by not charging proper prices from the businessmen lucky enough to land concessions for these resources?

The other structural problem the Indian economy faces is the mismatch between a national political culture that is democratic and a model of resource allocation that resents dissent. All those who are busy denouncing Trinamool Congress leader Mamata Banerjee for her decision to withdraw support to the UPA should remember that India is perhaps the only country in the world to have established universal adult franchise and a mature parliamentary system well before it turned to building capitalism in earnest. In virtually every other country, capitalist industrialisation came first and democracy followed, or the two developed side by side. If we are to build ‘capitalism with Indian characteristics,’ this requires a reimagining of the economic decision-making process. This means decisions cannot be taken in a peremptory, top-down manner, ignoring the views and concerns of voters and communities whose land, resources and labour industry needs to utilise.

At the event to relaunch Frontline magazine on Thursday, the noted economist, Prabhat Patnaik, spoke of the social contract of fraternity which lay at the base of the freedom struggle and of the Indian state which emerged. Springing from this are five universal rights which he said were non-negotiable: the right to food, employment at a living wage, education in good quality neighbourhood schools, healthcare and pension security for the elderly and disabled. None of these rights can be realised by granting concessions and subsidies to the corporate sector.

It is the failure of the system to deliver these basic rights that lies at the root of the current crisis in Indian political economy. And the current political crisis is also a reflection of the same deficit.

LAUDABLE

On Friday, Ms Banerjee delivered on her threat to withdraw support to the UPA. She deserves applause, if only for being one of the few politicians to stick to her stand even at the cost of surrendering her share of power in Delhi. Her other faults need not detain us today — most notably her intolerance. Nor should too much time be spent wondering whether the UPA government will survive her departure. It will survive, and do so handsomely, thanks to the outside support it receives and will continue to receive from the Samajwadi Party and the Bahujan Samaj Party. The Opposition Bharatiya Janata Party is in no position to face a snap poll, whatever L.K. Advani may say or want, nor is the Left. In the weeks and months ahead, there will be skirmishes in the Lok Sabha and some moments of tension too. But Dr. Singh and Congress president Sonia Gandhi — who have proved to be superb tacticians — will survive the bumpy journey to 2014.

What happens after that, of course, is anyone’s guess. It is one thing to master the tactics of survival on the battlefield, and quite another to have a strategy that can win a war. No Congress minister sees the party winning more than 150 seats if general elections were to be held today. Dr. Singh hopes to compensate for this dwindling public support by courting investors. This constituency, of course, is happy to be courted. Whether they deliver what the Prime Minister wants is the 272 seat question.