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Reserves and convertibility

Friday 14 April 2006

Of the many positive features of the macroeconomy, especially of its external sector, that are cited in support of a quick move towards full convertibility of the rupee, the level of foreign exchange reserves today ranks high.

In fact, it is difficult to think of any other feature of the economy, including the inference that GDP growth has entered a higher orbit, that seems to buttress the case for full convertibility as well as the dramatic transformation in the level of forex reserves over the last decade. In the early 1990s the country had just a billion dollars, barely sufficient to take care of a month’s import requirements. Today foreign exchange reserves, at $154 billion, cover about 13 months of imports and exceed the country’s external debt by about $30 billion. There is no doubt at all that the rapid accretion to forex reserves is among the major developments that have already propelled policy moves towards a more open capital account. However, the key question remains: is the abundance of reserves an unmixed blessing? Much before the ongoing convertibility debate, there have been serious discussions over the consequences of a rapid reserves build-up. Some key issues that have defied a consensus are the correct level of external reserves for a country like India, the deleterious consequences of dollar inflows on the exchange rate management, and the enhancement of domestic liquidity consequent on the RBI’s moves to absorb the dollar inflows.

A recent report by the international rating agency, Standard & Poor’s, provides a new dimension to the debate by correlating the levels of forex reserves with the quality of sovereign ratings earned by the countries holding them. India alone, among the top eight nations that together hold two-thirds of the world’s official reserves, has a sovereign rating that is below investment grade. Since sovereign ratings are used as benchmarks for determining borrowing costs by other entities, it becomes fairly clear that some of the presumed benefits from a full convertibility regime will not flow readily, for instance, to Indian corporates. Though they will have far greater access to global capital, they may not be able to borrow at advantageous rates when the sovereign rating is below investment grade. Few will disagree with the other findings of the report titled "Official reserves: Flexibility is more important than size." It points out that reserves do provide policy makers with greater flexibility to deal with any contingency. But such flexibility does not necessarily go up with every increase in reserves and, at some stage, it might even become a negative factor. It has for long been realised in India that there are a variety of costs associated with accumulating reserves and that the issue can never be examined in isolation from other macroeconomic parameters and policies. Fiscal consolidation and financial sector reform should come first in any agenda for full convertibility of the rupee.

See online : The Hindu

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