External reserves: A Keynesian angle

In recent days much has been written about the growth in India's external reserves, but the economic impact of this increase has not yet been analysed.

In two reports, Business Line, the Hindu's economic publication made two separate points: first that our exchange reserves have outgrown India's monetary base composed of currency in circulation and bankers deposits with the Reserve Bank of India; in the second report it has been suggested that there is a profitable hedging possibility for non-resident Indians borrowing money in international markets and buying the forward rupee and simultaneously lending in India.

The argument in the second report is curious; it is suggested that Non-Resident Indians can borrow cash at London's inter bank rates of 1.5 per cent, lend the money in India at 7 per cent and cover their Indian liabilities by purchasing forward premiums at 3.5 per cent, leaving them with a net profit of 2 per cent with no risk.

If these figures are correct that is indeed remarkable, for it implies that there is a simple way of making money, open to those financiers who are quick in   exploiting arbitrage possibilities.

Those familiar with money markets will be puzzled for it is not customary to do as well with such simple schemes in financial markets as the report implies.

Either the figures are wrong or there is an element that has not been understood. The obvious question, if such borrowing and lending rates are available must be why the premium on forward covers is so cheap.

With such riskless opportunities all the world's liquid funds should be deposited in India and we have the prospect of increasing Reserves to any magnitude.

The less spectacular conclusion is that the figures are inaccurate; but the fact that exchange dealers can even hint at such possibilities indicates the extent to which the Indian reserves position has changed.

The accumulation of reserves has been condemned by many commentators, including myself; but there may be another story to tell which one should look at. And if you are a Keynesian you learn not to accept the obvious.

It was part of Keynes's originality that he discarded the supposed mechanical rationality that preceded and has also followed his economic insights.

Those of us who have condemned RBI policies have argued that RBI has either borrowed or encouraged NRI deposits at too high a cost and that the rate of lending should be cut in order to employ these resources successfully towards encouraging investment.

This has been countered with Hayekian arguments that earlier malinvestments have left no scope for an increase in investment through cutting interest rates.

Keynes would not have disagreed with that, but for another reason. He would have said that the effect of interest rate change is marginal and will be ineffective.

To the extent that I had advocated a cut in interest rates, I should in self defence point out that I had suggested a very sharp cut of 5 per cent about 4 years ago. It was not the 5 per cent that was relevant but the need to cut rates suddenly and drastically before the boom petered out.

However in proposing such dramatic changes I should have heeded Keynes's own warnings that banking systems are incapable of dramatic alterations and that we were more likely to fall into a liquidity trap where pessimism of expectation would encourage investors not to unleash their resources.

Bankers may be willing to lend, but on such high rates that borrowers will not wish to borrow. That actually happened and we suffered a down-turn when we now have the spectacle of the monetary authorities urging banks to seek out borrowers to enable the economy to advance faster.

With this background we must re-examine the policy of reserve accumulation. Is there any merit in continuing to pay a cost either by offering too high a rate or by holding on to an under-valued exchange rate?

In Keynesian logic there are two factors necessary for private investment to take place. The first which is broadly held by all economic schools, is a reduction in interest rate policy.

But America, Japan and now the EEC have tried or are trying that policy without much success. The other requirement for encouraging investment is the build up of confidence.

In formal economics not much can be said about ‘confidence'; it seems too ephemeral a notion to be scribbled into equations that constitute rationality.

Yet it is in this context that we should perhaps reconsider the question of the right level of Reserves.

India has in the past suffered needlessly from a preoccupation with foreign exchange.

For those who think they understand the game, there are plenty of solutions like allowing the exchange rate to take the strain rather than losing reserves as Thailand did.

However, none of us expositors of free exchange rates have ever seriously addressed ourselves to the damage such losses can do to investors' confidence.

We have perhaps ignored the collapse of expectations that can rise from a loss of reserves.

In this context there may be merit in accumulating unused reserves.

One of Bimal Jalan's arguments that he advances at public meetings is that we no longer find every rise in the price of oil a matter of crisis causing the Cabinet of ministers to grope for a dramatic solution.

It must surely add to investors' confidence that we are capable of overcoming routine difficulties because we hold substantial reserves.

If that be the case it would be good Keynesian logic to consider a slightly larger cost either by way of higher interest rates or  by maintaining an under-valued rupee.

This aspect of confidence is a judgement in political economy, and no one has greater intuition in this direction than the present governor.

Yet there is an economic danger in these policies. The trouble with numbers and confidence is that we associate the level of confidence with familiar numbers and they are present ones.

The public forget that our $71 billion have risen from $3.0 billion in 1990. Thus a drop from $71 billion to $50.0 billion will hurt investors' confidence as much as any devaluation.

It is necessary therefore to accustom investors to fluctuation in reserves or in exchange rate norms. The governor cannot control the size of reserves but he can allow fluctuations in exchange rates.

It would seem sensible to allow the rupee-dollar rate to move anywhere between Rs 40 and 55 without panic buttons being pressed.

The endless concern with exporters' grievances if the rupee appreciates and with everyone's grief if it depreciates is as foolish as always expecting reserves to rise.

It should be a part of education in political economy that we should learn to allow changes to reflect the existing state of affairs.

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