Booming Sensex and record foreign exchange which has touched 130 billion US $ is good news. P. Chidambaram is no saint and is often seen quoting Sensex to drive home a point as to how the Indian economy is doing well.
The point needs to be noted by Planning Commission Deputy Chairman, Montek Singh Ahluwalia, who thought that he had given an exceptional idea of funding infrastructure projects with foreign exchange reserves. What it would mean is absorbing the capital flows. Large capital flows into an emerging economy may get you accolades, but it has its own costs and attendant risks.
The financial crises in Asia should have taught us a few lessons. Countries which experienced the crisis had to reduce domestic absorption of capital flows and had to increase exports to generate trade surplus. Fortuntely we have one institution in the form of Reserve Bank of India which does not get carried away when Sensex goes on a roll. Its observations on the attendant risks of booming capital flows are worth taking note of. “The behaviour of the capital flows during the 1990s reveals that these flows can increase rapidly but can be highly volatile. Surges in capial flows and the associated volatility have implications for the conduct of monetary exchange rate and foreign exchange reserve policies. The emerging market economies thus need to be equipped to deal with such volatility in order to ensure monetary financial stability,” said RBI in its recent report on currency and finance.
The Asian financial crisis brought in a few lessons for the emerging economies. It reflected on the need for accumulation of reserves to maintain a competitive exchange rate as well as self-insurance against volatility. Net foreign assets have emerged as a key driver of reserve money.
Had the Planning Commission Deputy Chairman listened to the advice of RBI, he would not have given his ‘brilliant’ idea of using forex reserves for building infrastructure projects. If it was that easy, the NDA government would have used this money in building roads, ports and power plants.
In the face of volatility of foreign exchange flows, their absorption has to be reduced and not enhanced, as suggested by Shri Ahluwalia, who barely survived the Leftists’ onslaught about filling Yojna Bhawan with World Bank cronies when he came out with the ‘brilliant’ idea of funding big time projects.
RBI thinks it otherwise. It wants the reserves to be maintained as reserves since the world financial architecture is not all that strong. “The need for reserves as a self-insurance emanates from the volatile nature of the capital flows…. Capital inflows can reverse quickly, leaving the country exposed to a liquidity crisis. Monetary authorities need to decide as to whether capital flows are durable or reversible. In case the flows are perceived to be reversible, the authorities need to be prepared for building up foreign exchange reserves.”
Yet another challenge for the government is sterilisation of surge in forex reserves. This is because the excess supplies in foreign exchange markets pose a threat to price stability in the emerging economies. The intervention purchases by the central bank result in expansion of base money and may spill over to inflation.