STRONG CAPITAL INFLOWS, BUT…:: Business Line

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Despite higher capital inflows witnessed for close to two years now, India's foreign exchange reserves are still short of their all-time high of May 2008. Data released by the RBI on Friday peg the foreign exchange reserves at $308.2 billion, as of April 8, 2010, $8 billion short of the 2008 high.

Change in foreign exchange reserves is determined by a change in balance of payments position (an accounting record of all transactions between a country and the rest of the world) and by fluctuations in the value of a country's currency vis-à-vis other currencies. Much of the growth in India's forex reserves during the recent period has been due to higher capital flows than due to appreciation in the value of the rupee.

STRONG CAPITAL INFLOWS, BUT…

RBI data suggest that the $20 billion capital outflows from forex reserves seen in 2008-09 has come back ($24 billion inflows) to the country over the subsequent 21 months ending December 2010. The latest March quarter numbers are yet to be disclosed. While capital flows have been strong, post FY-09, why have forex reserves not bounced back to 2008 levels? A weaker rupee than in 2008 is the key reason.

Widening current account deficit during recent times has been chipping away the effect of strong capital inflows. This has also curtailed the rupee appreciation. It may be recalled that before forex reserves peaked in 2008, an ideal environment of higher capital flows and low current account deficit meant smoother appreciation of the rupee vis-à-vis other currencies. During the credit crisis, the rupee witnessed a sharp drop in valuation against major currencies; this alone accounted for two-thirds of the fall in reserves in FY-09.

The fall was so significant that despite rising from the lows, the rupee spot rate has not yet gone back to the 2008 levels against five out of the six currencies with which the trade weighted exchange rate (NEER) of India is calculated. The British pound is the only exception.

ALL IN THE TRADE?

If oil remains on boil, the rupee may see further pressure, thanks to a higher import bill. Also, the end of ‘quantitative easing-2' may see capital flow out of countries such as India back to the US, thanks to real interest rates improving there.

As of February 2011, India's forex reserves are sufficient to fund 9.5 months of import bill as against the peak of 16.9 months in March 2004 and 16.5 months in February 2009. The shrinking ratio is a result of import growth outpacing the expansion of reserves.

Another concern is quantum of volatile money coming in. The ratio of short-term money and portfolio flows to total forex reserves has shot up from 48 per cent in March 2009 to 69.3 per cent in December 2010.

Higher current account deficit due to rising import bill and lower proportion of long-term money flows could put the brakes on forex reserves taking higher strides too soon