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Rising Forex Reserves: A Boon or Bane

History is witness that whenever there have been attempts to tax these foreign investors, they have ditched these efforts by 'blackmailing' the government and the country. — Dr. Ashwani Mahajan


Our policy makers, pink (economic) newspapers and pro-foreign investment economists are all are obsessed by India's rising foreign exchange reserves. In this regard, the government seems to be patting its back that the investment climate in the country has improved. Pink newspapers appear to consider surging foreign exchange reserves as a barometer of the economy's well-being due to rising foreign investments.

It is worth noting that although our foreign exchange reserves have been increasing continuously for the last three decades, but in the last 18 months this growth has become faster than ever. Significantly, the foreign exchange reserves have reached $ 611 billion by July 3, 2021, increasing from $ 431 billion in January 3, 2020 (most significantly during the period of the global pandemic). Compared with 1991, when India faced a situation of acute shortage of foreign exchange, such that our reserves were not enough to pay for imports of even 7 days, today it is the situation that our foreign exchange reserves are enough to pay for 18 months of imports. The growing foreign exchange reserves do give a sense of satisfaction and relief. It is also true that if foreign exchange reserves are not sufficient, there is a danger of default in repayment of interest and principal of foreign loans. We realized this worst scenario in 1991, when we were forced to mortgage our gold with the Bank of England as a guarantee against eminent default.

Citing the same history, some economists consider the rising foreign exchange reserves to be auspicious. They argue that foreign exchange reserves act as insurance for the country, so that there is never a situation of a sovereign default. They also compare India’s foreign exchange reserves with that of China’s. Significantly, China's foreign exchange reserves are 6-7 times more than India's reserves. We have to understand that China's foreign exchange reserves increased mostly due to surplus in balance of payments, thanks to balance of payments (BOP) surplus of China with most of their trading partners. To some extent they also grew due to foreign direct investment. Whereas if we see, the increases in India’s foreign exchange reserves, they are mainly due to foreign direct investment (FDI) and foreign portfolio/ institutional investment (FPI), because generally our balance of payments remains in huge deficit.

So, more than the amount of foreign exchange reserves, we have to pay attention to what are the sources of increase in foreign exchange reserves. It also has to be kept in mind the far-reaching consequences of foreign exchange received from these sources? Economists agree that the best option as a source of foreign exchange is balance of payments surplus. If our exports of goods and services are more than imports, the foreign exchange thus earned is the best option. This has actually happened in China. But if this foreign currency is obtained by borrowing, then it is the worst option. Even if the foreign exchange is obtained through investment in the stock markets, then also it has many side effects. The first side effect is that it causes volatility not only in the stock markets, but also in the exchange rate. Its result is ominous for the country. Another side effect of this is that the country has to pay a heavy price for this inflow of foreign exchange, as these investors take huge profits to their respective origins and at the same time the value of their assets keep increasing.

Significantly, while foreign institutional investors have invested a total of 281 billion dollars in India till date, the total valuation of their assets has reached 607 billion dollars as of 31 March 2021. Apart from this, they have also earned dividends of $ 64.28 billion. They can sell their $607 billion worth of shares and bonds and go back at any moment and all our foreign exchange reserves can run out in a jiffy. That is why; portfolio investment is also called 'hot money'.

However, foreign investment, foreign loans taken by private companies and remittances by Indians to the home country are all important for increasing foreign exchange reserves. But not all these sources have the similar effect. While remittances by Indians normally don’t have any repayment obligations and generally all these amounts remain in India forever; but foreign investors, whether they are foreign direct investors or portfolio investors, all repatriate huge amounts of money. These investors take away huge amount of foreign exchange in the form of dividend royalty, technical fees, interest, salary etc. In addition to that, the share of imports in the products produced by these foreign companies is also very high, due to which huge quantity of foreign exchange outflow happens. Significantly, from the year April 1, 2000 to March 31st, 2021, the total foreign direct investment has been 763.6 billion dollars.

If we take see, in the last ten years (2010-11 to 2019-20), these foreign investors have withdrawn 390 billion dollars, in the form of dividends, royalties, technical fees, interest and salaries; and this amount has been increasing year after year.

On the other hand, when it comes to portfolio investments, they are even more dangerously more profitable. It has to be understood that there is no stability in the portfolio investment. It is not possible to estimate how much foreign exchange the portfolio investors will bring in and when they will withdraw. Their volatility affects the exchange rate, causing huge losses. Not only this, these investors cause huge volatility in the stock markets. Today, when India's foreign exchange reserves are booming, it’s the time to consider what price the country is paying for this growing foreign exchange reserves. Because foreign investors are repatriating huge profits from India, however, the country’s returns from these foreign exchange reserves are very negligible. Avenues will have to be found for gainful use of foreign exchange reserves beyond a limit.

History is witness that whenever there have been attempts to tax these foreign investors, they have ditched these efforts by 'blackmailing' the government and the country. Since there is always the fear that these foreign institutional investors may get away with their 'hot money’ anytime, it is absolutely necessary to restrict any eventuality of that kind, by regulating them. In this regard, a provision of a 'lock-in period' can be imposed on them. Along with this, if they want to take their money back, then a provision can also be made to levy tax on them. This tax was suggested by an economist named Tobin; hence it is also called ‘Tobin Tax’. Today, as our forex reserves are in a comfortable position, it is high time to use these measures to discipline these foreign institutional investors.       

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