What does the forex forecast on raining dollars really mean?
In India, dollars are coming like the monsoon deluge. Initially, the inflow was like a drizzle—soothing the starving nerves of the country that had seen scarcity
Johnny was engrossed in reading the forecast of the day, which said that it might rain today. He was amused because what he was reading was not a weather forecast talking about the Mumbai rains, but a forexforecast talking about raining dollars.
In India, dollars are coming like the monsoon deluge. Initially, the inflow was like a drizzle—soothing the starving nerves of the country that had seen scarcity. Soon, the drizzle turned into a downpour and we started filling our buckets with a cheer. Now that all our buckets are full, the downpour has turned into a deluge. Our forex reserves have already crossed $210 billion (Rs8.6 trillion). What to do now?
Johnny has no idea how the inflow of dollars has changed our life. But the forecast that he read today forced him to think. Soon, he got an opportunity to discuss this with his trusted partner
Jinny:
Johnny: The forecast of today has really left me clueless. How could dollars rain? I have never seen dollars hanging on the clouds. Some say that we may catch a cold if we continue to get further soaked in the dollars downpour. I don’t know what this talk is all about.
Jinny: Well, I think you have missed the point. Don’t get confused by the comparison of forex inflows with the rainfall. Dollars don’t fall from the clouds. However, like the rains, their inflows sometimes may cause a problem of plenty.
I think I should tell you briefly about how inflows of forex take place in our country. But first of all you should know that the forex reserves of our country, apart from foreign currency, also include gold, special drawing rights (SDRs) and reserve tranche position. But here we would be discussing only inflows of foreign currency.
There are many sources through which a country can earn forex. Take, for instance, the most common source—exports of goods. We make clothes in Mumbai and send these to London.
In this manner, we earn dollars. However, we have to also import goods that we require for ourselves, say the crude oil for which we may have to pay dollars.
The difference between the payment and receipts determines whether we are earning or losing dollars. Historically speaking, our imports have been more than exports and so we have been net losers of dollars on our trade account.
In 2005-06, we had a deficit of about $51 billion on our trade account (imports minus exports).
Johnny: If our forex is slipping because our imports are bigger than exports, then how are the piles of dollars accumulating?
Jinny: Well, export and import of goods is one part of the story. The other part is that we have been receiving net foreign exchange on account of invisibles. Please don’t get confused by the nomenclature invisibles. Simply put, invisible receipts are constituted of all our exports of services, incomes form our investment abroad, remittances from Indians working abroad, and official transfers received by the government.
Out of these, export of services and receipt of remittances have really been our shining stars. In 2005-06, the net earning on account of export of services has been $23 billion and the remittance receipt has been around $24 billion.
But, due to a negative net balance on account of investment income, the total invisible receipts have been around $42 billion. Not enough to completely wipe out the deficit on account of imports and exports, but covering a substantial portion of it.
Johnny: But we are still running a deficit…
Jinny: Don’t be impatient. You have still not seen the full picture. There are three more stars to come. These are foreign investments—both direct as well as portfolio, non-residents deposits, and external commercial borrowings. Foreign direct investments (FDIs), simply put, are long-term investment by foreign entities in Indian companies or projects in which the foreign entities are interested in taking part in management.
Foreign portfolio investments (FPIs) are investments made through stock exchanges, in which investors are not interested in exercising management control.
Both FDIs and FPIs (which are also commonly known as FIIs inflow) have been onthe rise. In 2005-06, the total net foreign investment has been around $17 billion.
Net commercial borrowings and net non-residents depo-sits have been around $2.7 billion each.
On the whole, in 2005-06, the net capital account inflow has been around $24 billion, more than enough not only for completely wiping out our total forex deficit, but also for creating an overall surplus.
Johnny: Now I understand how the dollars are falling on our roof. But why do some people call it a problem of plenty? In my view, we should be happy that from the days of scarcity we have moved to days of abundance. I don’t know what’s the problem.
Jinny: Excess inflow of dollars, like excess rainfall during the monsoon, can pose a problem of plenty if you don’t know how to put them into the right channels. Your domestic currency may start appreciating under the pressure of heavy inflows, which may hurt your exports.
Some people feel that just like monsoon rains, which we store in dams, dollar inflows can be saved in the form of reserves for future use. You may be aware that in 1991, India had a forex reserve of only $5.8 billion (Rs23,780 crore), which was not sufficient to cover imports of more than three weeks.
Now our forex reserves have crossed the figure of $210 billion. But nobody can predict what level of forex reserves would be more than necessary.
Some experts feel that things can go wrong any time. As you have seen, investments by foreign institutional investors (FIIs) in the stock markets constitute a substantial part of the total foreign exchange inflows. Net FII inflows each year have been around $9-10 billion in recent times. The level of our reserves should be sufficient to meet any worst-case scenario arising out of a sudden capital flight.
Johnny: True. Then we should keep on building the reserves. What’s the problem?
Jinny: The problem is that management of dollar inflows imposes cost. The country’s central bank has to keep intervening in the market for purchasing dollars. Experts have a special name for such frequent intervention by the central bank in the forex market: “dirty float system of exchange rate management”.
Frequent intervention by the Reserve Bank of India (RBI) prevents the domestic currency from appreciating. This no doubt to some extent can boost exports. But frequent dirty floats come with a cost.
First, the foreign currency assets purchased by RBI may earn lower interest than the domestic currency assets. This is because forex reserves are kept in the form of securities of foreign governments, deposits with other central banks and deposits with foreign banks, all of which are safe modes of investment, but typically earn lower interest.
Second, for purchasing dollars, RBI has to sell the domestic currency. Selling of domestic currency increases money supply in the economy, which in turn causes inflation. For controlling money supply, RBI has to carry out sterilization, which again imposes cost.
Johnny: You talked about dirty float first, now sterilization. Is the sterilization required to kill the germs coming out of the dirt?
Jinny: Not the germs exactly. Simply put, sterilization is done by selling securities in the market, which allows the central bank to absorb the liquidity. However, there are two problems. First, selling of securities entails cost in terms of interest paid to the purchasers. Second, the stock of securities available with the central bank, at one point or the other, is likely to get exhausted.
To overcome the second problem, in India, RBI started the Market Stabilization Scheme from 1 April 2004, in which securities are issued specially for carrying out sterilization.
Johnny: Well, sterilization solves just one problem. You said our forex earns less interest when deployed in the securities of another countries. Why can’t we put our forex to more productive use in some alternative avenues?
Jinny: There has been no dearth of suggestions about this. Some experts suggest that we should create investment vehicles on the lines of Temasek Holdings and Government of Singapore Investment Corp. for investing our forex in riskier assets for generating good returns.
But the point is, what is the purpose of creating forex reserves? Do we create reserves for generating profits through investments or do we create reserves for bailing us out in case of need? We need to look at all the pros and cons before taking any decision. This year’s Union Budget proposed to create subsidiaries of the Infrastructure Finance Co. for borrowing foreign currencies from RBI to invest in domestic infrastructure projects. We have yet to see how this proposal works out.
Johnny: Well Jinny, I think the debate for managing the forex can go on and on. Let’s not forget that it is better to get soaked in the rain than to sit idle and scratch our heads. I think the rising forex will one day teach us the art of eating our cake and saving it, too.
In India, dollars are coming like the monsoon deluge. Initially, the inflow was like a drizzle—soothing the starving nerves of the country that had seen scarcity
Johnny was engrossed in reading the forecast of the day, which said that it might rain today. He was amused because what he was reading was not a weather forecast talking about the Mumbai rains, but a forexforecast talking about raining dollars.
In India, dollars are coming like the monsoon deluge. Initially, the inflow was like a drizzle—soothing the starving nerves of the country that had seen scarcity. Soon, the drizzle turned into a downpour and we started filling our buckets with a cheer. Now that all our buckets are full, the downpour has turned into a deluge. Our forex reserves have already crossed $210 billion (Rs8.6 trillion). What to do now?
Johnny has no idea how the inflow of dollars has changed our life. But the forecast that he read today forced him to think. Soon, he got an opportunity to discuss this with his trusted partner
Jinny:
Johnny: The forecast of today has really left me clueless. How could dollars rain? I have never seen dollars hanging on the clouds. Some say that we may catch a cold if we continue to get further soaked in the dollars downpour. I don’t know what this talk is all about.
Jinny: Well, I think you have missed the point. Don’t get confused by the comparison of forex inflows with the rainfall. Dollars don’t fall from the clouds. However, like the rains, their inflows sometimes may cause a problem of plenty.
I think I should tell you briefly about how inflows of forex take place in our country. But first of all you should know that the forex reserves of our country, apart from foreign currency, also include gold, special drawing rights (SDRs) and reserve tranche position. But here we would be discussing only inflows of foreign currency.
There are many sources through which a country can earn forex. Take, for instance, the most common source—exports of goods. We make clothes in Mumbai and send these to London.
In this manner, we earn dollars. However, we have to also import goods that we require for ourselves, say the crude oil for which we may have to pay dollars.
The difference between the payment and receipts determines whether we are earning or losing dollars. Historically speaking, our imports have been more than exports and so we have been net losers of dollars on our trade account.
In 2005-06, we had a deficit of about $51 billion on our trade account (imports minus exports).
Johnny: If our forex is slipping because our imports are bigger than exports, then how are the piles of dollars accumulating?
Jinny: Well, export and import of goods is one part of the story. The other part is that we have been receiving net foreign exchange on account of invisibles. Please don’t get confused by the nomenclature invisibles. Simply put, invisible receipts are constituted of all our exports of services, incomes form our investment abroad, remittances from Indians working abroad, and official transfers received by the government.
Out of these, export of services and receipt of remittances have really been our shining stars. In 2005-06, the net earning on account of export of services has been $23 billion and the remittance receipt has been around $24 billion.
But, due to a negative net balance on account of investment income, the total invisible receipts have been around $42 billion. Not enough to completely wipe out the deficit on account of imports and exports, but covering a substantial portion of it.
Johnny: But we are still running a deficit…
Jinny: Don’t be impatient. You have still not seen the full picture. There are three more stars to come. These are foreign investments—both direct as well as portfolio, non-residents deposits, and external commercial borrowings. Foreign direct investments (FDIs), simply put, are long-term investment by foreign entities in Indian companies or projects in which the foreign entities are interested in taking part in management.
Foreign portfolio investments (FPIs) are investments made through stock exchanges, in which investors are not interested in exercising management control.
Both FDIs and FPIs (which are also commonly known as FIIs inflow) have been onthe rise. In 2005-06, the total net foreign investment has been around $17 billion.
Net commercial borrowings and net non-residents depo-sits have been around $2.7 billion each.
On the whole, in 2005-06, the net capital account inflow has been around $24 billion, more than enough not only for completely wiping out our total forex deficit, but also for creating an overall surplus.
Johnny: Now I understand how the dollars are falling on our roof. But why do some people call it a problem of plenty? In my view, we should be happy that from the days of scarcity we have moved to days of abundance. I don’t know what’s the problem.
Jinny: Excess inflow of dollars, like excess rainfall during the monsoon, can pose a problem of plenty if you don’t know how to put them into the right channels. Your domestic currency may start appreciating under the pressure of heavy inflows, which may hurt your exports.
Some people feel that just like monsoon rains, which we store in dams, dollar inflows can be saved in the form of reserves for future use. You may be aware that in 1991, India had a forex reserve of only $5.8 billion (Rs23,780 crore), which was not sufficient to cover imports of more than three weeks.
Now our forex reserves have crossed the figure of $210 billion. But nobody can predict what level of forex reserves would be more than necessary.
Some experts feel that things can go wrong any time. As you have seen, investments by foreign institutional investors (FIIs) in the stock markets constitute a substantial part of the total foreign exchange inflows. Net FII inflows each year have been around $9-10 billion in recent times. The level of our reserves should be sufficient to meet any worst-case scenario arising out of a sudden capital flight.
Johnny: True. Then we should keep on building the reserves. What’s the problem?
Jinny: The problem is that management of dollar inflows imposes cost. The country’s central bank has to keep intervening in the market for purchasing dollars. Experts have a special name for such frequent intervention by the central bank in the forex market: “dirty float system of exchange rate management”.
Frequent intervention by the Reserve Bank of India (RBI) prevents the domestic currency from appreciating. This no doubt to some extent can boost exports. But frequent dirty floats come with a cost.
First, the foreign currency assets purchased by RBI may earn lower interest than the domestic currency assets. This is because forex reserves are kept in the form of securities of foreign governments, deposits with other central banks and deposits with foreign banks, all of which are safe modes of investment, but typically earn lower interest.
Second, for purchasing dollars, RBI has to sell the domestic currency. Selling of domestic currency increases money supply in the economy, which in turn causes inflation. For controlling money supply, RBI has to carry out sterilization, which again imposes cost.
Johnny: You talked about dirty float first, now sterilization. Is the sterilization required to kill the germs coming out of the dirt?
Jinny: Not the germs exactly. Simply put, sterilization is done by selling securities in the market, which allows the central bank to absorb the liquidity. However, there are two problems. First, selling of securities entails cost in terms of interest paid to the purchasers. Second, the stock of securities available with the central bank, at one point or the other, is likely to get exhausted.
To overcome the second problem, in India, RBI started the Market Stabilization Scheme from 1 April 2004, in which securities are issued specially for carrying out sterilization.
Johnny: Well, sterilization solves just one problem. You said our forex earns less interest when deployed in the securities of another countries. Why can’t we put our forex to more productive use in some alternative avenues?
Jinny: There has been no dearth of suggestions about this. Some experts suggest that we should create investment vehicles on the lines of Temasek Holdings and Government of Singapore Investment Corp. for investing our forex in riskier assets for generating good returns.
But the point is, what is the purpose of creating forex reserves? Do we create reserves for generating profits through investments or do we create reserves for bailing us out in case of need? We need to look at all the pros and cons before taking any decision. This year’s Union Budget proposed to create subsidiaries of the Infrastructure Finance Co. for borrowing foreign currencies from RBI to invest in domestic infrastructure projects. We have yet to see how this proposal works out.
Johnny: Well Jinny, I think the debate for managing the forex can go on and on. Let’s not forget that it is better to get soaked in the rain than to sit idle and scratch our heads. I think the rising forex will one day teach us the art of eating our cake and saving it, too.
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