A developing economy needs foreign exchange to finance its international transactions for both the current account (goods and services) and capital account (assets) transactions. Foreign exchange reserves also signal its ability to meet potential obligations. The larger the stock, the more its reassuring value. The benefits of this stock are obvious, but there are also costs associated with the holding of these. Typically, because of their “liquid” nature, the returns on these are low.

A country can accumulate reserves by running current account surpluses (that is, keeping its total expenditure below its gross national product), and/or by interventions in the foreign exchange markets. India (usually) runs a current account deficit — in this century, it ran a surplus only in 2020-21 (the year of Covid-led disruptions). Its reserves are then accumulated solely through “sterilised” interventions. When foreign entities want to invest in Indian assets (stocks and debt), the RBI gives them rupees in exchange for foreign exchange. Mindful of the fact that this may cause a surge in inflation, the RBI then sells government bonds, sucking out the additional rupees. The foreign exchange reserves rise, and are matched by an increase in government bonds outstanding. The accumulation of foreign reserves limits the appreciation of the currency. The “exchange market pressure” caused by the capital inflows then is met partly by a currency appreciation and partly by foreign exchange accumulation.

But, in recent months, we have witnessed a reversal of this process — there is an outflow of foreign financial capital, with reserves falling and the rupee depreciating. International capital flows tend to be pro-cyclical, that is, they move with the world economic activity. Hence, a depreciation of our currency is unlikely to see our exports rise very much because the world income levels are down. What this depreciation will cause is imported inflation and bankruptcies.

When capital inflows were taking place, the RBI accumulated foreign exchange and allowed some currency appreciation. The price-sensitive exports never got off the ground, while imports increased. The unborn Indian export sector suffered a premature death, while the import-competing sectors gave way to cheap imports, from China for example. As long as capital flows were strong, foreign reserves kept piling up and the currency (in real terms) was strong. This gave rise to a feeling that the good times were permanent, causing complacency, and even hubris. Those engaged in “carry trades” continued without bothering about the exchange risk, as did those Indians who borrowed in foreign currency (external commercial borrowings).

The RBI threw caution to the winds and allowed outward remittances in foreign currency by Indian residents, with almost no questions asked (up to $2,50,000 annually). The rich bought properties abroad and sent their children to study in foreign universities. Note the inherent bias in favour of the wealthy, because to buy foreign exchange one needs an equivalent amount in domestic currency — it is unlikely that someone who is struggling to find regular MGNREGA work is going to ask for foreign exchange. It is, therefore, not quite correct when the RBI Governor says that during the inflows period foreign exchange reserves were piled up as umbrellas for rainy days of possible outflows. The RBI could have had a much larger supply of such umbrellas had they not generously handed out foreign currency to be frittered away.

I am sure the RBI is worried about the immediate future. While they have not restricted outward remittances, they are trying to shore up reserves by making FCNR (B) and FRE deposits more attractive. It is not in any individual’s interest to bail out the RBI, given that it is asking for these reserves in a bid to try and prevent a currency crisis. That is, we now have a one-way bet against the rupee, because no one expects its sizeable appreciation. The RBI has also committed to using reserves to ensure an orderly depreciation. The problem is that if the world economy enters a more turbulent phase, these initiatives will resemble King Canute ordering the waves. If the world financial markets want a depreciated rupee, the RBI would be foolish to throw reserves to prevent it — remember how George Soros defeated the Bank of England in 1992 (also in that year, France lost 155 per cent of its reserves and Italy 133 per cent). But in spite of this, the RBI, with its commitment to inflation targeting, would try to prevent a depreciation (because it causes the price of imported goods to rise).

We are standing at the edge of a precipice, but, hopefully, the world will pull back in the nick of time (my jeremiad, notwithstanding). If not, it would be the chronicle of a death foretold. Having too open a capital account policy was always fraught with risks. When countries are confronted with a crisis, the IMF is asked to provide assistance. This is done but they demand their pound of flesh. Here, that would involve a “structural adjustment”, including cutting back on subsidies for the poor and vulnerable. The irony is that these people never got any of the goodies when the party was on, but are now being thrown under the bus. A bigger question is about the lessons that the policy authorities would have learnt from this episode. Most probably, they would reset the clock, and go down the same path again. In the “currency crisis” literature, not learning from history is called “this time it is different”.

The writer is former Director and Professor of Economics, Delhi School of Economics