Dealing with Surpluses: Business Standard: 30th october 2010

The combined surplus cost of forex, money and commodity markets can be interpreted as the cost of stability and security

The era of socialistic economics typified a country with perennial shortages where success was measured by having enough to go by. Things have changed after reforms were introduced, which evolved in an era of globalisation when India has turned around to become a dominant force in the global economic space. Shortages have given way to surpluses quite often. The question that has arisen is whether or not we have learnt to live with surpluses and, as a corollary, the cost attached to those surpluses.

Three markets that come to mind when we talk of surpluses pertain to forex, money and foodgrain (commodities). In the past, we had shortages and the solution was straightforward: have exchange controls, print more money and import foodgrain. With surpluses, we can sit back and watch them grow, but the cost could be significant.

The forex market has seen our reserves grow substantially over the years and was around $255 billion by March 2010. The trade deficit is no longer a critical factor since software receipts, foreign institutional investors (FII) and foreign direct investment (FDI) inflows have more than made up for this deficit. While there has been debate over what should be done with these forex reserves, the Reserve Bank of India (RBI) has, as a prudent measure, parked them essentially in safe havens of Federal bonds, other central banks, the Bank of International Settlements and so on. This ensures that the money is safe.

The RBI Annual Report for FY10 states that the return on these reserves in the form of investments fell about 200 basis points in FY10 due to the global recession and the decision across the developed world to retain interest rates at a low level. Now, assuming that the prudential limit for forex reserves is four months of our imports, which in turn could be around $350 billion this year provided they grow by over 20 per cent, it works out to around $115 billion, which implies a surplus of $140 billion in our reserves. If a further provision of 50 per cent is made for short-term debt, which is around $50 billion, we would still have a surplus of $115 billion. The imputed cost of 2 per cent would mean a loss of around Rs 10,580 crore (based on an exchange rate of Rs 46/$). This is the cost of security on the external front.

If a commercial rate were applied to these surpluses, the cost would be even higher, though there would be a risk attached. Forex reserves also run the risk of losing value, which will happen every time the rupee appreciates considering that most of our reserves are in dollar assets. Hence, the RBI has to protect the rupee from appreciating in the interests of exporters as well as forex reserves.

Money market intervention is necessary for all central banks to control interest rates. Ideally, there should be intervention only when there is a high level of volatility in the call market. There were times when the rates would come close to zero or cross 100 per cent when there were acute shortages. The RBI would then try and draw out liquidity or supply it through the rediscounting window to stabilise rates. However, over time the RBI has fixed the upper and lower bands of the repo and reverse repo rates. While there are two views on this issue, the RBI does bear a cost when there are surpluses in the system. For example, in FY10, there were surpluses of an average of Rs 1,00,000 crore a day that went into the reverse repo auctions. Providing this window to banks cost the system Rs 3,250 crore, which may be interpreted as being the cost of monetary stability. At the other end, a continuous shortage of liquidity in the form of borrowing from the RBI through the repo means a subsidy to banks since the repo rate at, say, 5.75 per cent protects them from higher market rates.

The third market relates to commodities, where the government comes into the picture in the process of procuring foodgrain and then stocking it or distributing it. Since the procurement scheme is an open-ended one, the Food Corporation of India perforce has to take in what is offered. This being the case, it has stocked 58 million tonne as on July 2010 against a buffer norm of 32 million tonne, stored, which means there is a surplus of 12 million tonne of rice and 14 million tonne of wheat.

Rice is procured at Rs 10,000 per tonne and wheat at Rs 11,000 per tonne. The combined cost of these surplus foodgrain is Rs 27,400 crore. The government borrows from the banks (food credit) at, say, 10 per cent per annum, which means a cost of Rs 2,740 crore. To this one must add the other costs of procurement: Rs 2,890 a tonne for rice and Rs 2,120 for wheat, which indicates a cost of Rs 6,500 crore. The stocking of excess grains works out to a little over Rs 9,200 crore.

If all these three costs are summed, it would work out to between Rs 23,000 crore and Rs 25,000 crore a year, which is significant in a framework that is committed to the market mechanism. This can be interpreted as the cost of security or stability that is being borne by different arms of the government. There is ideologically nothing wrong or right about this expenditure, though it may be useful to revisit these policies and costs.