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Perhaps the time has come to pull the rug out from under the rupee, allow it to float free in the market

India's foreign exchange reserves are high again. Back up to $21 billion or thereabouts. A lot of the credit would go to the Budget presented by Finance Minister P Chidambaram. It has once again created a kind of confidence that India is well and truly set on the path to reform, and that it is a good safe place in which to invest.

So the dollars are pouring in from foreign institutional investment; from direct foreign investment (how do you think all those Korean, Japanese and American transnationals are taking over Indian companies?); and from external assistance agencies.

The inflow is bound to increase, what with FII funds coming in even faster as the capital markets go into a higher growth phase; a possibly high realisation coming from the Voluntary Income Declaration Scheme announced by the finance minister; and the likelihood of blue-chip public sector companies issuing global depository receipts.

All these dollars are happily being mopped up by the Reserve Bank of India, through market operations. The objective is dual. To see that the rupee does not rise too high and make exports unremunerable. And that the reserves are bolstered.

The only problem with this method of keeping the rupee low is that there will be too much liquidity injected into the system due to the RBI's buying spree. And if there is too many rupees chasing comparatively fewer goods, prices are bound to rise. Inflation.

That is the fear expressed. And the RBI will have to continue buying dollars as the inflows continue to rise.

However, I am not too sure that buying dollars at such a fast clip is such a bad thing. Because India will always need strong forex reserves. One, it has to keep buying crude oil as domestic production keeps plummeting. Two, how many months of imports can a comparatively paltry $21 billion fund?

Six months? Seven months? And there is no real guarantee that the dollars will keep flowing in forever. So the stronger our reserves the better.

Compare our dollar reserves with the rest of the region. China's are $104 billion; Taiwan's $88 billion; Singapore's $75 billion; Hong Kong's $62 billion; and Thailand's $38 billion. We aren't even in the ball game with our $21 billion!

One other advantage of a high level of reserves is that the government has a freer hand in determining import policy if it has the cushion of high reserves. And in fact, a freer import policy means less inflationary pressure.

The only real problem with mopping up dollars at the rate the RBI has been doing is the methodology of sterilising the rupees in the system.

For every $100 million that the RBI buys from the market, it releases Rs 3.85 billion into the system. How can that be sucked back out?

The RBI has been using the repos route to suck out the liquidity it creates. It issues short-term securities to the banks with the agreement that they will be bought back at a pre-determined rate. The RBI loses about 4.5 per cent each time it does that. And the banks gain from a risk-free guaranteed return. (Is it any wonder banks are not lending to corporate houses even though they are floating in money at the moment?)

But how does the RBI make any profit? Or is it in the business of propping up banks' balance sheets? The RBI makes a profit - theoretically -- from the issue of long dated paper. The only problem is, every time the government issues long dated securities, it devolves on the RBI. There are few takers.

That is because there is similar long dated paper available from the market at more attractive yields. What the RBI should be doing is issuing at higher yields, but that would cut into its profits. Not only that, it would be sending a high-interest-rate signal to the markets, and the already starved corporate houses would find even the trickle drying up.

On the other hand, if the RBI does not succeed in sterilising rupees at a high rate, we will probably be faced with excess liquidity to the tune of Rs 350 billion in 1997-98 (varying with the quantum of dollars the RBI will need to mop up, and the funds released recently by the cut in the banks' cash credit ratio).

This the dilemma in which the RBI finds itself. Should it simply stop mopping up dollars and leave the rupee to its own fate? It tried that too, recently, and was almost deafened by the protest from exporters.

It is damned if it does. It is damned if it doesn't.

Perhaps the time has come to pull the rug out from under the rupee, allow it to float free in the market, and intervene with the idea of merely bolstering the foreign exchange reserves. In other words, full and real convertibility. All those who protest should be told that they have had more than five full years to prepare for capital account convertibility, and if they are still not ready, they will never be.

Otherwise the RBI will have to continue walking its thin red line between bolstering reserves, and sterilising excess liquidity. One slip means certain... well, castigation, at least. Runaway inflation or shallow reserves, as the worst case scenarios. Catch-22, isn't it?