Foreign exchange reserves are not like a bank balance which can be converted entirely into cash for spending. The issue of government expenditure for infrastructural investment has little directly to do with using or not using these. It has to do more with the efficacy and efficiency of government expenditure, and with its possible demand side effects.

When governments spend, it is government expenditure that goes up. Even assuming that thereby it ends up enhancing the fiscal deficit, it is not automatic that, therefore, the balance of payments should decline and begin to show a deficit. This is possible only if the current account, which today shows a surplus, then runs into a large deficit and is not compensated by capital inflows. The reality of the Indian (and even more the Chinese) economy is that these economies can grow faster than the rest of the world without having to run a current account deficit.

The Indian economy has the ‘advantage’ of vast inflows on account of private (read Gulf) remittances. And the Chinese, quite like the Asian Tigers, given its pursuit of export-led growth (structural undervaluation of the currency in a situation of excellent price responsiveness of tradables, especially exports), grows as rapidly as it does with trade surpluses. Both show near balance or surpluses on current account. This is another way of saying the marginal savings rate in such countries is very high, and higher than or very close to the (high) investment rates they achieve (China), or could achieve (India).

In the ’80s, it was only the stupid pursuit of highly overvalued exchange rates in India that resulted in the forex crisis. We all know the response of the Indian economy to the currency adjustment was wonderful, with exports growing by 20% in dollar terms and for four years at a stretch, until the misalignment of the currency undid India’s tigerisation. 

Today, the luxury of vast inward remittances allows the RBI to pursue a policy of conservative pricing of the currency that punishes Indian exports and tradable goods production. In contrast to India, where our purchasing power GDP is only 2.5 times the exchange rate GDP, the Chinese PPP GDP (based on extending the Mark 5 measure of the World Penn Tables) is at least four times the exchange rate GDP!

If India were to follow the Chinese on its exchange rate, its exports would zoom and the reserves would accumulate even faster. And the accumulation would be due to current account surpluses rather than to the capital account, as it is at present. Supply side rigidities and inflationary impacts have been highly exaggerated, given the very elastic supply response the Indian economy is capable of. This is another way of saying the competitiveness of China (and potentially India) is unassailable.

From the monetary side, the fact that the dollar is the world currency means the US has to run current account deficits. When it overindulges in such deficits, the competitive countries have no other option but to accumulate reserves. The need is enhanced by the large volatility and asymmetric behaviour of hedge funds (arising out of severe home country biases). The price of this ‘excess’ reserve includes not only seignorage losses incurred by these countries to the benefit of the US and other reserve currency countries, but the implicit export of savings that the accumulation of reserves implies.

Where would the trillion plus dollar holdings of reserves by Asia end up finally? Would complete capital account convertibility by Asian countries help? That, in still transforming countries like India, would only speed up inflows in the short-run, while necessarily bringing about capital flight (outflows) in the long-term, arresting their economic transformation.

Whatever the IMF may say, and as Thailand and Korea learnt the hard way, currency crisis, even in well managed countries, is possible given the asymmetric behaviour of international capital. The chronic crisis countries of Latin America drive home the dysfunctionality of complete capital convertibility before the transformation.

Even without a currency crisis, current holders of dollar-designated assets are likely to lose as the dollar depreciates, and Asia can only pray the fall is not sudden. Their own strategies would decide whether there would be a collapse of the dollar. It is in their own interest not to fritter away these reserves by purchasing financial assets, especially those designated in dollars, but to buy up real assets (including stock) of long-term complementary advantage to their own economies since they have still not entirely finished their economic transformation.

Ensuring an orderly exit from the predominance of the dollar would demand coordination on the part of world central bankers and an acceptance by the US of the need for a world currency. Meanwhile, for East Asia and China it makes sense to hold on to a diversified basket of currencies and invest globally in real assets complementary to their economies — generally natural resources and stocks of high technology.

India is no exception, though in the Indian case the first best option is to pursue simultaneously export-led growth and ‘suffer’ an even faster accumulation of reserves from the current account side and simultaneously use a part for complementary real asset acquisition abroad. The argument for this is stronger in the case of India, since India’s debt and accumulated ‘non-debt’ creating capital inflows have been large relative to the size of the economy.