Also, there has been a substantial increase in the inflows of what are classified as "banking capital", to the tune of $4.6 billion. These are debt-creating flows; indeed, most of this amount was in the form of NRI deposits, probably in the Indian Millenium Bonds and similar deposits. Since these deposits bear higher interest than available on domestic deposits or even many international bank deposits, they are really also part of the total external debt.
 
So what exactly is going on ? It appears that the Indian economy is now attracting capital inflows which are not being utilised productively for investment, but are simply going into piling up the external reserves held by the central bank. Of course this represent s significant fiscal loss, since the interest being paid on the various form of debt instruments which are part of the inflow is very much higher than the interest available on the deposits of foreign exchange reserves.
 
But even more than that, it should be borne in mind that, just as is true in the case of the excess food stocks, excess foreign currency holdings reflect an excess of ex ante savings over ex ante investment. This suggests an economy operating well below potential, and an enormous slack in terms of the use of resources. It is both a reflection of the current economic recession and a contributor to it. Also, insofar as this process is associated with rising real exchange rates (the real exchange rate of the rupee has appreciated by about 16 per cent over the past two years) it can become a further factor in domestic recession.
 
While the government could certainly lift the economy out of its current recession through increased productive spending which would also generate more employment and reduce the other evidence of slack (the large foodgrain stocks) so far it has proved to be remarkably inactive on this front. It is not clear whether this reflects lack of enthusiasm for such expansion, or simply incompetence.
 
It can be argued that in the more open capital account regime, such high levels of reserves are necessary as a precautionary measure against possible capital flight and currency crisis. This is certainly an important consideration, especially given the current political developments in the sub-continent and the likelihood that investors will turn and stay shy of the region at least in the short term. While the level of reserves is enormous by conventional standards, amounting to around ten months' value of imports, it is still substantially below (less than two-thirds) the stock of short-term capital in the country. Therefore some could even argue that the level of reserves should be even higher in order to protect against possible capital flight.
 
Unfortunately, however, the experience of numerous crises in emerging markets has made one unpleasant fact quite clear : no level of foreign exchange reserves is enough to ward off a determined speculative capital attack. Most of the countries that have experienced currency crises over the past decade had levels of reserves which were considered comfortable if not excessive, and in all these cases these reserves proved to be totally inadequate to deal with the situation and prevent bleeding outflows of capital.
 
Indeed, the conclusion is inescapable that large foreign exchange reserves are no substitute for capital account controls in terms of regulating both inflows and outflows and preventing destabilising movements of capital and volatility in exchange rate movements. Therefore, the currently high level of reserves should not lead to complacency with respect to averting future crises : the likelihood of these reserves being enough to protect the economy in the event of a genuine collapse in investor confidence and capital flight is extremely small.
 
In fact, quite an opposite conclusion can be drawn. The current pattern in the Indian economy, of large inflows of relatively "hot" money, accompanied by domestic economic recession or stagnation, may appear paradoxical but it is not particularly new. Exactly such a combination has been experienced by quite a few emerging markets over the past decade : Mexico in the early 1990s, Russia, Thailand and other Southeast Asian countries in the mid-1990s, Argentina, Brazil and Turkey thereafter.
 
It should be obvious from this list that this process has usually been a prelude to the balance of payments and currency crisis, as the inflows dry up because of perceived threats to future currency stability. Indeed, it is the very fact of large capital inflows, which push up real exchange rates and shift domestic incentives away from tradeable to non-tradeable sectors and re-orient domestic investment and consumption patterns, which leads eventually to current account problems. These then ultimately cause the reversal of capital flows and create the conditions for a balance of payments crisis.
 
Since so many developing countries have experienced this very process quite recently, all this ought to be quite well-known to our policy makers. The government – and the Finance Ministry in particular – really will have no excuse, if they choose to ignore these danger signals and do nothing at the present time, and if this eventually leads to financial stress.