reflows from overseas as a result of the instability in the Middle East and money attracted by the rupee-dollar interest differential given expectations about the exchange rate. Whatever the reason, we show next that the reserve build-up has improved liquidity, but not solvency.

The high reserves have not strengthened the joint balance sheet of the general government and RBI because the RBI has been sterilizing the capital inflows to keep inflation low. Let δ denote the consolidated liabilities of the general government and RBI, which we call net public debt, _d_ general government debt, _f_ RBI’s net foreign assets and _c_ its net domestic assets, all expressed as ratios to GDP. By definition, δ is given by:<sup>36</sup>

> (1) δ _t_ = _d t_ − _f t_ − _ct_ , where t denotes time.  Now consider a situation where increases in reserves are sterilized by RBI sales of government securities, i.e., reductions in its net domestic assets, _c,_ so that ∆ _f_ = −∆ _c_ . 37  It then follows from (1) that:

(2) ∆δ = ∆ _d_ , i.e., the trajectory of net public debt and general government debt should be expected to be the same. In other words, while growing foreign exchange reserves boost international liquidity, they do not strengthen the combined balance sheet of the government and RBI. Essentially, domestic debt is being issued to finance the deficit and buy reserves.<sup>38</sup> Table 5 brings this out clearly. We see that net public debt increased by 23 percentage points of GDP between 1996/97 and 2002/03; from Table 1, general government debt increased by 20 percentage points of GDP over the same period. We also see that between 1997/98 and 2001/02, the sum of net foreign assets and net domestic assets (“base money”) fluctuated in a small range of about 13.5-14 percent of GDP, but fell sharply in 2002/03. This is consistent with a policy of sterilization to keep inflation low, with the fall in base money in 2002/03 attributable to the appreciation of the rupee.<sup>39</sup>

**<u>Table 5 : Net Public Debt (End March)</u>**

||90/91<br>Crisis|96/97|97/98|98/99|99/00|00/01|01/02|02/03|
|---|---|---|---|---|---|---|---|---|
|General govt debt (Rs. billion)|4121|8913|10127|11655|13669|15862|18323|20810|
|(-) Net foreign exchange assets of RBI|80|948|1159|1380|1659|1972|2640|3582|
|(-) Net domestic assets of RBI|682|952|1001|1042|933|878|569|-529|
|(+) Net non-monetary liabilities of RBI|270|352|433|605|702|793|1012|1265|
|Netpublic debt|3630|7364|8400|9839|11779|13806|16127|19022|
|**Memo : % GDP**|||||||||
|Net foreign exchange assets of RBI|1.4|6.9|7.6|7.9|8.6|9.4|11.5|14.6|
|Net domestic assets of RBI|12.0|7.0|6.6|6.0|4.8|4.2|2.5|-2.2|
|Netpublic debt|63.8|53.8|55.2|56.5|60.8|65.6|70.2|77.6|

Source: Reserve Bank of India, Monthly Bulletins

> 36 The definition of net public debt also includes some other terms on RBI’s balance sheet, as shown in Table 5, which we ignore here for simplicity.

> 37 Strictly speaking, this holds approximately because net foreign assets and net domestic assets are both expressed as shares of GDP.

> 38 Another way of making this point is to say that genuine assets can be created only by saving, not borrowing. To quote Flood and Jeanne (2000) “...reserves are expensive window dressing...by accumulating them the government behaves as an insolvent household that would try to impress creditors by financing large cash balances with credit card debt”.

> 39 That is, RBI was exchanging an appreciating asset (rupee government securities) for a depreciating one (dollars) with a lower nominal coupon. For an analysis of sterilization and its effects, see Lal, Bery and Pant (2003).

14