India’s Forex Reserves And The Problem Of Plenty
An employee wearing protective gloves counts U.S. dollar banknotes. (Photographer: Dimas Ardian/Bloomberg)

India’s Forex Reserves And The Problem Of Plenty

India’s foreign exchange reserves have surged to over $550 billion as a rare current account surplus and a steady flow of portfolio inflows prompted the central bank to add to the kitty.

Forex reserves touched $555.1 billion in the week ended Oct. 9, according to data by the Reserve Bank of India, compared with $474.660 billion at the start of the financial year. Since India’s last major external sector crisis, during the 2013 taper tantrum, reserves have now doubled from $275 billion.

The current level of reserves are enough to cover 12 months of the pre-pandemic level of imports. They are nearly 99% of India’s external debt of $558.5 billion as of March 2020.

By most standards, forex reserves are now considered adequate, with some arguing that reserves may be more than adequate.

The purpose of accumulating reserves is self-insurance, and to have access to liquidity as a first line of defence, said Renu Kohli, an independent economist. That purpose is served, Kohli said.

Sonal Varma, chief India economist at Nomura, agreed. At existing levels, reserves are adequate and maybe more than adequate, she said.

Rising Forex Reserves, Dire Financing Requirements

The build-up in reserves has rekindled a familiar debate over whether these funds can be put to work for the economy, particularly at a time government finances are constrained.

The answer, according to economists and a former central banker, remains no.

For one, much of India’s forex reserves have been accumulated out of capital flows since India’s current account has remained in deficit. In the first quarter of the year, India reported a rare current account surplus due to a sharp fall in imports. This, however, is not seen as sustainable.

Clearly, the current account surplus is a one-off rather than a sustained reversal, Varma said. Whether the Atmanirbhar Bharat programme is going to lead to a sustained boost in exports and a sustained moderation in imports because of the import substitution strategy remains to be seen, she said. “So the durability of this reserves increase is a question mark.”

R Gandhi, former RBI deputy governor, said India’s accretion of forex reserves has largely been through its capital account surplus. Hence, for managing reserves, safety, and liquidity should remain critical.

Any alternate use of reserves, very often debated, may not be a welcome move, Gandhi said.

The alternate use of reserves is very often debated. In my view, the moment they are used that way, they are no longer forex reserves. They become wealth. Reserves built out of current account surpluses can have that treatment, not those built on capital account surpluses.
R Gandhi, Former RBI Deputy Governor

Kohli agreed.

"Since these reserves are not created from current account surpluses, they are borrowed and don’t really belong to us," said Kohli. "In the event of sudden capital outflow, these reserves are liabilities that we pay to accumulate."

One common demand is that India’s forex reserves can be used to finance infrastructure development in the country.

Such an idea had come up in the past, in the 2007 period when India was considered to have adequate reserves, said Varma. Then RBI Deputy Governor Rakesh Mohan had opposed the idea. Besides, the 2008 global financial crisis proved the volatility nature of reserves as the country faced significant capital outflows.

"Are we making the same mistake if we extrapolate in the current conditions," Varma asked.

While we need infrastructure funding, how much will you take away from forex reserves? The fact is that when investors and ratings agencies compare India to other emerging markets, the external vulnerability is significantly lower because of these reserves. India stands out as quite vulnerable on the fiscal side. It is the external side that has been helping us.
Sonal Varma, Chief India Economist, Nomura

According to Kohli, any such alternate use of reserves for domestic spending purposes would also have implications for domestic monetary policies. “Net foreign assets in rupees will be a part of reserve money or base money and will have a potential monetary impact. Other implications also remain unclear.”

Kohli said any such move may set a poor precedent for future policymaking.

“Once you use a bad idea, you set the precedent for others and perhaps for less desirable uses of forex reserves for future years,” she said.

Add The Golden Touch To Boost Returns?

While any suggestion to use forex reserves for spending in the economy treads thin ice, there is merit to the argument that the RBI may need to keep an eye on returns as the kitty grows.

With the exception of a small proportion of gold, the forex reserves are invested in liquid assets like U.S. treasuries and Euro-denominated bonds of other advanced economies. Most of these economies have seen interest rates fall to near zero, with some securities even trading at negative yields.

Is there a reason for the central bank to reconsider the composition of reserves in order to secure better returns?

“If you have crossed a certain threshold which more than meets your liquidity needs then its possible that since you have enough of a liquidity cover, you can start to focus on returns,” Varma said. That is not the primary objective, it is a secondary objective of central banks, she said. While RBI does allocate a small portion of reserves to external asset managers to in-turn invest, maybe that allocation could be increased, suggested Varma, adding that the central bank could also consider non-liquid assets like gold.

Sanket Mohapatra, professor of economics at IIM Ahmedabad, said monetary easing by the U.S. Federal Reserve and in other advanced economies, has reduced the attractiveness of traditional reserve currencies. With further rounds of quantitative easing by the U.S. Federal Reserve during the current Covid-19 crisis, the allure of the U.S. dollar as a reserve asset is likely to reduce further and the demand for gold as part of emerging economies' international reserves may continue to rise, Mohapatra said.

Although prior to 2018 the RBI’s gold stocks in tonnes were quite stable with changes only every few years, these stocks have increased more frequently in recent years, suggesting the gold is being managed more actively as part of India’s overall international reserves portfolio. This is a welcome development since gold reserves, although currently a relatively small part (about 6.6%) of India’s overall international reserves, can help to progressively diversify India’s reserve portfolio.
Sanket Mahapatra, Professor Of Economics, IIM Ahmedabad

The RBI’s holdings in gold remain conservative even when compared to other emerging economies. While Russia held 23% of it’s reserves in gold by June 2020, Turkey’s holdings gold rose to constitute over 45% of it’s foreign reserve portfolio, according to data by the World Gold Council.

Mohapatra isn’t opposed to the idea of the RBI adding more gold to its forex reserves portfolio.

Gold reserves can help to progressively diversify India's reserve portfolio, said Mohapatra. It can play a stabilising role for India's external position given an uncertain global economic recovery, an extended period of near-zero or negative interest rates and loose monetary policies in advanced economies, and a "search for yield" among international investors that can result in greater volatility of capital flows to emerging market economies such as India in the coming years, Mohapatra said.

Gandhi agreed. “Diversification of investment is a key strategy and gold is a key element.”

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