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Problem of Plenty

Surging reserves can be a double-edged sword as there is a cost to holding them. High reserves will obviously lead to appreciation of the currency and rise in inflation, because capital inflows that result in high reserves are used to buy domestic currency, thereby expanding the domestic monetary base without a corresponding increase in production, and this causes a rise in inflation.

Govind Bhattacharjee | New Delhi |

For the week ended June 25, the Reserve Bank of India reported that India’s foreign exchange reserves had surged to an all-time high of $609 billion. The rise was caused by an increase in foreign currency assets (FCA), the largest component of forex reserves that include capital inflows, FDIs and external commercial borrowings, which rose to $566 billion. The reserves also include gold ($36 billion) and IMF’s Special Drawing Rights or SDRs ($1.5 billion), besides India’s quota of contribution to the IMF ($5 billion).

It was reported that the RBI was likely to engage external financial consultants to manage part of this reserve for improving yields at a time when global interest rates had hit a record low, with four major consulting firms reaching out to the RBI. The reserves, now grown to a fifth of the country’s GDP, are equivalent to 18 months’ imports. The crisis of 1991 with our reserves of $1.2 billion worth only three weeks of imports is now history. The reserves now are the world’s fourth largest, after China, Japan and Switzerland and just ahead of Russia’s.

Our reserves to GDP ratio now is about 23 per cent, with 64 per cent of the reserves being held as treasury bills abroad, mainly the US; 28 per cent are deposited in foreign central banks and the rest are in foreign commercial banks. With interest rates in the USA and Eurozone falling to almost zero, the returns are hardly 1 per cent. Safeguarding reserves and using them to maximise returns is important for any central bank, and there is nothing unusual about appointing long-term asset managers for managing the FCAs.

Financial liberalisation attracts foreign capital and our reserves have been rising sharply ever since the rate of corporate taxation was reduced in September 2019, buttressed by a fall in crude price and reduction in our import bill. Buoyed by expectation of an economic turnaround soon, foreign investors have been acquiring stakes in Indian companies and Foreign Portfolio Investors (FPIs) are investing in the Indian stock market in a big way, though these are highly volatile funds and can disappear as fast.

Forex management includes intervention in the currency market to manage stability of the exchange rate and also to limit external vulnerabilities since liquidity of foreign currency can absorb shocks during times of crisis. High reserves provide market confidence about the country’s ability to meet external liabilities. Reserves indeed provide a great cushion in crisis times. They had helped the RBI to deal with the 2008 meltdown, while inadequate market intervention before the 2013 taper tantrum had resulted in current account deficit soaring to nearly 7 per cent of the GDP.

Given the possibility of the US FED raising the interest rate to contain inflation in the near future, it might be the same situation as in 2013, which may trigger capital outflow from emerging economies, leading in turn to depreciation of their currencies as happened between May and September 2013, when the rupee had fallen sharply from Rs 56.5 to Rs 62.8 a dollar.

Surging reserves can be a double-edged sword as there is a cost to holding them. High reserves will obviously lead to appreciation of the currency and rise in inflation, because capital inflows that result in high reserves are used to buy domestic currency, thereby expanding the domestic monetary base without a corresponding increase in production, and this causes a rise in inflation. Inflation targeting by the RBI of course provides some safety, but only within limits. High forex reserves also attract more inflows in a never-ending cycle as they reduce the currency risk for foreign investors in their confidence that the rupee will remain stable, which in turn will reduce their hedging costs while increasing the cost to the RBI of holding high reserves. To the extent that forex reserves are built up by external borrowings, the interest payments add to the cost. As of March 2021, India’s external debt was US$ 570 billion, equivalent to 21 per cent of the GDP, with long-term debt being US$ 469 billion. 52 per cent of our external debt is in the US Dollar, indicating our geopolitical vulnerabilities vis-à-vis the USA. Debt service payments – principal instalments plus interest – constituted 8.2 per cent of the current receipts.

To determine the optimum level of reserves, economists use several indicators, but the most common is to use trade-based indicators in terms of number of months of essential imports. A cap of 12 months was suggested by the Argentine Finance Minister Pablo Guidotti, known as the Guidotti Rule widely appreciated by central bankers. Switzerland, Japan, Russia and China hold much higher reserves, equivalent respectively to import covers of 39 months, 22 months, 20 months and 16 months, as against India’s 18 months.

A modified Guidotti-Greenspan rule requires that a country’s reserves should equal short-term external debt ~ enough to absorb any massive withdrawal of short-term foreign capital. While the short-term debt constituted 17.7 per cent of India’s external debt, its ratio to forex reserves was only 17.5 per cent. Hence India has nearly five times the limit suggested by the Guidotti–Greenspan rule, and apparently nothing to worry. But studies show that the ratio of reserves to external debt is a predictor of external crisis. With India’s external debt being equivalent to 94 per cent of its reserves, the situation is far from comfortable. Given our high reserves and steady macroeconomic fundamentals, India should try to attract more equity funds rather than debt funds from abroad.

To deal with the cost of high reserves and to curtail inflows, central banks often undertake “sterilisation” of capital flows by squeezing the excess liquidity out of the market through open market operations ~ i.e. by selling treasury bills and government bonds, or by encouraging private investments abroad, or by allowing foreigners to borrow from the domestic market. But sterilisation may also raise the domestic interest rates and thus stimulate even greater capital inflows, as experienced by China which has the largest forex reserves in the world exceeding $3 trillion, about 60 per cent of which are in US dollar assets like treasury bills, etc.

Open market operations also have a fiscal cost leading to increase in debt and debt-servicing charges. The other options are capital controls, which the RBI used in 2013, forward exchange market interventions or levying interest equalization taxes on inflow or outflow of foreign capital in order to equalise the yields of domestic and foreign securities. Often countries use a combination of these strategies. Capital controls are generally considered ineffective, and forward exchange market interventions require a developed forward exchange facility which we lack.

For utilising our reserves productively, one option is infrastructure financing which again carries the risk of inflation. Importing capital goods or technology for long-term capacity building in strategic sectors is a much better option for future growth. China has been using its reserves for financing the BRI projects abroad to extend its sphere of influence. India does not have that option, but it can always invest its reserves in Sovereign Wealth Funds through which assets can be acquired and managed abroad to generate wealth, given India’s net international investment position ~ i.e. the excess of assets over liabilities owed to foreigners ~ is minus 12.9 per cent of GDP. One way to acquire productive foreign assets is through Sovereign Wealth Funds. Singapore’s Temasek provides an interesting model for this, but it needs independent management, with the government kept at arm’s length which is doubtful in the heavily bureaucratised system of Indian governance.

Excessive intervention in the currency market, even to check volatility of the currency, has its risks ~ only in April 2021, the US treasury department had put India on a watch-list of currency manipulators, the second time since the start of the pandemic. It is to be noted that among all the major dollar holding countries like China, Russia, Saudi Arabia and Japan, only India has a current account deficit (despite a small surplus in FY21), which is being offset by an equivalent amount of capital inflow through FDIs and FPIs. There is a huge liquidity now available in the global banking system, and given India’s macroeconomic stability, the continuous inflow of foreign capital is hardly surprising. Despite RBI’s intervention, the rupee has already appreciated, and further appreciation may affect India’s export competitiveness, which though does not depend solely on the exchange rate. Any excessive intervention in the currency market by the RBI also carries the risk of speculation and hence more volatility.

One unintended consequence of high reserves could be the dilution of the central bank’s independence. With large reserves, the RBI’s balance sheet which is measured in rupees gets inflated whenever the rupee falls, forcing it to pass on the surplus as dividend to the government. This could be a potential for friction between the government and the RBI as happened in the recent past, raising questions about the RBI’s independence. It is imperative that the RBI has to work with the government, while maintaining a fine balance between its monetary policy independence and aligning its reserve management with the government’s objectives of growth and fiscal policies. Reserve adequacy is to be determined in a nuanced manner, keeping in mind the risks in a world of heightened uncertainty, caused by intense fluctuations in the interest and exchange rates due to the large-scale flow of international capital which poses higher risks for reserve management.