India’s Forex Reserves And The Problem Of Plenty

India’s foreign exchange reserves rose to more than $ 550 billion as a rare current account surplus and a steady stream of portfolio inflows prompted the central bank to add to the kitten.

Forex reserves reached $ 555.1 billion in the week ended October 9, according to the Reserve Bank of India, compared to $ 474.660 billion at the beginning of the fiscal year. After the last major crisis in the foreign sector in India, during the momentum in 2013, reserves have now doubled from 275 billion dollars.

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

The purpose of stockpiling is self-insurance and access to liquidity as a first line of defense, said Reno Colli, an independent economist. That goal has been met, Collie said.

Sonal Varma, India’s chief economist at Nomura, agreed. At existing levels, the reserves are sufficient and perhaps more than sufficient, she said.

Growing foreign exchange reserves, requirements for direct financing

The accumulation of reserves has renewed a familiar debate over whether these funds can be used for the economy, especially at a time when public finances are limited.

According to economists and a former central banker, the answer remains no.

First, much of India’s foreign exchange reserves have been accumulated by capital flows as India’s current account remains in deficit. In the first quarter of the year, India reported a rare current account surplus due to a sharp drop in imports. However, this is not considered sustainable.

It is clear that the current account surplus is a one-off rather than a sustainable turnaround, Varma said. Whether the Atmanirbhar Bharat program will lead to a sustainable boost in exports and a steady decline in imports due to the import substitution strategy remains to be seen, she said. “So the sustainability of this increase in reserves is questionable.”

R Gandhi, a former deputy governor of RBI, said that the accumulation of foreign exchange reserves in India is largely due to the surplus of its capital account. Therefore, safety and liquidity must remain critical for reserve management.

Any alternative use of reserves that is often discussed may not be a welcome move, Gandhi said.

Collie agreed.

“Because these reserves are not created from current account surpluses, they are borrowed and do not actually belong to us,” Collie said. “In the event of a sudden capital outflow, these reserves are liabilities that we pay to accumulate them.”

One common demand is that India’s foreign exchange reserves can be used to fund infrastructure development in the country.

A similar idea arose in the past, in 2007, when India was thought to have adequate reserves, Varma said. RBI Deputy Governor Rakesh Mohan then opposed the idea. In addition, the global financial crisis of 2008 proved the instability of reserves as the country faced significant capital outflows.

“Are we making the same mistake if we extrapolate under the current conditions?” Varma asked.

According to Collie, any such alternative use of reserves for internal expenditure purposes would also have implications for domestic monetary policy. “Net foreign assets in rupees will be part of reserve money or base money and will have a potential monetary impact. Other consequences also remain unclear. “

Collie said any such move could set a bad precedent for future policy-making.

“Once you use a bad idea, you set a precedent for others and perhaps for less desirable use of foreign exchange reserves for years to come,” she said.

Add the golden touch to increase the return?

While any proposal to use foreign exchange reserves for spending in the economy is stepping on thin ice, there is reason to argue that RBI may need to monitor returns as the kitten grows.

With the exception of a small fraction of gold, foreign exchange reserves are invested in liquid assets such as US treasuries and euro-denominated bonds of other advanced economies. In most of these economies, interest rates fall to almost zero, with some securities even trading at negative yields.

“If you have exceeded a certain threshold that more than meets your liquidity needs, it is possible that, as you have sufficient liquidity coverage, you will start focusing on returns,” Varma said. This is not the main goal, but the secondary goal of central banks, she said. While RBI allocates a small portion of the reserves to external asset managers to invest in turn, perhaps this allocation could be increased, Varma suggested, adding that the central bank could also consider illiquid assets such as gold.

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

RBI’s gold assets remain conservative, even compared to other emerging economies. While Russia held 23% of its gold reserves until June 2020, Turkey’s gold holdings have risen to make up more than 45% of its foreign reserves portfolio, according to the World Gold Council.

Mohapatra does not oppose the idea of ​​RBI adding more gold to its portfolio of foreign exchange reserves.

Gold reserves can help progressively diversify India’s reserve portfolio, Mohapatra said. It can play a stabilizing role for India’s external position, given the uncertain global economic recovery, the prolonged period of near-zero or negative interest rates and loose monetary policies in developed economies and the “search for profitability” among international investors, which could lead to more -large instability of capital flows to emerging market economies such as India in the coming years, Mohapatra said.

Gandhi agreed. “Investment diversification is a key strategy, and gold is a key element.”