India’s Swelling Forex Reserves

As the nation is rejoicing in the knowledge that India’s foreign exchange reserves, having touched an all-time high of $393.448 bn in the week to August 4, are surging towards the unprecedented $400 bn mark, the RBI must be rocking in the chair wondering how to keep rupee stable, make exports competitive and at the same time contain its underlying cost.

Before getting into the nitty-gritty of its effect on national economy and its effective management, let us first look at what the accumulating forex reserves portray. India, having emerged as the highest holder of Forex reserves among the countries with current account deficit, can certainly feel happy of its management of macroeconomic affairs, particularly its external sector. But these reserves do have their own costs and benefits, that too, of complex nature as they involve external security and strategic issues. From whatever information available from the reports, it becomes evident that these reserves are exposed to high currency—for mostly these assets are denominated in the US dollar—and liquidity risk, while credit risk and interest rate risk are relatively low.  In the recent past gold reserves too have gone up by $750 million to a high of $20.6 billion—a pointer towards the conservative stance (?) of the RBI.  All this could mean that the RBI must be making a negative return from these foreign currency assets.

The reason behind this negative return is obvious: the RBI must be paying more than what it is earning from its reserves while undertaking sterilization of dollar inflows, for the banking system is already saddled with huge rupee liquidity owing to the recently concluded demonetization. Indeed, banks are already facing the problem of paying interest on the suddenly swelled up deposits, more so in an environment where loans are not picking up. One of its unintended consequences is: the country’s largest bank has cut its interest rate on even savings bank accounts while the long-term interest rates on deposits have drastically come down.

As the RBI is struggling to cope with the demands of managing the surge in liquidity by undertaking open-bond market bond sales as well as long duration repos besides imposing additional costs on bonds under market stabilization scheme, foreign institutional investors have poured in $18.5 bn into Indian equities and bonds in the year through June. All this obviously raised stabilization costs of the RBI as a result of which its net transfer to the government in the form of dividend has almost halved from that of the budget estimates, which in turn is certain to disturb the fiscal math of the government for the fiscal 2018.

And this environment is likely to continue into the future, for India with comparably comfortable external debt indicators—external debt stood at $471.9 bn as at the end of March 2017 registering a fall of 2.7% from that of March 2016; ratio of external debt to GDP has come down from 23.5% as of March 2016 to 20.2% by March 2017; debt service ratio too has come down from 8.8% to 8.3%, while the coverage of debt provided by the foreign exchange reserves has gone up from 74.3% to 78.4%—is perceived to be among the less vulnerable countries. This trend is already palpable: outperforming its Asian peers, the rupee has gained a 16-month high of around 2% in March following the landslide victory of ruling party in the state elections.

One immediate effect of such an unabated inflow of forex is: theoretically, it raises the monetary base of the nation. It in turn means increased inflationary pressures. Obviously, to contain this inflationary pressure, the RBI must continue to sterilize its dollar purchases by issuing rupee bonds, which is an expensive affair, for the RBI gets a meagre return on its dollar reserves vis-à-vis what it has to pay on the rupee bonds.

Forex reserves thus entail a very high opportunity cost unless they are used for some productive purposes. One often resorted method of utilization is: investment in infrastructure projects, which could earn some decent return for the Central Bank besides adding wealth to the nation. This may, however, cripple the ability of the RBI in insuring against speculative attack on rupee. Further, there is also a school of thought which states that spending Forex reserves on non-traded goods is inflationary. It is interesting to know here that China, the world’s largest reserves holder—$3.12 tn— uses its reserves for investing in the overseas markets for acquiring assets.

Having said that, we cannot ignore the fact of a record Rs. 5 tn already lying as idle cash with the banking system. Which means there are no takers for bank credit. So, the need for using forex reserves for infrastructure investment does not arise. In the light of these complexities, RBI should get ready to use all its ingenuity including measures like increasing cash reserve ratio which alone can mop up liquidity with no underlying cost to the RBI, etc., to manage the swelling reserves so as to ensure that inflationary pressures are not allowed to surface derailing the growth prospects.