Ample reserves are a source of comfort, but there are costs in managing them as well as risks due to debt and hot money flows
The build-up in foreign exchange reserves to $610.01 billion as on July 2, an increase of around $33 billion over March 2021 and $96.8 billion on a y-o-y basis, comes amid an overall decline in India’s macroeconomic performance. The accumulation of reserves has its benefits as well as associated costs, raising complex questions and dilemmas on the trade-off between the quantum of reserves and the costs of managing them.
The components of the forex reserves as on July 2include the foreign currency asset or ($567 billion), gold ($36.4 billion), special drawing rights or SDR ($1.6 billion) and reserve tranche with IMF ($5.1 billion). Reserve assets constituted 67.2 per cent of the total international financial assets and 21.4 cent of GDP as on March 2021.
The reserves build-up entails a fiscal cost of sterilisation. Thus, it raises questions relating to how much of reserves are adequate, debt as a key constituent of these reserves and, above all, the low rate of return on the investment of these forex reserves vis-a-vis the fiscal cost.
There are reports of the RBI contemplating the use of outside experts to manage the reserves to better manage returns. On the positive side, the build-up of reserves helps meet the challenges of the balance-of-payments (BoP) along with the pressure on depreciation in the exchange rate, thereby providing a source of comfort in addressing disorderly market conditions.
A look at the trends in the increasing reserves in nominal terms (including valuation) reveals that on four occasions there were significant reserves built up — 2007-08 ($101 billion), 2017-18 ($83 billion), 2019-20 ($66 billion) and 2020-21 ($103 billion) — which aggregated $353 billion, accounting for nearly 61.2 per cent of the total reserves (up to March 2021).
In terms of BoP transactions (excluding valuations), it was only in 2020-21 that the contributing factors for the accumulation of forex reserves were the current account surplus ($23.9 billion) and net capital flows ($63.7 billion). On the other three occasions (2007-08, 2017-18, 2019-20), the net capital inflows contributed to forex reserves after meeting the current account deficit.
Period of declines
In contrast to this, in the period immediately after the global financial crisis, there were three episodes of decline in forex reserves — in 2008-09 ($20.1 billion), 2011-12 ($12.8 billion) and 2018-19 ($3.3 billion). The decline in forex reserves was on account of a higher current account deficit and lower net capital flows.
During 2020-21, the increase in reserves on BoP basis (excluding valuation) amounted to $87.3 billion. However, including valuation gains, due to the depreciation of the dollar against major currencies, increase in forex reserves aggregated $99.2 billion. Such an increase in the flow of reserves has resulted in an appreciation of the rupee against the dollar (on a point-to-point basis) by 2.5 per cent. The Reserve Bank, to maintain an orderly condition in the market, intervened both in the spot (net purchase of $68.4 billion) and the forward market (outstanding net forward purchase of $72.8 billion) in 2020-21.
The net purchase of foreign currency by the RBI has monetary policy implications in terms of increase in currency in circulation (15.2 per cent), increase in Net Foreign Currency Asset (9.1 per cent) and increase in reserve money (15.2 per cent) on a y-o-y basis. In addition to regular fixed reverse repo operations, the RBI conducted open market operations, variable 14-day reverse repo operations and twist OMO (simultaneous purchase and sale of government securities) to absorb the excess liquidity.
In BoP parlance, capital flows include equity flows (mainly foreign direct investment and portfolio investment) and debt flows (essentially consist of external commercial borrowing or ECB, NRI deposits, trade credit and portfolio debt investment). As per the IIP, debt liabilities account for nearly 48 per cent and carry the risk of debt service (repayment and interest payment). Portfolio equity investments are known as “hot” money or speculative money and as on March 2021, these flows accounted for 23 per cent of total liabilities. Thus, the forex reserves build-up has the potential risks of growing debt liabilities and facing the vagaries of “hot” money.
The Reserve Bank of India Act, 1934, provides an overarching legal framework for the deployment of reserves in different foreign currency assets (FCA) and gold. By end-March 2021, out of the total FCA of $536.69 billion, $359.88 billion or 67.1 per cent was invested in securities, $153.39 billion or 28.6 per cent was deposited with other central banks and the BIS and the balance of $23.43 billion or 4.4 per cent comprised deposits with commercial banks overseas.
According to the RBI Annual Report 2020-21, the income from foreign sources decreased by 2 per cent from ₹82,367.02 crore in 2019-20 to ₹80,715.82 crore in 2020-21. The rate of earnings on foreign currency assets was at 2.10 per cent in 2020-21 as compared with 2.65 per cent in 2019-20.
Sterilisation of liquidity
What is important in this context is the fiscal cost of sterilisation of durable liquidity emanating from capital flows. If we take into account only the fixed overnight reverse repo, which carries an interest rate of 3.35 per, the fiscal cost thus works out to 1.25 per cent (3.35 per cent minus 2.10 per cent). But the fiscal cost works out to be much higher if the OMO purchase/sale of securities is considered. Thus, the fiscal cost is a burden when we build up forex reserves. This is essentially the outcome of interest rates abroad being lower than the interest rates in India.
Another important aspect is the adequacy of forex reserves. Our reserves can meet 17.5 months’ imports as against the benchmark of three months. The Guoditti-Greenspan rule, however, suggested “liquidity-at–risk” to measure adequacy of reserves. The rule states that a country’s reserves should equal short-term external debt (residual maturity), implying a ratio of reserves-to-short term debt of one. In our case, reserves were 2.23 times of short-term debt in 2020-21.
This provides comfort given the market situation in a globalised world that is going through conditions that are not stable. This comfort helps the nation address the volatility of the exchange rate by protecting the rupee from speculative attack, but this cover comes at a significant cost.
Given this, the current forex management structures may be allowed to continue with a careful scrutiny of ways and means to push up returns. But any attempt to “milk” the reserves for higher returns with wildcat changes like bringing in outside agencies to manage returns will inject a new source of risk, and this is an experiment that may well be avoided in these volatile times.
The writer, a former central banker, is a faculty member at SPJIMR. Views are personal. Through The Billion Press