BackThe fiscal cost of RBI’s bulging foreign exchange stash
We have more than we need and reserves invested in foreign bonds get us very low returns
PremiumIndia has faced four major global economic shocks over the past 25 years. The current shock is the only one which has not led to panic selling in the foreign exchange market. Each of the other three shocks saw the Reserve Bank of India (RBI) dipping into its foreign exchange reserves to counter immense selling pressure on the Indian currency. Many other emerging markets have had a similar experience this year.
A look at changes in Indian foreign exchange reserves during each episode is instructive. I have considered only foreign currency assets without counting holdings of gold or special drawing rights, since they give a better idea of international financial flows in and out of the Indian economy. Holdings of gold are particularly sensitive to movements in the international price of the yellow metal.
The first episode was the Asian financial crisis of 1997. India’s foreign exchange reserves went down by $3 billion between November 1997 and July 1998. The second episode was the North Atlantic financial crisis of 2008. Sudden capital outflows from India meant that foreign exchange reserves in October 2008 were $50 billion less than their level in May 2008. The third episode was the taper tantrum in 2013. Indian foreign exchange reserves fell from $263 billion in May that year to $246 billion in September, a loss of $17 billion.
Now look at the numbers in the ongoing pandemic year. The foreign currency holdings of RBI have gone up from $439 billion in early April 2020 to $533 billion at the end of November 2020, a massive increase of $94 billion in the first eight months of the pandemic. The reason for this is well known. India has seen strong inflows of global capital this year, even as the current account has moved into surplus territory.
India may end this financial year with a balance-of-payments surplus of close to $100 billion. And while the external balance for the financial year ending 31 March 2022 is not clear, most investment banks are forecasting a large balance of surplus of another $60-80 billion, as foreign capital inflows continue to be strong even as the current account records a smaller surplus or perhaps slips into a minor deficit. What this basically means is that India could have foreign currency reserves of close to $650 billion by 31 March 2022, and foreign exchange reserves totalling $700 billion.
It is important to see this number in context. It will be around a quarter of India’s gross domestic product (GDP) by the end of 2021-22. The foreign exchange reserves will also be more than adequate when considered in the context of three measures—the monthly import bill, foreign exchange debt, and broad money. The thumb rule is that foreign exchange reserves should cover at least six months of imports, be enough to repay the entire foreign debt maturing within a year, and be equal to around a fifth of the broad money in circulation in an economy. The range of potential pressure points on the balance of payments can be broadened to include possible outflows of portfolio capital invested in the stock market, as well as a decline in export earnings or an increase in the import bill because of a shock to the terms of trade.
The reserve accumulation over the past five years is more than enough to cover such precautionary motives. India has enough hard currency in its kitty to withstand a global shock. Yet, the Indian central bank will have to keep buying dollars to prevent an appreciation of the rupee, which is already overvalued by some metrics because of high inflation in India.
This intervention tends to push up domestic money supply, at least to the extent that it is not sterilized through sales of government bonds to soak up excess liquidity in the money market. Reserve money has already increased by ₹4 trillion in first eight months of the ongoing financial year. A central bank in a country with an open capital account has to eventually choose between targeting the exchange rate and targeting domestic money supply.
There is a broader lesson here. The traditional view was that the Indian economy was constrained by a lack of foreign exchange to import fuel, food and machines needed to keep the economy on track. Economists of an earlier vintage were taught to habitually think of foreign exchange as a scarce resource. That assumption has been upended. India has not had a balance-of-payments crisis since 1991, and for most of the past two decades has been holding more foreign exchange than is required as insurance. It is akin to the government holding more food stock than is needed as a strategic reserve, an operation that imposes significant fiscal costs.
The size of the Chinese economy in 2006 was similar to that of the Indian economy before the pandemic hit—and what it will revert to by the fourth quarter of 2021-22. China at that point of time had foreign exchange reserves of around $1 trillion, though these were based on massive trade surpluses rather than capital inflows. Yet, the fact that India is now getting more international capital than our economy can currently absorb is a hard truth.
Holding excess foreign exchange reserves involves fiscal costs. Sterilized intervention in effect means that RBI is replacing high- yielding Indian securities with foreign bonds that offer interest rates that are close to zero. The central bank is thus deeply engaged in a complicated balancing act, as it was in similar earlier episodes as well.
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