The curious case of India’s rising forex reserves and falling rupee
4 min read 12 Dec 2021, 10:41 PM ISTAny unintended further expansion of RBI’s balance sheet without normalizing credit offtake will only raise economic risks
PremiumFor the uninitiated, the Reserve Bank of India’s (RBI) balance sheet is a concoction of both domestic and international assets carefully modulated regularly. Importantly, foreign reserve assets contribute to over 70% of the central bank’s combined balance sheet and hence impact its operations more significantly. Therefore, while analysing RBI’s financial statement, one must understand that what is bad for the rupee might turn out to be good for RBI. This makes the rupee’s relationship with much of RBI’s asset side inversely proportional. A case in point is the fact that while RBI has accumulated an additional $61 billion since the start of the current financial year, the rupee has lost value.
From this perspective, perhaps the right way of looking at RBI’s balance sheet is to consider the composition of Reserve Money (RM) or base money. While on the asset side, RM is made up of net domestic assets (NDA) and net foreign assets (NFA), on the liability side, it is composed of Currency in Circulation (CIC) and Deposits made by banks. During normal operations, RBI must balance its balance sheet through a careful modulation of the two sides. In situations such as the one spawned by the covid crisis, however, the system goes haywire as RBI gets inundated by cheap money from overseas. This is because an accommodation-biased monetary policy not only leads to liquidity creation, but also a near-zero rate policy at most origin points of capital. This phenomenon is popularly known as ‘quantitative easing’.
Globally, as interest rate differentials with emerging markets increase, the liquidity created transforms itself into yield-chasing capital. India often finds itself as a major recipient of such hot money. In the market, the simultaneous buying of rupees and selling of dollars can lead to rupee appreciation and negatively impact the value of RBI’s NFA (as the dollar depreciates). But ongoing dollar inflows adjusted for volatility increase its NFA. However, since RM on the asset side is now higher, RBI adjusts the liability side by increasing CIC, thereby creating new money.
As soon as the output gap closes in the developed world, monetary policy normalization occurs, reducing the interest rate differential vis-à-vis emerging markets. During this phase, capital flight creates demand for dollars, depreciating the rupee. RBI intervenes in the open market to stabilize the rupee, selling some of its dollar reserves. While reducing its NFA, this process increases its NDA. A case in point pertains to the period 2009-10 and 2013-14, when NDA averaged nearly 33% of assets. RBI had intervened to support the rupee during those volatile times, as a great financial crisis unfolded amid strong domestic credit growth in the first episode, and as a global rate-differential shift led to outflows of capital in the second. Those were times when the fall in rupee’s exchange value induced a simultaneous reduction in foreign assets. As stability returned, RBI’s average NDA reduced to 24% on average, and a rising NFA even exceeded the central bank’s RM.
Theoretically, CIC already created leads to the formation of broad money with the help of a multiplier effect. The subsequent systemic liquidity can flow into RBI’s balance sheet through the liquidity adjustment facility, balancing out the asset side (repo operations) and liability side (reverse repo operations) as per the state of credit demand. An expanding economy and a rise in credit offtake results in a steady deposit rate. Resultantly, bank deposits with RBI in the form of a cash-reserve-ratio increase, completing the RM adjustment on the liability side.
Throughout the current crisis, however, the continuous inflow of foreign money increased foreign currency assets, creating new money that had nowhere to go. This conundrum was caused by weak credit offtake for much of the pandemic, along with rising deposits that force-fed commercial banks. RBI in turn also had to sterilize the system via massive reverse repo operations, increasing its Deposit account even further. Such was the situation that deposits were 26% of liabilities in 2020-21 and contributed vastly to RM. At the same time, RBI had to be careful of a depreciating dollar and its impact on NFA value. Note that CIC as a percentage of RM grew slowest since demonetization.
Fast-forward, with inflation’s “transitory" story becoming questionable, central banks globally have started talking about normalization. Even so, Indian markets, driven up to a large extent by domestic investors, have been attracting intermittent foreign-investor interest. While market volatility is creating a difficult situation for the rupee, for RBI’s balance sheet, such conditions are supportive. Global volatility involving outflows raises the value of foreign holdings on the asset side, and the liability side adjusts via the revaluation account without impacting RM, until the next deluge from abroad occurs. Unless RBI props up the rupee, once the momentary spikes subside, its foreign currency assets are set to appreciate in value.
Analysts therefore must be forewarned that accretion of foreign exchange reserves must be taken with a pinch of salt. Forex volatility is a reality in these times, as the economy will take time to function normally and new money created will merely invade RM as deposits. As credit offtake picks up, reverse repo operations will decline, opening space for an increase in CIC. This is often inflationary and may result in the rupee losing value. We must note that while the NFA/CIC proportion was fixed at 70% by the Tarapore Committee, the metric has breached 140%. Any further growth in NFA without simultaneous degrowth in deposits will create incremental CIC, expanding RBI’s balance sheet unintentionally. Also, in the event of rapid rupee depreciation, RBI will have no option but to use its reserves to safeguard the currency, exposing its balance sheet to external shocks. The frame of analysis that looks at forex reserves in terms of import coverage, therefore, seems outdated now, given the intricacies and uncertainties of a world with large capital flows.
Karan Mehrishi is the author of ‘The India Collective: What India is Really All About’
