Are our foreign exchange reserves sufficient?
The growing foreign exchange jackpot has created an abundance problem for the Reserve Bank of India. It attracts unwanted attention, as well as calls for the use of reserves to finance infrastructure spending, capitalize public banks and better management of assets on reserves.
The RBI’s latest monthly bulletin attempted to bring the discussion to another channel by pointing out that reserves may not be as strong as people think.
The report, while highlighting the $ 600 billion mark for foreign exchange reserves, pointed out that India currently holds the fifth largest foreign exchange reserves, the twelfth largest holding of US Treasury securities and the tenth largest. gold reserves.
But the central bank also made two other observations alongside. First, he said that the 15-month import coverage provided by our reserves compares poorly with other countries with large foreign exchange reserves like Switzerland (39 months), Japan (22 months), Russia (20 months) and China (16 months). Second, the net international investment position of -12.9 percent of GDP should be taken into account when assessing reserve adequacy.
It is not easy to assess the adequacy of a country’s foreign exchange reserves. As the IMF states, “Assessing the appropriate level of reserves to hold is a challenge, not only because of the multiple roles that reserves play, but also because of the complexity of quantifying external risks and vulnerabilities, and the complexity of quantifying external risks and vulnerabilities. opportunity cost which each country faces ”.
That said, the conventional ratios used to assess the adequacy of foreign exchange reserves show a marked improvement now, compared to two years ago. Moreover, given that the central bank will have to continue to intervene in the market in order to maintain the stability of the rupee, reserves are expected to increase further.
There is no need, however, for the RBI to get on the defensive in the face of growing reserves. Rather, it should look for ways to use reserves optimally.
Are the reserves sufficient?
The debatable question is: what is the correct way to assess the adequacy of reserves? The metrics used for this purpose have evolved with the evolution of the composition of the external account over the years. Many committees set up by the RBI have deliberated and improved these, suggesting the measures most relevant to the country.
While the trade-based measure, such as import coverage, was most popular before 2000, the use of debt-based indicators became more relevant as external debt increased. The predominance of foreign portfolio flows in the capital account also made it necessary to measure reserves in the context of these flows.
Considering the import coverage provided by foreign exchange reserves now, it was 15 months towards the end of last month. While the RBI has pointed out that coverage is much lower compared to other countries, a better way to analyze the number will be to compare it with past data. The current import coverage is, in fact, a great improvement over the coverage we had historically. For example, the import coverage in March 2019 was 9.6 months and in September 2013 it was 6.6 months.
Another measure used to measure foreign exchange reserves – the ratio of short-term debt (based on original maturity) to reserves – has also improved in recent times. This ratio fell to 17.7% towards the end of December 2020, from 26.3% in March 2019. It peaked at 34.2% in September 2013.
While the RBI is not wrong to point out that we have more external liabilities than external assets in the PEG, the higher holding of reserves currently, reassures on one of the most volatile components of our external account, portfolio flows. The ratio that takes into account more volatile portfolio flows – the ratio of volatile capital flows (including cumulative portfolio inflows and outstanding short-term debt) to reserves – improved to 67% in December 2020, compared to 86.7% in March 2019 or 97.3% in September 2013.
The accumulation of reserves can continue
Given the position of global central banks to continue buying bonds and keeping interest rates ultra-low, global investors are expected to stay afloat, at least until the first half of 2022 and research higher yield and better growth bring these investors into the Indian equity and debt market in the near future. The RBI will have to keep buying dollars in this scenario to keep the rupee’s movement stable.
The increase in reserves is therefore largely due to the policies of other central banks and it is not necessary for the RBI to be defensive against the accumulation of reserves. As Governor Shaktikanta Das said at Nani Palkhivala’s memorial conference in January, “EMEs usually stay at the reception. In order to mitigate the global fallout, they have no recourse but to build up their own foreign exchange reserves, even at the cost of being included in the currency manipulator list or the US Treasury watch list. I think this aspect requires better understanding from both sides so that EMEs can actively use the policy tools to overcome challenges related to capital flows. “
In addition, with most central banks likely to begin normalizing monetary policy by 2022 or 2023, deleveraging and risk-free trading can lead to volatility in financial markets and the reserve cushion will be useful in absorbing more. such shocks.
The central bank should, however, begin to seriously consider diversifying the assets held in its reserves away from US Treasury securities that pay no interest and also carry the risk of capital loss. Engaging an external consultant to recommend an appropriate allocation is the way to go to get the most out of reserve holdings.