India's forex reserves can be used for infra investment, say economists

As on September 18, India's foreign exchange reserves stood at $541.67 billion

The Reserve Bank of India (RBI) could be nearing the end of its reserves accumulation as costs may slowly be beginning to outweigh the benefits. To reap these benefits, some reserves could be used for local purposes, experts say.  

As of September 18, India’s foreign exchange (forex) reserves stood at $541.67 billion. Reserves have risen at the fastest clip on record in the past one year. 

Deutsche Bank India’s Chief Economist Kaushik Das estimates that the reserves could rise to $575 billion. However, the adequate level of reserves to cover external volatility could be just $300-325 billion, according to Dhananjay Sinha, director research of Systematix Institutional Equities.

Both Das and Sinha advocate using the reserves for local purposes. Sinha argues that reserves could be about 50 per cent more than what is required, and the surplus can be used to improve infrastructure.   

The RBI would still buy forex reserves, but not as aggressively, as the foreign fund flows could slow amid costly equity valuations, says Indranil Sen Gupta, India economist of BofA Securities. According to him, reserves are now just about adequate, but the scope for accumulating more is limited and RBI might want to grow reserves to about $550 billion.    

“Risk-off sentiment could take hold again because of the coronavirus and reversal of the US dollar weakness. RBI has to be prepared for any sudden reversal of flows, which the current level of forex reserves ensures,” Sen Gupta said.  The accumulation has to be viewed in a global context, said Sameer Narang, chief economist of Bank of Baroda. 

Japan and China, too, have seen large increases in their reserves this calendar year. 

“While the rupee has appreciated in the last three months, it is still lower compared with its value at the beginning of the calendar year. Thus, RBI’s intervention has been able to ensure the right balance for exporters and importers,” Narang said. 

Whether reserves should be used for fiscal spending is a contested issue. RBI has shown no inclination to part with its reserves in the past, whereas the government has demanded that some amount be used to build infrastructure, or even capitalise government-owned banks. 

In the past, experts had sided with RBI. But they are beginning to side with the government now.   

According to Sinha, India could witness $100 billion of yearly capital flows in the next couple of years because of excess global liquidity, compared to an average of $70 billion over the past three years. The increased flow has pushed the balance of payment towards surplus.

KEY TAKEAWAYS 

• RBI’s forex reserves could be 50 per cent more than needed, estimate some economists
• Most of the reserves accumulated due to portfolio flows
• The excess reserves could be used for domestic infrastructure purposes
• RBI could be nearing the end of its reserves accumulation
• The cost of holding reserves could be outweighing the benefits
• Some say as oil prices rise in the coming days, the reserves may not look as high

“The rise in reserves is not just a function of endogenous capital flows. There is also evidence of currency inflexibility and proclivity of RBI to accumulate reserves since 2013. Continued bloating of forex reserve will dominate incremental base supply, which will require sterilisation as it can shore up inflation. But the problem is also compounded because of the need to manage G-Sec yields in the wake of rising fiscal deficit in the aftermath of the pandemic,” said Sinha. 

Since 2014, the rupee has become considerably overvalued, according to Sinha. This is partly because of policy inflexibility, and the situation will get complicated with the depreciation of the dollar, he added. 

Deutsche Bank’s Das argued this point recently.  “With India’s reserves adequacy having strengthened significantly and with reserves likely to increase, there should be a debate on whether a small part of such reserves can be used for funding growth-critical strategic (particularly health related) infrastructure investment,” Das told Business Standard.  

However, both Sen Gupta and Narang argued that with the rise in oil prices, the reserves might not seem so large after all. “The large intervention is driven by a sharp decrease in India’s trade deficit as a result of lower imports, in particular, non-oil-non-gold imports. With gradual unlock of the economy, imports will increase. Hence, demand and supply of US dollars will balance, reducing the need for intervention,” said Narang.