Forex has helped avert a currency run, but continuous inflow has its risks

At a time when India is facing stagflation, its forex reserves have helped avert a currency crisis, but there are unintended consequences of accumulating forex. Manojit Saha explains the risks

From a low of $275 billion in September 2013, when the country had a run on its currency, India’s foreign exchange reserves have more than doubled in the past eight years to $605 billion. Only three countries in the world have substantially higher forex reserves than India – China, Japan, Switzerland. As on June 4, Russia’s and India’s reserves were at almost the same level; these could swing either way in the coming weeks and months.
 
Between 2014 and 2020, while India’s forex reserves grew in all years but one (2018), the year 2020 saw the highest build-up of reserves – almost $128 billion, on top of $89 billion in 2019.

 
The US treasury department put India under its currency manipulator watch list in December last year, saying India, along with three other countries, intervened in the foreign exchange market in a sustained and asymmetrical manner. The rupee was the worst-performing currency in Asia in 2020, mainly due to a heavy intervention by the Reserve Bank of India (RBI) amid robust inflows.
 

So far this year, RBI’s forex kitty has swelled by close to $20 billion.
 
It’s true that forex reserves act a cushion for the domestic currency against external shocks like a war or a sudden surge in oil prices. The present level of reserves could provide an import cover for about 15 months. At a time when the country is facing stagflation – a contraction in growth and inflation rising, with interest rates continuing to be benign – there was a risk of another currency crisis. That did not happen because the country’s ample forex reserves gave the central bank ammunition to act against undue volatility in the currency market.

 
“Under ordinary circumstances, if RBI was to keep interest rates low at a time of stagflation, we could have risked a currency run,” Ananth Narayan, senior India analyst at Observatory Group, told Business Standard. “But with $600 billion of spot and forward purchases, the RBI has the ability to manage a currency crisis. There is no question of a currency crisis now because we have so much of reserves.”
 
“The central bank very clearly perceives our very significant forex reserves as the first and primary line of defence against global spillover risks,” according to Suyash Choudhary, head of fixed income at IDFC AMC.

 
“With this war chest in place, it (the RBI) finds more room to pursue looser financial conditions locally as it deems currently appropriate in the local context, without worrying as much about external dependencies. Of course, this can only be done within reason and doesn’t mean that the RBI can insulate the local market from offshore-led tightening of financial conditions, should one come about,” Choudhary said.
 
But is accumulating foreign exchange reserves totally risk-free? No, that also has a cost. There are unintended consequences in terms of the central bank’s policy-making flexibility.
 
There are two ways the central bank intervenes in the forex market – through the spot market and in the forward market. An intervention in the spot market — where the RBI buys dollars and gives away rupee — adds directly to the foreign exchange reserves. If the central bank does not want the dollars immediately, it has the option to intervene in the forward market, where these can be rolled over during maturity.

 
Since the beginning of 2021, the central bank was intervening mostly in the forward market. According to currency dealers, the intervention strategy changed in the past three months or so and the central bank was seen intervening more in the spot market. One of the reasons for unwinding the forward book was to the reduce the hedging cost.
 
Now, as the RBI mops up dollars by intervening in the spot market, its balance sheet expands. The Economic Capital Framework, formulated in August 2019 to form a basis for the RBI’s surplus distribution policy to the government – mandates a contingency reserve of at least 5.5% of its balance sheet. This implies the more its balance sheet expands, the more funds the RBI has to allocate to the contingency reserve. That essentially results in a lower surplus transfer to the government.

 
“The issue of maintaining adequate capital buffers has been eating into the dividend payments for the past two years, and we reckon the RBI will continue to set aside more contingency buffers in the coming years as its balance sheet grows further,” said Rahul Bajoria, chief India economist at Barclays.
 
There is also a second problem that might arise on account of a high accretion of forex reserves. The economic capital is calculated on the basis of the rupee’s appreciation and depreciation. If the rupee appreciates on top of an expansion in the RBI’s balance sheet, things will get more complicated. In such a scenario, meeting the 20.5 per cent economic capital mandated by the Economic Capital Framework will be difficult. This will force the central bank to stem the rupee’s appreciation by buying more dollars by selling the rupee in the market; that will lead to a further increase in forex reserves.

 
“The RBI has been dealing with the ‘impossible trinity’ (of free capital flows, exchange rate management and monetary policy autonomy) for some time. In the past 12 months, it has grappled with this trilemma. In the current circumstances, we believe having a stable currency with cheaper hedging costs, allowing the RBI to undertake delivery of their forward contracts, becomes a priority,” Bajoria said.
 
Of the aspects of the ‘impossible trinity’, policymakers can choose only two macroeconomic objectives, not all three. And, the third arm of the trinity, interest rates. Is crucial. As the RBI keeps on buying dollars by giving away rupee, it increases domestic money supply which could stoke inflation.

 
As Ananth Narayan says, M1 — the currency in circulation plus current and savings account — has grown by over 15 per cent annually in the past two years. “Despite the economy contracting, our money supply has increased quite a bit. While at the moment these look more like supply-side issues than demand-side, all this money could lead to inflation as and even the economic activity resumes. Because interest rates are so low, the inflow of so much money can cause asset price inflation and import of assets like gold,” he said.
 
If RBI wants to increase interest rates to control inflation, growth revival —which is at a nascent stage — will be hit. The central bank, maintaining an ultra-loose monetary policy since the Covid-19 pandemic broke out in March last year, has ruled out any normalisation of its policy. It has assured that an accommodative stance of the policy will continue till growth revives on a sustainable basis, even as inflation has started creeping up, as seen in the recently released May retail inflation numbers.