India's high foreign exchange reserves not enough to shield rupee

A sharp rise in oil import bill has led to a big decline in forex reserves to imports in FY22

With crude oil touching $90 a barrel in international markets, India’s record foreign exchange (forex) reserves of $634 billion may not be enough to shield the rupee from the adverse effects of a spike in oil prices.

There has been a sharp rise in India’s overall import bill in the first nine months of FY22, leading to a decline in import cover despite record forex reserves.

Forex reserves at the end of December 2021 were equivalent to 12.8 months of India’s merchandise imports, down from a record high of 17.7 months in FY21.

The ratio is expected to decline further as Brent crude oil price averaged $74 a barrel in the first nine months of FY22, nearly 18 per cent lower than the current price of around $90 a barrel (see the adjoining chart).

Many analysts say India requires much higher forex reserves to shield the economy from a further spike in crude oil prices.

“Our estimate of India’s requirement of optimal forex reserves has surged to $659 billion from the post-Covid low of $270 billion in April 2020 on the back of higher volatility in the current account deficit and rising India-US short-term interest rate differentials,” wrote Dhananjay Sinha, managing director and chief strategist, JM Finance Institutional Equity.

India’s forex reserves are not only around $25 billion lower than the optimal requirement, they are down from a peak of $642 billion at the end of October 2021.

“This has resulted in forex reserves/monthly imports (ratio) declining from 24x in April 2020 to the current 12x,” Sinha said.

This is likely to keep the rupee under pressure in the forex market.

“With oil prices touching $90 a barrel, the rupee is likely to come under renewed pressure. Higher oil prices imply a larger import bill, which is negative for the rupee. We estimate that a 10 per cent hike in oil prices leads to a $15 billion increase in the current account deficit,” said Madan Sabnavis, chief economist, Bank of Baroda.

Historically there is a high negative correlation between the import cover of India’s forex reserves and the crude oil prices. For example, import cover had declined to a low of 7.2 months during 2011-12, when the price of the Indian crude basket reached an all-time high of $112 a barrel.

India’s crude oil imports were up 119.2 per cent on a year-on-year basis to $118.3 billion during April-December 2021, up from the $54 billion during the same period in FY21. At this rate, India oil import bill is expected to be around $158 billion in FY22, just a notch below the all-time high of $165 billion in FY14.

The price of the Indian crude basket was up 85 per cent year-on-year during the period from an average of $39.3 a barrel in the first nine months of FY21 to $72.8 a barrel in the equivalent period of FY22.

A higher import bill for oil also led to a sharp rise in the country’s overall imports and a big increase in the trade deficit and the current account deficit.

India’s overall goods imports were up 69 per cent y-o-y from $263 billion in April-December FY21 to $444 billion in April-December FY22. The overall trade deficit during the period shot up to $142.4 billion in April-December FY22 from $61.4 billion in April-December FY21.

Most analysts now expect a sharp rise in India’s trade deficit and current account deficit. Sabnavis expects the current account deficit to widen to around 2 per cent of GDP in FY22 from a surplus in FY21. Sinha, on the other hand, anticipates a rise to 4 per cent of GDP in the second half of FY22 from around 3 per cent in the first half of FY22.