Building currency buffers in the new world

If FY23, crude oil prices were to average $120 a barrel, our current account deficit could rise to 3.8 per cent of GDP. Until the quality of our external balance improves, India needs forex buffers

The Bank of Russia (BoR) grew its forex war chest to $643 billion in December 2021, from $350 billion in 2015. As of June 2021, it held just 7 per cent of its assets in the US. Instead, it denominated 32 per cent of its reserves in EUR, 22 per cent in gold, and 13 per cent in the Chinese Yuan. In February, BoR seemed prepared for US sanctions, but Russia’s economy is now under immense strain.

The Reserve Bank of India (RBI) holds a record $682 billion in forex buffer. What should we learn from BoR’s experience? Does RBI hold “too much” in reserves? Should it review where it deploys these assets?

India’s trade deficit may register a record $200 billion in FY22; and $150 billion of this deficit will be bridged by services trade surpluses and remittances. That would still leave an energy and consumption-oriented current account deficit (CAD), to be funded either by capital inflows, or by RBI’s buffers.

Brent crude oil averaged $102/barrel between FY09 and FY14, and our CAD stayed high at 3.1 per cent of GDP. With crude oil prices averaging $55/barrel between FY16 and FY21, CAD dropped below 1 per cent of GDP. If FY23 crude oil prices were to average $120/barrel, our CAD could rise again to 3.8 per cent of GDP. Till the quality of our external balance improves, we need buffers.

How much by way of buffers do we need? Between FY07 and FY11, RBI’s buffers were over 20 per cent of GDP. Despite the global financial crisis and high energy prices, therefore, the markets stayed reasonably stable till FY11. However, as buffers dipped below15 per cent of GDP in 2013, our financial stability was threatened.

Today, thankfully, our buffers are at 22 per cent of GDP. This gives us immense degrees of policy freedom and buys us time -- as it did during FY09-FY11. During this time, we must either hope that energy markets calm down, or create jobs, output, and exports. As FY13 showed us, hope is not a great strategy. We now need Atmanirbhar Bharat to succeed.

Considering BoR’s experience, how should RBI deploy its buffers?

There is much hand-wringing about western weaponisation of trade and finance. However, what options remain outside of Western currencies? While China accounts for 15 per cent of global trade, do we really want to hold assets in Chinese Yuan? To paraphrase Winston Churchill, fiat currencies issued by democracies are the least reliable, except for those issued by all other forms of government.

While there are ideas for an alternative exchange system, it’s unlikely that the West will relinquish the status quo. The other option that is periodically floated is that RBI should deploy its buffers to fund India’s infrastructure investments. Such suggestions reflect a lack of understanding of how reserves work. In addition, there’s a financial services ecosystem available to provide commercial credit and forex.

What about diversifying reserves away from currencies? While gold is an option, without access to other currencies, BoR’s large gold reserves themselves may be of limited use. In any case, Indian households reportedly hold $1.5 trillion of gold. We hardly need RBI to add to our weakness for a non-productive asset.

One option is to use some part of our buffer to build a strategic crude oil reserve. While the value of crude oil holdings would be volatile, this would serve as a “right-way” mitigant for India’s underlying economic risk as a big energy importer. Unlike gold, oil can also be deployed in the real economy, if needed.

But there are objections. For one, the International Monetary (IMF) doesn’t count oil holdings as central bank reserves. There’s also the question of ownership and logistics — between the RBI, government, and oil majors. When we reflect that it makes more risk-management sense to hold $44 billion worth of crude oil than $44 billion of gold, these operational issues may be worth addressing.    

The writer is Associate Professor at S P Jain Institute of Management & Research, and Senior India analyst, Observatory Group LLC