What $650 billion can buy

India’s foreign exchange reserves have gone up by over $160 billion since the beginning of the last fiscal year and are currently at about $640 billion. If the trend continues, India could soon have reserves worth over $700 billion. The country clearly has come a long way from the situation it faced in the early 1990s when it narrowly avoided a default. But now that India has one of the largest foreign exchange reserves, the debate has shifted to what it should do with the pool. It is often suggested that reserves should be used to finance infrastructure needs. But it’s not clear how this can be done. Foreign currency can be used to buy foreign goods and services, or assets. Thus, the use of reserves would mean that India will be importing a lot of equipment and material for building infrastructure. This is unlikely to be the preferred way and will have a variety of macroeconomic implications. 

Another option that is often suggested is forming a sovereign wealth fund, which would allow India to buy assets overseas. It is also argued that the Reserve Bank of India (RBI) should diversify its investment to increase yields. Since it invests in highly liquid assets, such as US government securities, returns are usually low. Returns may have suffered further because of lower interest rates in developed markets. On the face of it, the argument makes sense, but the central bank may not have the wherewithal to make investments in stocks or high-yield bonds. Besides, this will increase risks and could potentially defeat the purpose of holding reserves.
 

In this context, it is important to recognise that India has not built its foreign exchange reserves by running a current account surplus. India regularly runs a current account deficit, which means it is a net importer of goods and services from the rest of the world. India’s reserves essentially reflect the excess flow of capital, and part of it could get reversed fairly quickly. According to the RBI’s latest report on foreign exchange reserves, the ratio of volatile flows to the reserves is over 65 per cent. India’s reserves went up sharply over the last 18 months or so because of higher capital flows. Excessively accommodative monetary policy in advanced economies, particularly the US, led to a higher flow of capital. In the given situation, the RBI did well to actively intervene in the currency market to build reserves. A lower level of intervention would have resulted in an unnecessary appreciation of the Indian rupee, which is anyway overvalued in real terms, and affected India’s external competitiveness. 

Intervention in the currency market also helped as it added to the rupee liquidity in the system and enabled the RBI to push market interest rates lower during the pandemic. But the tide may now be turning. The US Federal Reserve has decided to “taper” its asset purchase programme, and higher inflation could force it to tighten monetary policy sooner than anticipated. This could result in tightening of global financial conditions, and capital could flow out from a country like India, at least temporarily. Although India is in a much better position compared to the “taper tantrum” episode of 2013, it could still see significant outflows as global money managers adjust their positions to the changing interest rate environment. Portfolio managers tend to sell more in large markets as it is relatively easy to do so without affecting prices disproportionately.

The advantage of having large reserves in such a situation would be that the RBI will be in a position to quell volatility in the currency market, which would discourage traders from betting against the rupee. A fall in currency triggered by large capital outflows can become self-fulfilling and pose risks to financial stability. Thus, the most valuable thing that higher reserves can buy in the given global economic environment is financial stability. However, too much of it can also pose problems. Besides, higher reserves should not be seen as a substitute for policy prudence. India’s biggest vulnerability at this stage is its fiscal position. Although the deterioration was unavoidable because of the pandemic, both foreign and domestic investors would be keen to see how effectively India gets back to a longer-term sustainable fiscal path. A significant delay, among other things, would increase growth risks and affect capital flows.   

While higher reserves provide stability on the external account, the RBI cannot endlessly keep accumulating foreign exchange because of its own set of policy complications. Higher reserves can potentially attract more capital flows and make currency management difficult. This would keep putting upward pressure on the rupee and affect India's competitiveness. Sustained intervention by the RBI will push up the level of rupee liquidity in the system and increase inflation risks. Continued sterilisation has its own costs. 

Therefore, instead of heavily intervening in the currency market, which has its limitations and costs, India can revisit the kind of foreign flows it needs. Foreign direct investment and equity flows should be preferred to debt. India’s stock of external commercial borrowing, for instance, is in excess of $200 billion. The policy establishment, however, is moving in the other direction. It is aiming to get government bonds included in global bond indices. This will increase the flow of debt capital, which is not desirable at this stage, and would make foreign exchange management more difficult. This would also increase India’s exposure to external shocks. Although the RBI has done well in managing the currency market, policymakers must align the capital account to broader macroeconomic objectives.