A $700 billion war chest: India's external sector needs skilful management

Increasing geopolitical tensions in West Asia have put pressure on the Indian rupee, which breached the 84 mark against the US dollar last week. There are primarily two reasons why the rupee could witness volatility if the conflict escalates. First, the conflict could increase risk aversion among foreign investors, resulting in capital outflows. Second, it could potentially disrupt the supply of crude oil, leading to a significant increase in prices. Since India imports the bulk of its crude oil needs, this could increase dollar demand. Higher energy prices are always a risk for India. While oil prices are currently within a manageable range, India seems confident of dealing with global financial and energy market volatility. One of the key sources of this confidence is its massive foreign exchange reserves. It crossed the $700 billion mark recently.

Higher foreign exchange reserves and active intervention by the Reserve Bank of India (RBI) have kept volatility in the currency market contained. The rupee has depreciated by just about 1 per cent since the beginning of the year. In fact, some economists argue that the volatility is too low. There are various reasons for accumulating large reserves, and India has consistently pursued this approach since liberalisation, with only brief periods of exception. The official stance of the RBI is that it intervenes in the foreign exchange market primarily to contain volatility.

Foreign exchange reserves provide insurance against sudden outflows. Since India is getting more integrated with the global economy, it will need large reserves to manage global shocks that could trigger large outflows, potentially increasing volatility in the currency market and impacting real economic activity. For instance, the RBI used its reserves to manage extreme volatility in 2022 when a surge in commodity prices due to the Ukraine war widened the trade deficit.

Meanwhile, the coordinated monetary tightening by large central banks, led by the US Federal Reserve, resulted in large capital outflows. Foreign investors sold stocks and bonds worth over $30 billion between January and June 2022. While dealing with this twin shock, India’s foreign exchange reserves declined from about $635 billion at the beginning of 2022 to about $525 billion by October. Although part of the decline may have been because of the revaluation effect, owing to heightened volatility in global currency markets, the RBI could contain volatility in the rupee because it had large reserves and was willing to use it. Crucially, large reserves can help avoid the self-fulfilling aspect of capital outflows. In this context, a new research paper by economist Chetan Ghate and others, which looked at data in detail, notes that reserves lower the outflow of portfolio capital in the event of global financial distress. It also reduces the volatility of debt portfolio flows in case of relative policy interest rate shocks. Overall, the results show that additions to reserves reduce the economy’s exposure to global financial market risks.

Another paper by RBI Deputy Governor Michael Patra and others, published in the RBI’s June 2022  bulletin found that there is a 5 per cent chance of portfolio outflow worth 3.2 per cent of gross domestic product, or $100.6 billion, in a year in response to conditions like Covid-type contraction in real output, the global financial crisis-like decline in interest rate differential with the US, and a surge in the volatility index. In an extreme risk scenario, outflows could be much higher. Since India runs a current account deficit — which is perfectly fine given its investment needs— and reserves have not been accumulated by running a trade surplus, there is a strong case for holding higher reserves to deal with global shocks like the one witnessed in 2022.

Higher reserves also provide policy freedom. For instance, India has been running a large general government budget deficit in the post-Covid period—though it’s on a firmly declining path— along with elevated levels of public debt. This could have become a significant source of macroeconomic vulnerability in 2022 when global interest rates were increased aggressively. Sustained higher budget deficits after the global financial crisis were a key source for the loss of investor confidence, which led to a near-currency crisis in 2013. Besides, higher reserves allowed the RBI to focus independently on domestic inflation and macroeconomic conditions during the recent tightening cycle. While the Federal Reserve raised policy interest rates by over 5 percentage points, the RBI increased the repo rate by 2.5 percentage points, narrowing the yield difference.

While it is clear that higher foreign exchange reserves have been instrumental in managing volatility and providing policy flexibility, it is worth debating as to what level the RBI should continue to accumulate reserves. As noted in one of the above-mentioned papers, India’s reserves are comfortably above common measures of adequacy. Notably, there could also be risks associated with holding large reserves. The cost is usually seen as a loss of interest income because the RBI is substituting government of India bonds with foreign assets — US treasuries, for instance — which tend to yield less. However, that may not be much.

The important question is what if the insurance of higher reserves and stability in currency attracts substantially more capital inflows? It is worth noting that Indian bonds are being included in widely tracked global indices. The actual inflow could be much higher than the weightings in global indices because of increased investor confidence and the issuance of more bonds under the accessible route. Stability on the external account will also encourage Indian corporations to raise capital abroad. Sustained higher inflows and active RBI intervention in the market could create challenges for monetary policy operations. It could also push up the rupee and affect the competitiveness of India’s tradable sectors. As reported by this newspaper recently, despite the recent correction, the rupee was overvalued by over 5 per cent in August in real terms. Sustained overvaluation can create long-term risks for growth and macroeconomic stability. Given India’s history, the problem of plenty may seem counterintuitive in this context, but the external sector will require skilful management even with higher reserves. Complexities may only increase over the medium term.