More cover needed

It is a matter of comfort that India’s foreign exchange reserves are nearing an all-time high of $321 billion, but this does not mean that the Central bank can relax its vigilance. The recent volatility in financial markets, triggered by developments in West Asia, only reinforces the risk that the country faces from accelerated capital outflows. With volatility expected to increase once the global interest rate cycle reverses, it is imperative that the Reserve Bank of India persists with its efforts to increase the country’s reserves, something it has been concentrating on over the past three quarters. Thanks to this effort, reserves have increased from the low of $275 billion last September, aided by the inflows through the Foreign Currency Non-Resident deposits swap scheme and the continued purchase of Indian stocks and bonds by foreign portfolio investors. That current forex reserves are sufficient to finance over eight months worth of imports is far more comfortable that the 6.6 months cover towards the end of last September. The higher reserves also mean that any sudden outflows of dollars which have come in via either portfolio investments or debt are adequately provided for.

That said, these numbers do not mean that the reserves are at an optimum level. As RBI Governor Raghuram Rajan recently said, the extent of the turbulence once the Federal Reserve and other central banks begin hiking interest rates cannot be gauged by anyone. We have received $12 billion of funds into stocks so far this year and $13 billion into debt. While not all the money that has been invested in equity will flow out — since equity investors have a longer investment horizon and are betting on improvement in economic growth and company fortunes —– the entire inflow into debt is at risk since these investors are only concerned with interest rate differentials. Almost $13 billion moved out of debt between last June and November on fears of the Federal Reserve tapering its quantitative easing, even as $2 billion was invested in equity. Most of the foreign investors in debt have a very short-term investment horizon and are neither foreign central banks nor multilateral financial institutions or investment funds, which have a longer-term view on the markets they invest in.

Given these risks, there are various methods the RBI can use to increase reserves including issuing overseas bonds such as the Resurgent India Bonds or India Millennium Deposits, that can raise at least $5 billion. The improving sentiment towards India with a stable government at the Centre can ensure the success of this scheme. Improving trading and liquidity in the corporate bond market will also help, since foreign investors have utilised only two-third of their investment limit in this segment.

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