Are our forex reserves adequate?

The growing foreign exchange kitty has created a problem of plenty for the Reserve Bank of India. It’s attracting unwanted attention, along with calls for using the reserves to fund infrastructure expenses, capitalise state-owned banks and better management of the assets in the reserves.

The RBI’s latest monthly bulletin has tried to take the discussion along another channel by pointing out that the reserves may not be as robust as perceived.

The report, while highlighting the $600 billion milestone for forex reserves, pointed out that India currently holds the fifth largest foreign exchange reserves, twelfth largest holding of US treasury securities and tenth largest gold reserves.

But the central bank also made two other observations alongside. One, it stated that the import cover for 15 months provided by our reserves compares poorly with other countries with large forex reserves such as Switzerland (39 months), Japan (22 months), Russia (20 months) and China (16 months). Two, that the net international investment position of -12.9 per cent of GDP needs to be taken in to account while assessing the adequacy of reserves.

It is not easy to assess the adequacy of forex reserves of a country. As the IMF states, “Assessing the appropriate level of reserves to hold is challenging — not just because of the multiple roles played by reserves, but also because of the complexity of quantifying external risks and vulnerabilities, and the opportunity cost each country faces.”

That said, conventional ratios used to gauge adequacy of forex reserves show a vast improvement now, compared to two years ago. Also, given that the central bank will have to continue market intervention in order to maintain rupee stability, the reserves are likely to grow further.

There is however no need for the RBI to get defensive about the growing reserves. It should instead look for ways to put the reserves to optimum use.

Are reserves adequate?

The moot question is: what is the right way to gauge the adequacy of reserves? The metrics used for this purpose have evolved with the changes in the composition of the external account over the years. Many committees set up by the RBI have deliberated and improved upon these, suggesting the most relevant measures for the country.

While trade based metric such as import cover was the most popular pre-2000, use of debt based indicators became more relevant as external debt grew. The predominance of foreign portfolio flows in the capital account called for gauging the reserves in the context of these flows as well.

If we consider the import cover provided by forex reserves now, it was 15 months towards the end of last month. While the RBI has pointed out that the cover is much lower when compared to other countries, a better way to analyse the number will be by comparing it with past data. Current import cover is, in fact, a vast improvement from the cover enjoyed historically. For instance, the import cover in March 2019 was 9.6 months and in September 2013, it was at an abysmal 6.6 months.

Another metric used to measure forex reserves — the ratio of short-term debt (based on original maturity) to reserves — has also improved of late. This ratio has declined to 17.7 per cent towards the end of December 2020 from 26.3 per cent in March 2019. It stood at a high of 34.2 per cent in September 2013.

While the RBI is not wrong in pointing out that we have more external liabilities than external assets in the IIP, the higher holding of reserves currently, give comfort on one of the most volatile component of our external account, portfolio flows. The ratio that takes into account more volatile portfolio flows — ratio of volatile capital flows (including cumulative portfolio inflows and outstanding short-term debt) to reserves — has improved to 67 per cent in December 2020, from 86.7 per cent in March 2019 or 97.3 per cent in September 2013.

Reserve accretion may continue

Given the stance of global central banks to continue their bond purchases and to maintain interest rates at ultra-low levels, global investors are likely to remain flush with funds, at least until first half of 2022 and the hunt for higher yield and better growth will bring these investors to Indian equity and debt market in the near future. The RBI will have to continue buying dollars in this scenario to maintain stability in rupee movement.

The reserve accretion is therefore largely due to the policies of other central banks and there is no need for the RBI to be defensive about the growing pile of reserves. As the Governor, Shaktikanta Das, stated in Nani Palkhivala Memorial Lecture this January, “EMEs typically remain at the receiving end. In order to mitigate global spillovers, they have no recourse but to build their own forex reserve buffers, even though at the cost of being included in currency manipulators list or monitoring list of the US Treasury. I feel that this aspect needs greater understanding on both sides so that EMEs can actively use policy tools to overcome the capital flow related challenges.”

Also with most central banks likely to begin monetary policy normalisation by 2022 or 2023, de-leveraging and risk-off trade can cause volatility in financial markets and the reserve buffer will be handy to absorb such shocks.

The central bank should however begin to seriously consider diversification of assets held in its reserves away from US treasury securities which do not yield any interest and also carry risk of capital loss. Engaging an external consultant to recommend apt allocation is the way forward to make the most from the reserve holdings.

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