India today has above $600 billion in forex reserves which is an all-time high number. How good is it really? In terms of hierarchy, India now has the 4th or 5th highest reserves, competing closely with Russia (China, Japan and Switzerland have higher assets). It would take time for India to cross the $1 trillion mark and hence we would be 4th as of today with Russia slightly lower but having the advantage of oil which can push it higher in future. But $600 billion is a very healthy number.

How should these reserves be benchmarked against? The normal metric used is the number of months of imports that are covered. Here the Indian metric is quite impressive at 18 months going by FY21 imports of $392 billion ($32.6 billion per month. As FY21 was unusual, if the same is reckoned over FY20 when imports were $ 474 billion, the cover would be 15 months. The highest imports reckoned by India was in FY19 where the cover would be 14 months.

India has historically had a favourable import-cover ratio with the number being less than 10 between FY11 and FY15 and again in FY19. Therefore, import cover is not important.

Another metric that can be used is the forex reserves to external debt ratio. This is important because at times countries build forex reserves by seeking recourse to large external borrowings — the ECBs. As money is cheaper in the West, companies borrow quite aggressively in the market. This can be sticky in case the levels are high.

On this metric, the forex reserves look less exciting as the multiple was as high as 1.07 in FY10 but has been less than one since then and was at 0.76 in FY19 and rose to 0.85 in FY20. (While FY21 data is not yet available, it looks like that it will cross one again this year as outstanding debt was $563 billion in December 2021 and ECBs were less attractive this year).

But debt should not be a problem as normally the repayments are staggered and with borrowings continuing, there will be inflows countering the same. In the last 10 years, the highest net outflows were in FY17 at (-) $7.6 billion. Therefore, such a threat is not really likely.

The other component that can be a problem is FPIs, as FDIs are always positive and the former is considered to be fickle. In FY16, they were (-) $3.5 billion and hence quite low. Therefore, again it looks unlikely that this can be a major concern in terms of a run on the forex reserves.

Current account deficit

The last factor that can cause concern for the central bank is the trade deficit and hence the current account deficit. Here it will be useful to see if the reserves have fallen sharply in any year. Data from 2001 onwards suggest that there were four years when forex reserves declined. The highest was $58 billion in FY09 and $12.5 billion in FY19.

In FY12 and FY13 there were declines of $10.4 billion and $1.7 billion respectively. During these two decades, there were pre-emptive steps taken by the RBI like the swap facility in 2013.

All this data show that our forex reserves are very strong at over $600 billion and there is really no fear of a severe shock. Even a $100 billion decline can be absorbed quite easily. This is why there is the opening of a discussion on the RBI investing in instruments that give higher yields.

Presently, the structure of our foreign currency reserves is quite well defined. Over time the share of securities has increased from around 50 per cent in 2010 to close to 73 per cent in 2020. Share of deposits with other central banks and BIS has almost halved to around 25 per cent in 2020. Deposits in overseas branches of commercial banks has ranged between 5-7 per cent.

The securities part has caught the attention of economists who argue that the yield can be increased by investing in private bonds. As long as the West pursues QE (quantitative easing), the yields will remain depressed, and the RBI Annual Report shows that the average return came down from 2.65 per cent in FY20 to 2.10 per cent in FY21.

As of June 11, the forex reserves of $608 billion had foreign currency assets of $563 billion or ₹41.14 lakh crore. Intuitively, a 100 bps (basis point) additional return would be around ₹41,000 crore. Such a gain will be useful for the government as the sum is added to the surplus of the RBI, which moves to the Budget.

Safety first

The fundamental question now is whether the central bank should be involved in treasury operations? There is a risk involved and the RBI has been exhorting companies to hedge their forex risk. In that case, logically, the RBI has to get into hedging the same if it invests in corporate bonds. Central banks don’t have business acumen, though admittedly hiring professionals from the market can fill this lacuna.

The job of a central bank is to ensure safety of the financial system and it cannot be seen taking risk in the market merely because returns are higher. Just think of a situation where the RBI invests in bonds issued by blue chips like Google or Facebook and there are litigations somewhere in the world which affect their yields.

This can have a ratchet effect in Indian markets once it is known that the RBI’s investment valuation has changed. Therefore, central banks as a rule should not be taking any risk. Even the securities that are invested in are in the AAA rated sovereigns and not the lower rated ones which could give higher returns.

No doubt our forex reserves are strong and there is no threat of a shock that can cause disruptions. That said, the RBI should be conservative in their deployment and not take any risk to maximise returns.

The writer is Chief Economist,

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