India’s foreign exchange (FX) reserves — foreign currency assets (FCAs), to be precise — continue to rise inexorably. In the last 12 months, they rose around $60 billion to touch the current level of $460-470 billion. In the past six years, they have zoomed $150 billion. In comparison, FCAs were at $30 billion in March 2000.

In addition, if the investment intentions of large global players such as Amazon are any indication, it is almost certain the country’s FCAs will continue to rise strongly — provided there is no change in India’s policy (implemented through the Reserve Bank of India) of absorbing incoming foreign flows of capital (equity and debt) into the country’s FX reserves.

Let’s explore in-depth the above said policy of absorbing foreign capital inflows into FX reserves. The purpose that the policy says its seeks to serve is the maintenance of external sector stability as well as of the country’s ability to pay for critical imports when external financing arrangements are constrained. As is well known, people say almost axiomatically that our FX reserves are equivalent to “so many months of imports”, the implication being that if other financing sources dry up, India can still carry on.

Indeed, India now figures among the top global holders of FX reserves, within a larger set of Asian countries — viz China, Japan, South Korea, Taiwan, Singapore, Hong Kong, Saudi Arabia — that dominate global FX reserve holdings.

A crucial difference, though, is that the reserves of the above Asian countries also comprise a significant component of export surpluses in addition to capital flows.

India’s reserves, though, are 100 per cent capital flows only, with no trade surpluses.

Reserves and debt servicing

In fact, this 100 per cent “capital flows reserves” is another factor highlighted to buttress the argument for holding large FX reserves: external debt servicing is made comfortable by holding large reserves. This means that India first permits foreign debt, buffers up the FX reserves when the large debt capital flows take place, and then says the reserves enable smooth debt servicing.

Over the last nearly-quarter century, we have not explored alternatives to the above sequence of capital flows reserves/debt servicing. At the very least, this policy has the adverse implication of creating a moral hazard all across the spectrum – whether it is for the foreign creditor (investor) or the Indian borrower. By holding large FX reserves and also announcing that it will enable smooth debt servicing, India is effectively enabling foreign investors (creditors) to outsource financial risk management to the RBI. When push comes to shove, if there are large debt servicing demands, creditors can always transfer borrower credit risk onto the country, after which it becomes sovereign risk.

In financial markets, in the 1990s and 2000s — and maybe even now — one would to talk about a Greenspan put option bought by investors (and sold, of course, by central banks). This meant that the central bank will protect the downside for investors. The “Greenspan put option” analogy seems very much applicable to the large FX reserves/debt servicing argument.

External sector stability

Large FX reserves help preserve external sector stability. They also are critical in maintaining essential imports. Let’s see if these objectives have been attained in the past 20 years, and if they are at all capable of being attained. We can take the rupee’s “stability” as a proxy for external sector stability.

Between mid-2011 and mid-2013, the rupee fell around 50 per cent from ₹45-levels to the US dollar to ₹65 per dollar. It was in a narrow range of 45-48 in the period after the Lehman Brothers crisis of September 2008, and even stronger before then.

The FX reserves had, of course, risen inexorably all the way up to mid-2011. But the rupee still fell a staggering 50 per cent in the span of the next 18-20 months. Would one call this 50 per cent fall ‘stability’?

The problem simply was that too much of pressure was kept bottled up in the earlier period by the RBI’s massive FX market intervention (absorbing inflows) — and eventually, when it had to fall, it fell hard.

Will it not be better if a +/- 10 per cent trend takes place almost continuously, instead of letting things remain seemingly calm, leading to all hell breaking loose at once?

Financial risk management skills will develop notably if markets experience significant two-way moves consistently. The RBI need not offer a put option for investors in that scenario.

But that will happen only if such large FX reserves are not built.

Import financing

The 2011-2013 rupee crisis was because of the widening gap of India’s current account deficit. So, how much of the FX reserves — which were, of course, abundant — was used to douse the fire then? At most, it looks like around 7 per cent (going by published data), or to put it in money terms, around $15 billion, were used.

The rupee’s exchange rate, of course, took the bulk of the hit, as noted above. So, why were the FX reserves left mostly unaffected?

The fact is, draining the FX reserves would have created such a monetary squeeze that it would have been intolerable for the domestic economy. The “so many months of import financing” argument for large FX reserves is unfortunately unrealistic in the real world.

In the larger picture, with this level of capital openness and a desire for domestic monetary stability, India has to move decisively towards unfettered foreign exchange markets. Or else, sub-optimal outcomes will continue, whether we look at the domestic economy or in the markets.

The author is a Chennai-based financial consultant.

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