For a country like India, forex reserves have long been treated as precautionary savings that the government acquires as a “rainy day” fund to tide over any sudden decrease in capital inflows. In other words, it acts as a buffer against shocks to external wealth.
On the other hand, countries like China, the UAE, Norway, Saudi Arabia, Russia, Singapore and many others prefer higher returns to liquidity. The precautionary savings in such countries manifest in the form of sovereign wealth fund (SWF), a state-owned investment fund that is riskier than traditional forex reserves.
Over the last two decades, India has exhibited robust macroeconomic fundamentals and is one of the most attractive destinations of foreign investment. This has resulted in an unprecedented accumulation of forex reserves. It may be noted here that India’s forex reserves accumulated to a record high of over $600 billion a few weeks back. This makes us the fifth largest holder of forex reserves after China, Japan, Russia and Switzerland, according to RBI.
Such a high accumulation of reserves has prompted the government to explore an investment strategy whereby the accumulated reserves can be better utilised. It is imperative to unleash the catalytic power of government investment to offset the shadow of the Covid-19 pandemic on India’s growth story. The newly announced Pradhan Mantri Gatishakti National Master Plan for infrastructure and other mega infrastructure projects necessitate a careful appraisal of our financial firepower.
That brings us to the fundamental question: Does India have “too much” reserve build-up and hence “surplus” reserves for the government to explore an investment strategy? To answer this question, we look at two popular measures of reserve adequacy of a country (Park and Estrada, 2009).
The first measure of a country’s susceptibility to currency crisis is the ratio of reserves to short-term external debt. Also known as Greenspan-Guidotti rule, the critical value of this ratio is one, with a value below one being undesirable.
The second indicator of reserve adequacy is the ratio of reserves to M3 or broad money. This ratio is especially relevant for countries like India that are a haven for ‘hot money’ investment by large foreign institutional investors and hence are subject to a major risk of capital flight. It is suggested that a critical value of this ratio in the range of 5- 20 per cent is desirable.
An analysis of time-series data on Indian economy for past three decades suggests that India comfortably fulfills both these measures. With the ratio of reserves to short-term external debt exceeding one in all the years since 1991-92 and the ratio of reserves to broad money above 20 per cent for all the years since 2002-03, there is ample evidence — established by the first author — of “too much” of reserves buildup for the Indian economy.
The caveats
However, the following precautions may be noted. First, creation of SWFs tends to be common practice among major fuel and commodity exporting countries. SWF creator countries, which are not intensive fuel exporters, otherwise possess large current account surpluses (namely, China). India is neither an oil exporting country, nor has current account surplus.
Secondly, India’s growing fiscal deficit has the potential to create adverse trade imbalances, popularly known as ‘twin deficit’, thereby prompting the government to adopt a cautious approach.
In addition, RBI has advised a pragmatic assessment of reserve adequacy in view of existing level of forex reserves being projected to cover less than 15 months of imports (while countries higher than us in forex reserves position boasting anywhere between 16 and 39 months of import cover), net international investment position of (-) 12.9 per cent of GDP, exposure to valuation changes and market risk in a world of heightened global uncertainty. It has been held — rightly so — that accumulated reserves are not ‘owned’, they are liabilities. Essentially, forex reserves are built up from investment flows and have long been used as a cushion to avert crises that cause precipitate outflows of foreign exchange.
Nonetheless, just as a bank lends out money from its liabilities (read deposits) while keeping aside a part that is deemed sufficient to take care of exigencies, forex reserves may be suitably subject to this calculus.
While it is apparent that RBI is already diversifying its forex investments in a basket of currencies to earn higher returns, some part of our reserves can be committed for longer-term investments.
As India turns 75, it is time to assess whether our forex reserves can help further our geo-economic and strategic priorities while not disregarding the above expressed concerns. A wider consultation on the subject is the need of the hour.
Mukherjee is Associate Professor in Economics, Indian Institute of Foreign Trade, and Kamila is Assistant Director, Economic Division, Ministry of Finance. Views are personal