Unravelling the surge in India’s forex reserves

One of the biggest positives for our economy has been on the external front, where forex reserves have risen quite consistently in FY20 and continues to rise even today, with the number expected to cross the $500 billion mark. This comes as a major source of comfort, considering that there were times when there was talk on raising sovereign bonds to shore up the forex reserves.

The increase in reserves from $412 billion as of end-March 2019 to $476 billion in March 2020 and further to $493 billion is a display of strength of the external account. It is probably this reassuring trend that has prompted S&P to acknowledge India’s external position in its report. Forex reserves are the final indicator of the strength of a country’s economic fundamentals, as they are the result of inflows and outflows on balance of payments during any time period. In India’s case, an increase of $80 billion over 14 months is more than impressive.

Current, capital accounts

This increase has been brought about by a combination of both the current and capital accounts. However, the reasons for the same are quite different.

The lower growth in GDP, for example, has led to a sharp decline in imports and for a country with a perennial trade deficit there was bound to be improvement. The fall in crude oil prices has helped the cause in FY20 and the shutdown has virtually lowered the demand for imports to bare minimum, resulting in a lower trade deficit. While exports of goods have also fallen and invisible receipts affected by the global lockdown, the CAD (current account deficit) is still expected to improve sharply in Q1 of this year and could turn into a surplus at the extreme.

The area of interest is, however, the capital account where flows have been steady, lending strength to the external story. FDI has been the scoring point and there have been equity flows of $50 billion in FY20 and a total of $73 billion, including reinvested earnings and other capital. This is a testimony of two things. First, India remains an attractive destination for FDI, and it has been so for the last 5-6 years, with only FY19 showing a marginal dip.

Second, the government needs to be credited for both easing the rules and widening the scope of FDI as also improving the ease of doing business environment. Quite clearly, with the resolve to further improve the latter, FDI flows should increase even more in the coming years. FY21, however, will be a testing period, as the supply of funds may be limited given the recessionary trends in most countries.

The other factor responsible for forex flows has been ECBs (external commercial borrowings). The relaxation of ECB norms by the RBI and the favourable environment overseas, where interest rates are likely to remain at very low levels for the next couple of years, really means that companies can continue to access this market.

ECBs touched an all-time high of $53 billion in FY20 — from less than $30 billion till FY19. Companies which were not able to borrow at favourable rates in domestic markets, especially in the BFSI space, did reach out for these markets and that has led to the surge. Hence, higher FDI and ECBs were able to counter the negative FPI flows, resulting in accretion to the country’s forex reserves.

Rupee value

The picture changes when this is seen against the currency movement. Under normal circumstances, strong fundamentals lead to appreciation of a currency. However, over the last 14 months there has been a distinct fall in the exchange rate of the rupee from ₹69.17/$ as of end- March 2019 to ₹75.64/$ as of end-May. This fall, by nearly 9.5 per cent, goes with forex reserves increasing by around 19.5 per cent. A part of the reason for the rupee not strengthening can be attributed to the RBI, which purchased around $45 billion in FY20 to ensure that the rupee did not appreciate too much.

However, the external factor of the dollar strengthening in international markets was primarily responsible for the rupee declining, which, in a way, worked to our advantage in providing a fillip to exports. However, the fact that all competing currencies also depreciated meant that this advantage got eroded. The currencies of Brazil, Russia, Turkey and South Africa fell by over 10 per cent while those of Indonesia and Korea were by comparable to the rupee’s. Hence, the benefits of the mounting forex reserves did not quite lead to appreciation in currency, and the resulting depreciation did not deliver the export advantage.

Looking ahead

Going ahead, the current situation on the reserves front can be expected to continue, though the pace of increase will depend a lot on how foreign investors behave. Indian companies will continue to use the ECB route. While this is good for the borrowers, the RBI will be more watchful because a situation where the currency ceases to be linked with fundamentals can add to the risk attached to forex borrowings which have to be serviced at a higher currency rate.

Currently, the forward rate is around 3.8 per cent for one year and may not necessarily have been taken by companies borrowing for longer periods of time. The problem will arise only when there are exposed positions and the rupee continues to decline. Normally, a 3-4 per cent annual depreciation cannot be ruled out and hence hedging is a necessity.

Given this anomaly between fundamentals and currency movements, FY21 may be expected to see some degree of volatility in the latter depending on when countries move out of the lockdown and normalcy is restored.

The writer is Chief Economist, CARE Ratings. Views are personal

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