What $650 billion can buy – On India’s currency reserves

News: India’s foreign exchange reserves have gone up by over $160 billion since the beginning of the last fiscal year and are currently at about $640 billion.

Since, India has one of the largest foreign exchange reserves, the debate has shifted to what it should do with the pool. Many options are being debated.

But it will be more effective if the higher reserves can be used to maintain the financial stability, given the global economic environment.

What are the various options, and the issues with them?

Firstly, using reserves to finance infrastructure needs. But it’s not clear how this can be done.

Secondly, using foreign currency to buy foreign goods and services, or assets. But it is unlikely to be preferred as it will have a variety of macroeconomic implications.

Thirdly, forming a sovereign wealth fund, that would allow India to buy assets overseas.

Finally, there are suggestions that the Reserve Bank of India (RBI) should diversify its investment to increase yields. Since it invests in highly liquid assets, such as US government securities, returns are usually low. However, this will increase risks and could potentially defeat the purpose of holding reserves.

So, the best option would be to use the reserves to maintain financial stability, given the global economic environment.

Why the reserves should be used to maintain financial stability?

Firstly, India is a net importer of goods and services from the rest of the world, and India regularly runs a current account deficit.

Secondly, India’s reserves essentially reflect the excess flow of capital, and part of it could get reversed quickly as the US Federal Reserve has decided to “taper” its asset purchase program.

This could result in tightening of global financial conditions, and capital could flow out from a country like India, at least temporarily.

As a consequence, a fall in currency triggered by large capital outflows can pose risks to financial stability.

In such a situation, the RBI will be able to control volatility in the currency market, due to its large forex reserves.

What is the way forward?

While higher reserves provide stability on the external account, the RBI cannot endlessly keep accumulating foreign exchange. Because of two reasons,

– One, higher reserves can potentially attract more capital flows and makes currency management difficult. This would keep putting upward pressure on the rupee and affect India’s competitiveness.

– Two, sustained intervention by the RBI will push up the level of rupee liquidity in the system and increase inflation risks.

So, instead of heavily intervening in the currency market, India can revisit the kind of foreign flows it needs. Foreign direct investment and equity flows should be preferred to debt. Policymakers must align the capital account to broader macroeconomic objectives.

Source: This post is based on the article “What $650 billion can buy” published in Business standard on 25^th November 2021.