Management of foreign exchange reserves

The foreign exchange reserves include three items -- gold, special drawing rights (SDRs) and foreign currency assets. India’s foreign exchange reserves have seen a sharp accretion this fiscal with reserves hitting $620 billion mark as of August 7, thanks mainly to the Reserve Bank of India (RBI) soaking up the dollars flowing into the nation’s booming stock market through investments in the secondary market as well as IPO’s. India’s foreign exchange reserves are the fourth-largest in the world after China, Japan and Switzerland. Such large foreign exchange reserves call for an open discussion regarding the reserve’s adequacy, usage of the reserves and return earned on the investment of these reserves.

India’s current foreign exchange reserves are good enough to pay for 18 months of imports. In 2020-21, Indian imports were valued at $388.92 billion, an 18 % drop from 2019-20, when the country imported goods and services worth $474.71 billion. Though India’s import cover is better than most other countries, it is behind a few select countries - Switzerland’s reserves which can cover for 39 months of imports, Japan’s reserves which can cover for 22 months of imports and Russia’s reserves sufficient for 20 months of imports.

Although India’s foreign exchange reserves are rising, the economy still has a net negative international investment position -- meaning foreigners hold more Indian assets than the nation holds foreign assets. These obligations include External Debt, FPI investments in capital markets, Foreign Direct Investments (FDI) and Non-Resident Indian (NRI) deposits. At the end of March 2021, India’s external debt was placed at US$ 570 billion, recording an increase of US$ 11.5 billion over its level at end-March 2020. The external debt to GDP ratio increased to 21.1 per cent at end of March 2021 from 20.6 per cent at end of March 2020. Total NRI deposits touched $135.36 billion as of July 2020, up from $130.58 billion in March 2020.

The value of the foreign portfolio investors’ (FPI) holdings in the domestic equities reached a record $555 billion in 2020-21, a whopping $105 billion growth between September 2020 and March 2021, according to a report of Bank of America Securities.

In 2020-21, FPIs, which have been the main driver of domestic equities, have pumped in a record $37 billion into Indian equities, the highest in two decades.

A country’s foreign exchange reserves should be adequate enough to cushion the country from any possible external shocks. A recent working paper published by the Bank for International settlements in May 2021, depicted that India is vulnerable to monetary tightening by the Fed, with outflows potentially impacting domestic credit markets, rupee strength and the economy at large. The upcoming Fed taper and the rate hiking cycle will test the defence provided by India’s foreign exchange reserves.

One general advice is to use these reserves for financing infrastructure development. Utilizing forex reserves for infrastructure funding could lead to difficulties in monetary management and lead to an increase in government debt. Since a portion of forex reserves would have to be converted to rupees, that would lead to an increase in money supply and inflation.

The most feasible option could be the import of capital goods directed towards building long-term productive assets in the country. Import of capital goods is feasible only when the domestic demand picks up. But countries do build additional productive capacities well ahead of an upward tick in demand, as long gestation periods are needed to build new capacities.

A major question on the level of reserves relates to the scope for measuring overall economic costs and benefits of holding reserves. If it is assumed that the direct financial cost of holding reserves is the difference between interest paid on external debt and returns earned on external assets in reserves, such costs have to be treated as an insurance premium to assure and maintain confidence in the availability of liquidity - to ward off external risks and to ensure better credit rating. However, setting up an investment entity akin to a sovereign wealth fund to manage a part of foreign exchange reserves could maximise the returns.

( The writer is a retired corporate professional)