India’s total foreign exchange (Forex) reserves stood at around US$572.771 billion on November 13, 2020, the highest ever. The USD-INR exchange rate is USD1 = Rs.73.82 as of November 26, 2020, up from Rs.75. The RBI has also commented that “the recent appreciation of the rupee is working towards containing imported inflationary pressures”. The forex reserve, the exchange rate, and the RBI’s comment have raised important questions: are the growing currency reserves a sign of a healthy external balance? How are these reserves deployed currently, and could India use them more effectively to achieve growth and prosperity? Finally, with so many reserves, should we now let the rupee appreciate so that inflation softens and our wealth increases?
India over the years has been a consumption-based economy with a Balance of Trade deficit. In COVID-19 times, there has been a huge surplus in the Current Account but are not sustainable in nature. In recent quarters India has managed to keep its BOT below USD 10 bn from USD 40 bn per quarter last year. Had this reflected as an increase in exports, which would have implied economic strength. Exports fell by one-third. But imports contracted even more. This reflected not economic strength but an economy collapsing so much faster than others that India’s demand for imports fell faster than foreign demand for Indian exports.
Now coming to the first question, “are growing currency reserves a sign of a healthy external balance?” And the answer is simply “NO” when it comes to Indian perspectives. This is primarily because India sponsors its consumptionoriented imports either by external borrowing or by disinvestment in public sectors and at times by the Forex reserves. There is no huge fiscal stimulus by the likes of Japan and the US, an increase in unemployment and a decrease in domestic savings all together have resulted in a decrease in domestic demand thus a Current Account surplus. We also need to notice that reserve surpluses are majorly due to Capital Account surplus. This led to our second question, are these reserves, India could use more effectively to achieve growth and prosperity?
What India needs now is capital accumulation and promoting economic activities and the foreign currency inflow should be channeled into the monetary-economic cycle through good quality money creation, which some may argue. Accordingly, there will be domestic investments, thus job creation, and hence a rise in domestic demand for domestic goods.
Generally, RBI invests the reserves in gold, sovereign debt, and other risk-free deposits in developed economies. But with loosening monetary policies around the world as EMEs are accumulating huge forex surpluses, RBI is adopting a diversifying approach and for the very first time to invest in AAA-rated corporate bonds. It is assumed that a rise in forex reserves of EMEs means, countries like India lending their surplus reserves to rich countries for better returns. This would not matter if these forex reserves would have been a permanent surplus for India. Some say in situations of a deep recession, India needs to invest heavily at home, not abroad. But this is debatable as these are opportunistic flows.
A similar idea of financial infrastructure development was earlier proposed in 2007 forex surplus to which the then RBI governor opposed and we knew what happen in 2008 and saw the volatile nature of the reserves with the capital outflow from the Indian economy. Plus any alternative use of reserves also comes with domestic monetary policy implications. By an estimate, the current account in India to stand at – 17000.00 in 12 months and USD -14400.00 million in 2021, and India’s accumulation of forex reserves has largely been through its capital account surplus. Hence, for managing reserves, safety and liquidity should remain critical. As these reserves are not created out of current account surplus, these are like external borrowing and at times of capital outflow, these are the liabilities we pay. Reserves are not meant to be used for fiscal distress or domestic capital formation. By doing so it becomes wealth and reserves accumulated as a result of the Current account surplus can have that treatment. Instead what RBI can do is direct the excess INR reserves with him to banking sectors through OMOs and by lending to the government to relax its fiscal pressure.
We know high inflation undermines domestic purchasing power. As the INR is overvalued in the world market, now the question is, should we let the rupees appreciate? Due to capital inflow through institutions and FDI, there was an appreciation pressure on the INR but RBI regularly brought Dollars through state-run banks to maintain the price stability. But by allowing the rupee to appreciate, RBI has allowed the exchange rates to ward off inflationary stress. The typical policy instrument used by RBI or the Monetary Policy Committee to target inflation is interest rates. However, increasing interest rates at a time when there is a prediction of a forthcoming recession can have catastrophic effects. This ties the hands of RBI as it attempts to fight inflation while supporting future market revival. Appreciation would result in imports becoming cheaper which could offset the impact of an increase in duties or any inflationary pressures in the global market on India’s inflation. For the time being it seems this is the most feasible option to check the inflationary pressure. However, appreciation should not be the method to be undertaken for a long period while RBI maintains its “watch and wait for” policy by not cutting its repo rates down although in the past interest cuts when passed down to the consumers haven’t produced any significant improvement. Also, we need to keep in mind the real appreciation effects. It will only have a transitory effect which provides valuable time for the adjustment of the domestic economy with the new global environment (ex. Covid Pandemic) which might be good in a point of view for net welfare gains but cannot be thought of as a permanent tool as it will hamper the global competitiveness of domestic producers in EMEs like India.
To conclude, if we take India as an individual then surplus forex reserves are like those excess savings (unequal) out of her everyday transactions that she saves in a secondary bank account or as a fixed deposit for precautionary measure (sometimes transactional), for interest earnings, and as a backup to the primary bank account. Here the individual should treat these excess temporary surplus opportunities as “Reserves”, not wealth for day-to-day expenses or to create long-term physical assets like building a house or buying a car.
Note: The questions that we addressed in this byte are taken from an article by “The Mint”. Although this is contradictory most of the time, there can be some similar point of view, given the nature of the topic.
