Rising forex reserves

Large inflows can increase policy challenges

India’s foreign exchange reserves would soon touch the $500-billion mark if the Reserve Bank of India (RBI) continues to accumulate foreign currency at the same pace as last year. India’s reserves have touched a new lifetime high of $462.16 billion, according to the latest data, after going up by over $60 billion in 2019. While higher reserves would increase India’s capacity to deal with external economic shocks, the continued flow of foreign money at this pace could complicate domestic policy management.

The flow of foreign funds increased significantly in 2019, owing to easier monetary conditions in advanced economies, particularly the US. Since monetary policy is likely to remain accommodative in the foreseeable future, it is reasonable to expect that the flow will continue in 2020 as well. Research shows while foreign direct investment depends on the domestic policy and regulatory environment, portfolio flows are driven largely by the availability of liquidity in the global financial system. Since a higher flow of foreign capital puts upward pressure on the rupee, the RBI is rightly intervening in the market to protect India’s trade competitiveness. The Indian rupee is anyway significantly overvalued in real terms, which, among other factors, has resulted in export stagnation over the last few years.

While it is important that the RBI doesn’t allow the rupee to appreciate, continued interventions can lead to significant policy complications. For instance, the RBI’s intervention in the market to absorb foreign currency results in an infusion of domestic currency, which increases liquidity in the system. Surplus liquidity in the banking system was above Rs 4 trillion at the beginning of the year. Continued liquidity infusion when inflation is above the upper end of the central bank’s target band could affect its objective of price stability. Excess liquidity is also not allowing the central bank to effectively intervene in the bond market, which has steepened the yield curve. In fact, the RBI may be forced to sell bonds to absorb excess liquidity at some point. This would again affect yields. Further, the shift in favour of low-yielding foreign assets on the RBI’s balance sheet will affect its earnings and the surplus transferred to the government. Higher reserves have costs.

Given the complexity of the situation, India’s overall policy approach to external finance is puzzling. While on the one hand, the RBI is buying foreign currency in large quantities to avoid rupee appreciation, on the other hand, it is encouraging foreign debt flows. For instance, last week it raised the limit for foreign portfolio investment in the Indian bond market. Similarly, last year it had relaxed the end-use restrictions related to external commercial borrowing by Indian companies for working capital requirement and repayment of rupee loans. Higher-rated Indian firms would want to borrow abroad to take advantage of the difference in interest rates. But a higher flow of foreign debt in the given circumstance will affect economic policy management. Therefore, given the level of reserves and state of global finance, the central bank, along with the government, would do well to review what kind of foreign funds will serve the Indian economy better. Flows coming in just to take advantage of interest rate difference can escalate policy challenges.