When $640 billion is not enough

Currency management is inherently tricky for a large emerging market country like India with a near-perpetual current account deficit (CAD). Since India imports a significant amount of capital from the rest of the world, a sudden change in global financial conditions could be potentially destabilising. It is, therefore, extremely important for the Reserve Bank of India (RBI) to remain vigilant.

The complexity of currency management can be gauged from developments over the past year. Reserve accumulation looked a bit excessive to some as it crossed the $600-billion mark last year. Ideas were floated as to how the RBI can maximise returns. This column in November 2021 had discussed the practicality of some such ideas and argued that the “most valuable thing that higher reserves can buy in the given global economic environment is financial stability.” Given the nature of India’s external position, things can change fairly quickly as has happened over the past several months, particularly since the Ukraine war. While inflationary pressure was building in many economies, higher commodity prices forced large central banks, particularly the Federal Reserve, to act quickly. It raised the policy rate by another 75 basis points this week.

These developments affect India in different ways. First, higher commodity prices are pushing up the trade deficit. The CAD is expected to be worth over 3 per cent of gross domestic product (GDP) in the current year. Second, tightening of financial conditions and risk aversion in global markets are leading to capital outflows. Foreign portfolio investors (FPIs) have sold Indian assets worth over $30 billion since the beginning of the year. Higher dollar demand by both importers and FPIs is affecting the value of the rupee. It has fallen about 7 per cent against the dollar so far this year. The rupee would have lost more ground had the RBI not intervened aggressively. The reserves have come down by over $60 billion since January, though part of it could be because of revaluation.

To be fair, the RBI has broadly done well in terms of managing the currency since the outbreak of the pandemic. Massive stimulus injection in advanced economies led to higher capital inflows. Timely intervention by the RBI, for instance, resulted in reserve accumulation worth over $100 billion in 2020-21. Had the RBI not intervened, the rupee would have appreciated, affecting India’s external competitiveness and increasing currency volatility. While the RBI is now intervening in the market to quell volatility, there are concerns that it might be overdoing it.

One of the reasons why the rupee and other currencies, including hard currencies like the euro and yen, are under pressure is because the dollar is strengthening. The dollar index has gone up by about 11 per cent in 2022. Capital would continue to flow to the US, largely because of monetary policy divergence. It is highly unlikely that the European Central Bank or Bank of Japan will be able to match the Fed’s policy response. Increasing rate differences will encourage investors to move funds to the US, which would keep the euro and yen, along with other currencies, under pressure. In the given backdrop, defending the rupee beyond a point could become counterproductive or even unsustainable.

One of the reasons for defending the rupee could be to contain imported inflation. The cost of this strategy, however, will keep increasing if global commodity prices remain elevated for some time. Another reason could be that firms have unhedged external loans. Such firms should be encouraged to hedge and not depend on the rest of the system to bear the cost. Besides, a falling currency often doesn’t make a good political headline. But this should not be a worry for the RBI. In fact, it should use every opportunity to explain as to why allowing the rupee to adjust is in India’s interest. It is worth noting here that one of the factors behind China’s transformation into a manufacturing and export powerhouse is said to be its undervalued currency. This is not to suggest that India should do the same. But it should certainly not be on the other extreme where it is borrowing to defend the currency.

The RBI recently announced measures to boost foreign currency flows. For instance, it has given more flexibility to banks in terms of raising deposits from non-resident Indians for a limited period. Further, besides giving more flexibility to FPIs in the debt market, it has allowed domestic firms to borrow abroad on more liberal terms. Although these measures may not increase inflows immediately, overall, they suggest India is willing to borrow, including for the short term, to boost its reserves and currency.

India’s external debt went up by over $47 billion in 2021-2022 to $620.7 billion and the proportion of short-term debt — maturity up to one year—was about 20 per cent. Accounting for longer-term debt maturing by the end of this fiscal year, the number goes well over 40 per cent. Differently put, over $260 billion worth of foreign debt will need to be repaid by March 2023. A large part of this might get rolled over, but it could still be a source of uncertainty in the given circumstances. Although India’s external debt-to-GDP is not very high, it can increase risks. Therefore, as the global financial system stabilises, it would make sense for both the government and the central bank to review foreign flows. Non-government foreign debt, for instance, is approaching $500 billion. Excessive foreign borrowing by corporations for interest rate arbitrage could create risks. It also affects the tradable sectors by keeping the currency overvalued.