Vote of confidence

RBI has done well, but new external challenges can emerge

The Reserve Bank of India (RBI) has managed volatility on the external front in recent times remarkably well. The external value of the rupee, as a result, has been reasonably stable even as currency markets in some advanced economies witnessed heightened volatility. In this context, RBI Governor Shaktikanta Das rightly noted at the recent Business Standard BFSI Insight Summit that the inclusion of Indian government bonds in the JP Morgan Bond Index was a vote of confidence. He was also on the mark in saying that the inclusion was a double-edged sword. While the index inclusion will lead to inflows, a change in weighting can also lead to outflows. The central bank, however, is well positioned to deal with such situations. Higher foreign exchange reserves have clearly increased confidence in managing external-sector volatility. However, given the ongoing structural changes in the global economy, the RBI may have to deal with a new set of challenges in the near to medium term.

Central banks across the world reduced policy interest rates and flooded the system with liquidity to contain the impact of pandemic-induced disruption in 2020. Governments, particularly in advanced economies, also significantly increased spending. Excess liquidity in the system with near-zero interest rates in advanced economies led to significantly higher capital flows into emerging markets, including India. Instead of allowing such inflows to push up the exchange rate, the RBI took a prudent call to build reserves. The central bank sensibly refrained from its post-global financial crisis error of not using capital flows to accumulate reserves, which resulted in excess currency market volatility during the “taper tantrum” episode in 2013.

Owing to the RBI’s interventions, India’s foreign-exchange reserves in 2020-21 went up by over $100 billion. The exercise continued in 2021, with reserves going over $640 billion. The Ukraine war and a late realisation by large central banks that the post-pandemic increase in inflation rates was not transitory in nature sharply reversed capital flows. Along with India’s need to finance the current account deficit, this resulted in reserves depletion of over $100 billion between January and November 2022. Had the RBI not built reserves when the flows were good, India would have witnessed very high levels of currency volatility on both sides, with implications for economic activities.

While the RBI has done well in recent years, in the immediate near term, the biggest risk is geopolitics. An escalation in West Asia can not only increase risk aversion, resulting in higher capital outflows, but higher oil prices can also significantly expand the current-account deficit. Besides, there are other structural changes underway in the global economy, which could play out over a period of time. The Budget deficit in the US, for instance, has moved up structurally and will corner more savings. Some economists are of the view that interest rates in the US and, possibly, other advanced countries will remain elevated for much longer because of structural changes in savings and investment patterns, which will have implications for capital flows. The world may not go back to excessively loose monetary policy anytime soon. In an uncertain global outlook, while higher reserves will always be useful, India should strengthen macroeconomic stability. This would require, among other things, maintaining low and stable inflation with a faster reduction in the fiscal deficit.