Problem of plenty

India needs a prudent policy on rising forex reserves

The Covid-19 pandemic has made macroeconomic management significantly more difficult. Despite a somewhat improved outlook, India is likely to end the current financial year with a near double-digit decline in output. Although the economy is expected to recover in the next fiscal year, going back to a higher growth trajectory will remain a challenge. India’s fiscal position is under stress and public debt is likely to expand to about 90 per cent of gross domestic product in the current year. Inflation has been running above the Reserve Bank of India’s (RBI’s) tolerance band for months and is not allowing the monetary policy committee to cut rates to support the economy. Most economists had expected the inflation rate to fall because of lower demand. One area that has provided comfort in macroeconomic management in these difficult times is the external financial position. However, it could soon become a problem.

India is now facing a problem of plenty in foreign exchange management. The RBI has accumulated reserves worth about $100 billion since the beginning of the current fiscal year. There are a number of reasons for this massive build-up of reserves. India’s import bill has declined significantly since the outbreak of the pandemic because of weaker demand and lower crude oil prices. However, the capital flows have been strong, resulting in a significant balance of payments surplus. Foreign portfolio investors, for instance, have bought Indian stocks worth about $7 billion so far in November. Capital flows are likely to remain strong in the foreseeable future because of the monetary policy stance of large central banks. The US Federal Reserve has, for example, moved to average inflation targeting, which means interest rates would remain near-zero for an extended period.

The RBI has done well in recent months to absorb the excess flow of foreign currency. Intervention in the foreign exchange market has also resulted in the infusion of rupee liquidity in the system, which has helped bring down market interest rates. However, the RBI may not be able to do this indefinitely. Continued intervention in the currency market and the resultant excess rupee liquidity in the system could affect the central bank’s inflation-targeting mandate. The RBI may not want to absorb excess liquidity from the system as that could push up bond yields and increase the cost of money. Further, as the current account is likely to be in surplus this year, continued intervention to prevent appreciation in the value of the rupee could attract charges of currency manipulation.

However, not intervening in the market would result in rupee appreciation, which will affect India’s external competitiveness and potentially create longer-term imbalances in the economy. The Indian rupee anyway is overvalued in real terms. Even in nominal terms, the rupee has appreciated since the beginning of the fiscal year. Thus, at a broader level, since the economic setting is unlikely to change and inflows may remain strong, both the government and the RBI will need to work on prudent policy options to deal with the situation. One possibility could be to restrict the flow of external debt capital. The stock of external commercial borrowing is over $200 billion. Further, higher foreign exchange reserves and import cover should not result in complacency in wider policymaking. India needs to improve its competitiveness to revive growth and exports.