By Indroneel Das
India has been a part of global news lately, for all the right reasons. India has evolved from being just another ‘developing nation’ to an emerging global power. While this implies political, military and economic connotations, let us focus on the latter. Very recently, India’s forex reserves skyrocketed by $4 billion USD, touching a new high of $381 billion USD.
While this is a monumental event, what opportunities does this overflowing chest of forex reserves offer to the country? What are the opportunity costs? Like any economic development, this event also has its share of pros and cons. The specific impacts and the immensity of the $381 billion USD worth of forex reserves must be put in perspective by considering the Indian context.
Reasons for the build-up of forex reserves
The build-up of forex reserves is linked to the inflow of foreign currency. This foreign currency is predominantly the US Dollar: the currency that the world transacts in. There are several reasons for the inflow of foreign currency into India. Firstly, being a strong emerging market, India finds favour among foreign investors as an investment destination.
Secondly, with a young population and rapid reforms by the government, the business environment is extremely conducive. Thirdly and most importantly, Indians are becoming truly global in their lifestyle habits, now more than ever. India is also a hub for both MNCs and startups. In fact, India has the third largest start-up base in the whole world. Foreign investors are investing into both Indian MNCs and lately, into startups too.
How does forex enter the economy?
Foreign investments can be made through Foreign Institutional Investments or Foreign Direct Investments. Foreign Institutional Investments (FII) primarily involve channelling investments through the capital market in the equity or debt of companies based in India. This is the most convenient way for a large foreign investor to invest in promising Indian companies without having to ever set foot here.
Based on the expectations of a strong market, favourable interest rates, and a solid growth in corporate earnings, FIIs have pumped in unprecedented amounts of capital. Up to April 2017, net investments through FIIs in Indian equities and debt stood at about $7.5 billion. Ever since the turn of the millennium, the total FII investments have been to the tune of $185 billion.
Foreign Direct Investments (FDIs) involves setting up of operations in the country. The capital invested in a country through the FDI route is used for setting up plants, machinery, offices and other assets. The investing entity thus arrives and operates in the Indian market.
Indian companies showed tremendous resilience to the short-term hiccups arising from the governmental reforms and gave promising growth signals. The inflow of foreign capital through both these routes were major contributors in the build-up of forex reserves to the levels at which we see them now.
The impact of buying foreign currency
Another reason for the accumulation of foreign currency reserves is the buying of foreign currencies by India in the international market. With the Rupee soaring sharply for many months now, this can hurt the economy if not controlled. The Reserve Bank of India controls the appreciation of the Rupee by buying Dollars in exchange for Rupees in the global forex markets. This serves two functions. Firstly, we can buy more Dollars per Rupee when the Rupee is peaking. This is a great opportunity to build a cushion of forex reserves that can be crucial in the event of a foreign currency crisis.
Secondly, it can be used to stop a sharp appreciation in the value of one’s domestic currency. The RBI has tried to slow down the appreciation of the Rupee at various levels- first at Rs 66.4, then at Rs 65.6 and even now as the Rupee is close to Rs 64 to a Dollar. This is a well thought out and voluntary move by the RBI, as opposed to the FII and FDI inflows, that it can’t directly control.
The problem of excess liquidity
While having healthy forex reserves is considered an indicator of financial well-being, too much can prove to be harmful. Every Dollar that enters the market essentially increases the money supply in the economy. This means that too strong an inflow of foreign currency can cause problems of excess liquidity and result in inflation. Usually, the RBI conducts ‘sterilisation’ of foreign inflows to remove the excess liquidity in the market.
This is done by conducting Open Market Operations (OMOs). OMOs involve the floating of bonds worth the amount that the central bank wants to suck out of the markets, thus effectively neutralising the excess liquidity. However, the problem is that the bonds are an obligation which the central bank needs to collateralise, just like any other borrowing. However, the RBI cannot take on infinite amounts of liability because that will need infinite amounts of collateral. As the availability of collateral is limited, the RBI will fast run out of options to suck out this excess liquidity.
Maintaining the right balance
There is always a ‘right level’ of reserves that a country must hold as a percentage of its GDP. Reports suggest that awe might have significantly overshot it at the current record high of more than $381 billion. A need to pay constant attention to the forex scenario prevents the central bank from following a truly independent, growth focussed monetary policy. Also, the constantly rising foreign inflows can push the Rupee up to levels in the international market that will make Indian exports extremely uncompetitive.
If the current pace and level of forex reserves persist, the Government must start thinking of alternate investment avenues for this excess foreign capital. Like any capital at the disposal of the nation, the forex reserves can be deployed within the country for infrastructure development or invested further in foreign capital markets. The Government and the central bank are walking a tightrope and one must wait to find out what will happen given the current scenario.
Featured Image Credit: Visual Hunt