Treasuring American treasuries: A good idea?

By Jatin Bavishi

According to the latest RBI Bulletin, India increased its holding of American government securities to $124.1 billion at the end of April 2017. This is the largest Indian holding of American securities since July 2016 when the exposure stood at $123.7 billion. This makes India the third largest holder of treasuries among the BRICS nations after China and Brazil. Brazil’s exposure stands at $267.7 billion whereas China’s exposure to American government securities is a mammoth $1.092 trillion. What is going to be the likely impact of this accumulation?

The elementary concepts

National economies are becoming increasingly globalised. Countries are engaged in a complex network of exchanges like commodities and services on the one hand and investment finance (like foreign direct investment and portfolio investment) on the other. When a country exports a good or service by hiring domestic factors of production (like labour), it receives payments in some foreign currency. The labour, however, has to be paid in domestic currency. To meet this contingency, the foreign currency is sold in return for domestic currency. This heightens the demand for domestic currency the value of which appreciates vis-à-vis the foreign currency. Similarly, foreign agents wishing to invest in stock markets of another country, have to convert their currencies to the domestic currency as a pre-condition. These conversions may occur frictionlessly in the foreign exchange (forex) markets, but typically central banks intervene to prevent wild fluctuations since it can distort the economy.

A central bank can sit on the idle pile of forex, but it is advisable to use it to buy some asset. The advantage of holding assets as opposed to forex in physical form is that it guarantees a positive rate of interest at regular intervals to the central bank (given that currently, it yields no returns).

The obsession with US treasuries

For most central banks, including the Reserve Bank of India (RBI) the chosen asset are US government securities, popularly known as treasuries. They are short-term bonds of 1 year backed by American fiat. The underlying motivation is that the American government would not default on its payments and that its commitment to prudential regulations yields superior returns as compared to other economies that have an erratic record. The RBI, of course, buys other currency-denominated bonds as well given the importance of these bonds in India’s foreign trade market. Treasuries, nevertheless, are the single largest chunk of our forex reserves.

What caused the recent surge?

Given India’s low current account and fiscal deficits, capital has flown into Indian markets. According to a report by Financial Express, FPIs have bought Indian shares and bonds worth around $22 billion in 2017 alone. This is also helped by the fact that India is a net exporter of items like steel, textiles, gems and jewellery to the world along with its world-class IT/IT-Enabled Services. With the USA alone (until March 2017) India had a trade surplus of $24 million, as reported by The Hindu. In this rally, even the rupee has gained about 5%.

FPI’s (Foreign Portfolio Investment) are a form of investment made by foreigners but they are mostly invested in financial instruments and can be pulled out easily vis-à-vis other forms of investment. It is for this reason FPI’s are sometimes called hot money.

The likely effect of this large holding

Accumulation of forex and appreciation of the rupee might appear to some as a display of national pride but make no mistakes. The swelling is led by FPI’s (which can often be speculative in nature) and presumably has limited correlation to macroeconomic foundations. Nevertheless, it shields India’s economy from a short-term capital flight. The dependence on imports like oil has crippled the economy in the past and the brewing tensions in the Gulf can possibly shoot up our current account deficits. Moreover, it comes at a fortunate time when the US administration is flexing its trade and investment policies and the Federal Reserve is hinting at likely increase in its rates. The silos will act as a buffer to prevent any slippage arising from these accounts.

The current spree of inflows has actually been quite unprecedented. The RBI traditionally does not allow an indiscriminate inflow (especially when the flight is led by FPI’s) and sells rupee-denominated bonds to prevent any unwarranted appreciation. But it must be stressed that the rate offered on American treasuries is less than what our bonds offer. In other words, what is received on treasuries is less than what it actually pays, thereby increasing the burden of interest payments which have to be sponsored by the National Budget. The commitment to not exceed fiscal deficit targets imply that any additional burden would apparently come by cutting important capital investments which may lead to lowering future growth prospects.

The black box, however, is the status of India’s engagement with its other partners, specifically China with whom we have a huge trade deficit. The bloated balances have no effect over this. In fact, the position with other countries has not (judged by the Real Effective Exchange Rate, or REER) undergone any significant change. Any euphoria ought to, thus, be evaluated in light of our other exchanges.

Featured Image Credits: Visual Hunt