India’s foreign-exchange reserves have dropped to below $ 600 billion, a 7% fall in just the past six months. The reason for the fall is either that people (both Indians and foreigners) are taking dollars out of India, or that the Reserve Bank of India (RBI) has been selling dollars to “decrease” the pressure on a declining rupee.
Sharp rupee depreciation is bad news since it makes our imports expensive. Crude oil imports alone were $ 120 billion during last fiscal year. If the rupee slides, crude oil becomes expensive, which affects domestic price of petrol and diesel, contributing to inflation. On the other hand, the rupee can not be allowed to get too strong, because it will hurt our exports. The optimal level of the exchange rate is managed by the RBI. This dollar-rupee rate is the most important “price” which is managed in the economy. To manage the exchange rate the RBI needs to have some stock of foreign exchange, which is currently just below $ 600 billion.
Is that too much? Strangely this question has been recurring for almost 15 years. Even when India’s forex stock reached $ 100 billion some people started asking whether it was excessive. One of the benchmarks used to measure whether forex is adequate or not is how many months of imports it can support. This past year our import bill was around $ 620 billion. So, our current forex stock can pay for 12 months of imports. That seems like a safe stock.
Hence, some people have suggested that India should have its own sovereign wealth fund just like Abu Dhabi, Saudi Arabia, Norway, Singapore or China. All these countries have a very large stock of foreign exchange. But the first three of them are large oil exporters and have windfall gains from high oil prices, and their own domestic consumption of oil is very low. The last two, Singapore and China, are also major exporters and consistently have a current-account surplus, ie exports always exceed imports. India’s case is very different. It does not have any windfall gains from oil or any other commodity exports. Secondly, it consistently has a current-account deficit, sometimes as high as 2% or 3% of GDP. So, India is constantly running short of dollars on its trade account. The reason that India has ample supply of dollars is because its trade deficit is financed by foreign investors via the capital account. This includes money flowing into the stock market, via foreign loans and by non-resident Indians keeping fixed deposits in Indian banks. And of course through foreign-direct investment (FDI) in projects, companies and start-ups.
However, everything except FDI is hot money. It can easily be reversed. There can be sudden stops to stock market inflows. It’s a great testament to the confidence of foreign investors in India’s prospects that for past more than three decades they have poured investment dollars, which has taken our forex stock from barely $ 1 billion in 1991 to $ 600 billion in 2022. The call for using some of India’s forex stock to form an SWF is also because RBI earns barely 1% or 2% returns on its forex stock, which is mainly invested in the US and other sovereign bonds. By its charter, the RBI is not allowed to invest in any other asset, since it has to park the foreign exchange in only safe assets. On the other hand, other countries with large forex carve out a big fund into a SWF, which in turn is allowed to invest in more risky assets and earn a higher return.
There have been calls for India too to have its own SWF to use some of its own forex more productively. In a way we already have a SWF which is called The National Investment and Infrastructure Fund (NIIF), set up in 2016 and managed by a government-appointed team to leverage foreign investment into India. So far, its size is about $ 4 billion and its investments, mainly in the form of equity, are across sectors including infrastructure, e-commerce and perhaps future unicorns. But, $ 4 billion is but a drop out of $ 600 billion. The main thing to realize is that India needs a largish pile of forex as insurance against sudden flight of foreign capital, which can leave us in the lurch. It happened in 1997 to East Asian countries like Thailand. Ever since then many developing countries started having their own dollar pile as self-insurance. Since Sri Lanka did not have adequate forex stock it has defaulted and is facing bankruptcy in foreign bonds. India does not have the luxury of being an oil exporter like Abu Dhabi nor does it have a current-account surplus like Singapore or China. If it wants to secure higher returns for its forex, it can diversify away from dollar assets to euro or other currencies.
But as of now the dollar is king and our forex stock, safely managed by RBI is our insurance. In this coming year of high oil prices and inflation and slowing growth, it makes sense to conserve our forex.
Views expressed above are the author’s own.
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