India builds $610bn forex buffer to meet challenge from US Fed stance

India’s foreign exchange reserves have grown to over $610 billion, on the back of foreign direct investments and the inflow of foreign institutional or portfolio investors into the stock markets, which have seen a sustained bull run over the past year.

According to the Reserve Bank of India (RBI) data, for the week ended July 2, India’s foreign exchange reserves grew by $1.013 billion to touch an all-time peak of $610.012 billion. Earlier, in the week ended June 25, foreign exchange reserves shot up by $5.066 billion. The latest increase in foreign exchange reserves has largely been attributed to the rise in foreign currency assets of FCA, which went up by $748 million, according to the RBI.

The FCA include impact of depreciation/appreciation of currency units that are non-dollar. These could be the pound, yen or euro that are held in the forex reserves. India’s reserve situation with the International Monetary Fund also went up by $49 million to touch $1.548 billion.

With the latest increase, India’s foreign exchange reserve becomes the fifth largest after China, Japan, Switzerland and Russia. RBI research cited in news reports suggest that this reserve is sufficient to cover 15 months of imports. Meanwhile, Switzerland’s import cover is 39 months, while that of Japan and Russia stand at 22 and 20 months, respectively. China’s import cover is just a little more than India’s, at 16 months.

Buffer useful to beat exchange rate volatility

This buffer is important for India to protect itself from volatility in exchange rate; this was also reiterated by former RBI Governor at a recent event, news reports suggest. The need to manage exchange rate can be eventually done away with if India builds a certain amount of credibility for its inflation targeting apart from strengthening the financial system. India’s central bank, the RBI, maintains retail inflation at 4 per cent with a range of 2 per cent on both sides and the policy rates are decided on the basis of this retail inflation range. India shifted to this inflation targeting regime in 2014-15.

Also, there are concerns that though India’s foreign reserves have touched record levels, the country’s net international investment position (NIIP) is negative. The NIIP is a measure of the gap between a country’s foreign asset stock and a foreigner’s stock of the country’s assets. If the gap is negative, it means the country is a debtor. The NIIP is measured as a percentage of the GDP. This negative gap would mean that the RBI would like to have a solid foreign exchange reserve buffer and increase it as well, in order to battle any sort of volatility on the global front.

Protection from likely taper tantrums

A key reason why India needs to sustain and further increase its foreign exchange reserves is also because it seems to be mindful of the US Federal Reserve’s monetary policy stance. Although the Fed Reserve has maintained an accommodative stance, it has indicated the possibility of a couple of rate hikes by 2023. The Fed has also maintained that it would continue its bond buying programme to ensure the economy gets support and inflation of approximately 2 per cent is achieved. However, the Fed also eyes a reduction or tapering of its bond buying eventually. This underlines the need for a strong forex reserve. Back in 2013, when the then Fed chairman Ben Bernanke had signalled that the US central bank would taper its asset purchase programme, it had set off an alarm across Asia, an incident that is infamously called the taper tantrum.

While overseas inflows have strengthened India’s reserves, if and when the US Fed begins plans to withdraw a portion of its monetary stimulus, it may trigger an outflow from emerging markets including India. This means that the current foreign exchange buffer is significant and is likely to offer a level of comfort for the RBI.

India’s strong foreign exchange reserve is similar to the rest of the Asian economies whose central banks are also beefing up their reserves. According to a report, the central bank holdings of foreign currencies in Asia hit $5.82 trillion in May, the highest since 2014.

Conclusion

India’s $610 billion plus in foreign exchange reserves is likely to help the country fight any sort of market volatility in the event of monetary policy tightening of the US Federal Reserve. However, this may need to be sustained and boosted in the wake of any global spillover that may arise because of the evolving situation on the economic front, as pandemic-affected countries begin their path towards recovery.