India Foreign Exchange Reserves Comfortable
(This
is for information purposes only. This should not be construed as a
recommendation or investment advice even though the author is a CFA Charterholder. Please consult your financial
adviser before taking any investment decision. Safe to assume the author has a vested
interest in stocks / investments discussed if any.)
(update 13Nov2023 is available at the end of the blog post)
India's
foreign exchange reserves (or forex reserves for short) are maintained
by country's central bank, the Reserve Bank of India (RBI). RBI is the owner and custodian of India's forex reserves.
RBI also
sets monetary policy and manages exchange rate fluctuations in Indian
rupee, in addition to several other functions.
1. Healthy Forex Reserves
Adequate
foreign exchange reserves provide comfort to India’s real and external sector from shocks
emanating from volatility in capital flows and crude oil price shocks.
There
are some metrics to know whether a country’s forex reserves are adequate to meet the challenges in external sector (these metrics shall be discussed in later part of the blog).
This cost has to be balanced in the backdrop of absorbing shocks from volatile exchange rate and oil prices. India imports most of its energy / oil needs from abroad.
As
we have seen in August / September 2013, Indian rupee fell sharply due to a
variety of factors, like, surge in crude oil prices, India’s high current
account and fiscal deficits, stubborn food inflation and ‘taper tantrum’ remarks
by then-Fed chair Ben Bernanke in May 2013.
After
the Indian federal government took steps and Raghuram Rajan took over as RBI governor, Indian rupee stabilised
and appreciated to 63-level versus the US dollar by the second week of Sep2013
from its then-all-time-low of 68.80 at the end of Aug2013.
(blog continues below)
------------------------------Related blogs:
India Forex Reserves in Four Charts 08Mar2022
India Foreign Exchange Reserves Data 18May2022
Slowing Foreign Direct Investment to India 25May2022
Exit India Policy by Foreign Investors 10Jul2022
Central Bank Gold Holdings 21Mar2022
------------------------------
Over the past 10 years, India built up its forex reserves consciously after having seen some episodes of Indian rupee volatility in August 2013 as mentioned before.
Though the reserves have shrunk in the past one year, they have almost doubled from USD 292 billion at the end of March 2013 to USD 578 billion by the end of March 2023.
As of Oct2023, the reserves are at USD 586 billion.
Reserves accretion was at a faster pace between 2018-19 and 2021-22; one reason for this could be lower current account deficit (more on CAD in Section 4 below) during the period.
In India, a two percent current account deficit (CAD as a percentage of GDP or gross domestic product) is considered as sustainable to stimulate India's economic growth. Anything, above two percent CAD to GDP ratio is not sustainable creating instability in real and financial sectors.
Table 1: Forex Reserves, accretion / depletion and RBI USD sales / purchase:
2. Role of Foreign Investors
Foreign portfolio investors (FPIs) have been investing in Indian stock market since
1991. But,the foreign portfolio flows into India's stock and debt markets are
temporary in nature and they can be quite volatile.
In
order to mitigate any risks from volatile portfolio flows, India needs to have
adequate foreign exchange reserves as a cushion. Any substantial increase in
FPI flows needs to be buttressed with accretion to forex reserves.
There
are different types of FPIs (foreign portfolio investors) in Indian stock
market. They
are not homogeneous group. Their
objectives of investing in India are different.
FPIs
provide both stable and volatile capital to India.
Some part of the
flows can be considered as more stable, because entities,like, sovereign wealth
funds, endowments, pension funds and foundations tend to take a long term view
of India and they supply stable capital through their investments in Indian
financial markets.
Investors
that provide such stable capital are termed as 'long-term FPIs.'
Other investors prefer investing for short term. The
volatility in FPIs flows into Indian market depends mainly on this short-term-oriented FPIs.
FPIs
that invest for long term in Indian stocks and are stable capital providers:
1. sovereign wealth funds (SWFs)
2. endowments ad foundations
3.
India-only foreign funds
FPIs
that are short-term oriented with volatile capital:
1.
global funds
2. proprietary desks
3. hedge funds
Equity Assets held by FPIs / FPI AUC data:
As
on 30Sep2023, equity assets under custody (AUC) by FPIs increased by
17.3
percent in the past one year (between Sep2022 and Sep2023) in rupee
terms to Rs 54 lakh crore.
Whereas in US dollar terms, equity AUC held by FPIs in the same period
increased by 15.1 percent to USD 650 billion as the Indian rupee
depreciated by 1.8 percent versus the US dollar.
However, the share of FPIs in Indian stocks declined from 19.5 percent of total BSE market capitalisation in Mar2017 to 17 percent in Sep2023.
Volatile FPI flows in Indian equity / debt market:
The volatility of FPI flows into stock market can be gauged from the monthly numbers shown in table 4 below. In calendar year, their flows were negative in January, February, September and October.
Despite the outflows, the stock market remained more or less resilient, which can be observed from Sensex / BSE 200 levels provided in the chart.
Table 4 provides monthly data of FPI equity flows:
As shown in table 5 below, FPIs sold Indian stocks heavily between October 2021 and June 2022 amounting to more than Rs 2.55 crore of money. During the period, the Sensex lost about 10 percent of its value; the FPI flows were more or less matched by domestic investors.
Table 5 provides quarterly data of FPI equity flows:
Between 2010 and 2023, FPI flows into stocks were negative in three years, that is, 2011, 2018 and 2022. They were negative in three financial years in 2015-16, 2021-22 and 2022-23; with one year 2018-19 being practically zero net flows.
Tables 6 and 7 provide yearly (both calendar and financial) data of FPI equity flows (data from 2010 to 2023 -- 2023 data till 10Nov2023):
3. Slowing Foreign Direct Investment
Foreign direct investment (FDI) is considered as more stable when compared to foreign portfolio flows from FPIs.
While commenting on FDI flows, it is important to distinguish between gross flows and net flows.
Gross FDI inflows include repatriation / disinvestment (some multi-national corporations repatriate profits out of India and some MNCs close their India businesses) figures.
And from the resultant figure, we need to remove FDI by India (investments made by Indian companies abroad). That is how we arrive at the net FDI print.
In the past nine years, the lowest net FDI to India in US dollar terms is in FY 2022-23, when India received USD 28 billion of net FDI.
In
the past 9 years under PM Modi government, net FDI inflows showed an absolute
growth of 29.8 percent or just 2.94 percent annualised growth (CAGR)
which can be considered as abysmal.
Years 2019-20, 2020-21 and 2021-22 experienced bumper net FDI investment inflows. but they were down, year-one-year, more than 27 percent in 2022-23 in US dollar terms.
Table 8: Foreign Direct Investment (FDI) data for the past 17 years - both gross and net FDI:
4. Current Account Deficit in Control
One redeeming feature of Indian economy in recent years is the current account deficit, in general, is in control as compared to turbulent times India faced in 2011-12 and 2012-13.
PM Modi government deserves some praise on the balance of payments (BoP) position, though on the FDI front India lacks direction (Section 3 above).
As shown below, India enjoyed a current account surplus for the first time in several years - this needs to be tempered in the backdrop of severe and draconian COVID-19 lockdowns imposed in India.
The lockdowns contracted India's economic growth severely and merchandise trade collapsed resulting in a current account surplus of 0.9 percent of GDP during financial year 2020-21.
Current account balance in surplus is a rare phenomenon in India.
Table 9: CAD to GDP ratio from 2009-10 to 2022-23:
As mentioned above, a two percent current account deficit (CAD as a percentage of GDP) is considered as sustainable to stimulate India's economic growth.
As can be seen from above table, only in FY 2018-19, we had more than two percent CAD to GDP.
6. Adequacy of Reserves
Now, let us come to the main topic of examining whether India is in a comfortable position in forex reserves.
RBI mainly focuses on safety and
liquidity, rather than returns (earnings) while managing India's forex
reserves. Returns on forex reserves are incidental to the main objectives of safety and liquidity.
Global savings glut impacts not only savers but also RBI's balance
sheet. Rate of earnings on RBI's fx reserves: 1999-2000 to 2018-19 (sharp drop
from 2008 GFC)...
India's forex reserves
are not from trade surplus (as is the case with nations, like, China and Japan), but they are accumulated mainly from foreign portfolio flows, which can be quite volatile at times.
As such, having a large sized forex reserves may not be the ideal situation.
When RBI buys foreign exchange (mostly US
dollars) to add to its reserves, it releases money (rupees) into the banking
system. To neutralize the impact of excess money, RBI issues government
securities and takes away that money from the banking system, involving sterilization costs for the government.
As mentioned earlier, the opportunity cost of managing forex reserves has to be balanced in the backdrop of absorbing shocks from volatile exchange rate and oil prices; and providing financial stability.
RBI manages the forex reserves diligently taking into account the currency composition, duration and selection of instruments, applying prudent portfolio risk management policies.
RBI deploys these foreign
exchange reserves in several instruments, significantly in the US Treasury securities.
The currency composition of our forex reserves is mainly from US dollar, euro, British pound and Japanese Yen.
As stated by Mr Moses Harding, an expert on forex markets, the carry cost of India's forex reserves is high,
but benefits are more non-tangible, like, financial and macro-economic stability and stable exchange rate.
The optimum level of reserves is hard to quantify.
However, there are some metrics that can be used to assess whether India has adequate forex reserves. These are: import cover, short term foreign debt to forex reserves ratio and volatile capital flows to forex reserves.
We shall also examine how much returns (earnings) the RBI generates from the reserves.
a). Import cover
Import cover is number of months of imports forex reserves could pay for. As of June 2023, import cover is 10.2 months, meaning India's forex reserves are sufficient to provide for more than 10 months of India's imports.
This is a comfortable situation, though import cover was 17 months three years ago.
India's forex reserves were as low of one month import cover during the crisis year of 1991.
Table 10: Import cover:
b). Short-term foreign debt to forex reserves
During 2012 and 2013, the ratio was uncomfortably high at 29 and 34 percent respectively. The lower the ratio, the better for Indian economy.
Table 11: Short term debt to forex reserves:
c). Volatile capital flows to forex reserves
Volatile capital flows include cumulative portfolio inflows and outstanding short-term debt.
By this metric, India need not expect any trouble from volatile capital flows in the next one year. During 2013, the ratio touched almost 100 percent.
d). Rate of earnings
After the 2008 Global Financial Crisis (GFC), many major central banks followed zero interest rate policy (ZIRP), resulting in lower returns from reserves.
As the US Federal Reserves, European Central Bank and Bank of England started increasing interest rates in 2022, the returns have improved last year.
In fact, the earnings rate in FY 2022-23 was 3.73 percent, the highest in several years.
7. Summary:
India's forex reserves have to be seen in the context of various other macro variables.
We have examined variables, such as, total reserves, volatile portfolio flows, stable foreign direct investment and various metrics about adequacy of reserves.
Except slowing FDI flows, India seems to be in a comfortable position as far as adequacy of foreign exchange reserves is concerned.
As examined in Section 6 above, India is in comfortable position in terms of import cover, short term debt to foreign debt and volatile capital flows to forex reserves.
Slowing net foreign direct investment into India is area of concern, though with deft management of current account and fiscal deficits and foreign exchange reserves, India can weather any unforeseen or adverse internal or external developments.
Future is unknown in the backdrop of geopolitical risks (like, elevated interest rates for a long period of time, high crude oil prices and wars). There is no room for complacency. But overall, India's forex reserves are adequate barring any exigencies and unknowns.
- - -
P.S.: The following information / images are added after the blog was published on 10Nov2023:
P.S. 1 dated 13Nov2023: Page 92 of RBI's Annual Report 2022-23 provides a chart on External Vulnerability Indicators for India's external sector >
------------------------------
Additional Notes:
RBI has got two intervention currencies - the US dollar and Euro
Changes / movements in RBI's foreign currency assets (FCA) occur mainly due to:
1) purchase and sale of forex by RBI (daily intervention in forex markets by RBI to "smoothen volatility")
2) income from forex reserves deployed abroad
3) external aid receipts of Govt of India
4)
changes on account of revaluation of assets (fall of Euro and
British Pound versus the US dollar, during Apr-Sep2022, was one of the main reasons for the
steep fall in India's forex reserves, which are denominated in US
dollars -- aggressive sale of forex by RBI between Mar2022 and Aug2022
to defend Indian rupee from falling against the USD was another reason
for big drawdown of forex reserves)
------------------------------
(though it was uploaded around 6 PM on Blogger on 10Nov2023, it took another 5 hours or so to finish this blog)
References:
More weblink references are given throughout the blog
IMF Paper 14Feb2011 on Assessing Forex Reserves Adequacy
RBI annual policy statement by YV Reddy 18May2014 (on aspects of forex reserves management)
YV Reddy, RBI deputy governor, speech 10May2002 (forex reserves management)
YV Reddy, RBI governor, speech 23Jun2005 (managing external sector)
------------------------------
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Disclosure: I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets.
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