The curious case of the rise in India’s foreign exchange reserves and the fall of the rupee

For the uninitiated, the Reserve Bank of India (RBI) balance sheet is a mix of national and international assets carefully modulated regularly. It is important to note that foreign reserve holdings contribute more than 70% of the combined balance sheet of the central bank and therefore have a greater impact on its operations. Therefore, when analyzing the financial statements of RBI, one should understand that what is bad for the Rupee can turn out to be good for RBI. This makes the relationship of the rupee to much of the RBI’s assets inversely proportional. One example is the fact that while RBI has accumulated an additional $ 61 billion since the start of the current fiscal year, the rupee has lost value.

From this perspective, perhaps the correct way to look at the RBI’s balance sheet is to look at the makeup of the reserve currency (RM) or base currency. While on the asset side, RM is made up of net domestic assets (NDA) and net foreign assets (NFA), on the liabilities side, it is made up of currency in circulation (CIC) and deposits made by banks . In normal operation, RBI must balance its balance sheet by careful modulation on both sides. In situations like the one created by the covid crisis, however, the system goes haywire as RBI is inundated with cheap money from overseas. Indeed, an accommodating monetary policy leads not only to the creation of liquidity, but also to an interest rate policy close to zero at most of the points of origin of capital. This phenomenon is commonly referred to as “quantitative easing”.

Globally, as interest rate differentials with emerging markets increase, the liquidity created turns into yield-seeking capital. India often finds itself as a major recipient of such hot money. In the market, simultaneous buying and selling of rupees can cause the rupee to appreciate and negatively impact the value of RBI’s NFA (as the dollar depreciates). But volatility-adjusted open dollar inflows increase its NFA. However, as the RM on the asset side is now higher, the RBI adjusts the liabilities by increasing the CIC, thus creating new money.

As soon as the output gap is reduced in the developed world, a normalization of monetary policy occurs, reducing the interest rate differential vis-à-vis emerging markets. During this phase, the flight of capital creates a demand for dollars, depreciating the rupee. RBI intervenes in the open market to stabilize the rupee, selling part of its reserves in dollars. While reducing his NFA, this process increases his NDA. A concrete example concerns the periods 2009-10 and 2013-14, when NDAs represented on average nearly 33% of the workforce. The RBI had stepped in to support the rupee during these volatile times, as a great financial crisis unfolded amid strong domestic credit growth in the first episode and a shift in the global rate differential led to outflows. capital in the second. It was the time when the decline in the exchange value of the rupee led to a simultaneous reduction in foreign holdings. As stability returned, the average RBI NDA fell to 24% on average, and a rising NFA even exceeded the central bank RM.

Theoretically, the CIC already created leads to the formation of a broad currency using a multiplier effect. The resulting systemic liquidity can enter the RBI’s balance sheet through the Liquidity Adjustment Facility, balancing assets (repo transactions) and liabilities (reverse repo transactions) based on the state of the credit application. A growing economy and increased drawdowns translate into a stable deposit rate. As a result, bank deposits with the RBI in the form of a cash reserve ratio increase, complementing the RM adjustment to liabilities.

Throughout the current crisis, however, the continued influx of foreign money increased foreign currency holdings, creating new money that had nowhere to go. This conundrum was caused by the low consumption of credit during much of the pandemic, as well as the increase in deposits that forcefully fed commercial banks. In turn, RBI also had to sterilize the system through massive repo transactions, further increasing its deposit account. This was the situation where deposits made up 26% of liabilities in 2020-2021 and contributed significantly to RM. At the same time, RBI had to pay attention to the depreciation of the dollar and its impact on the NFA value. Note that CIC as a percentage of RM has grown the most slowly since demonetization.

Fast forward, with the “transitional” history of inflation becoming questionable, central banks around the world began to talk about normalization. Despite this, Indian markets, driven in large part by domestic investors, have attracted intermittent interest from foreign investors. While market volatility creates a difficult situation for the rupee, for the RBI’s balance sheet, such conditions are favorable. Global volatility involving exits increases the value of foreign holdings in the asset, and the liabilities adjust through the revaluation account without impacting RM, until the next Unless the RBI backs the rupee, once the peaks past moments, its foreign currency assets are expected to increase in value.

Analysts should therefore be warned that the increase in foreign exchange reserves should be taken with a grain of salt. Forex volatility is a reality in these times as the economy will take a long time to function normally and the newly created currency will simply invade RM in the form of deposits. As credit drawdowns resume, reverse repo transactions will decrease, paving the way for an increase in CIC. This is often inflationary and can cause the rupee to lose value. It should be noted that if the NFA / CIC proportion was set at 70% by the Tarapore Committee, the metric has exceeded 140%. Any further growth of the NFA without a simultaneous decrease in deposits will create an incremental CIC, unintentionally increasing the RBI’s balance sheet. Moreover, in the event of a rapid depreciation of the rupee, the RBI will have no choice but to use its reserves to protect the currency, thus exposing its balance sheet to external shocks. The analytical framework that examines foreign exchange reserves in terms of import coverage therefore seems outdated now, given the complexities and uncertainties of a world with large capital flows.

Karan Mehrishi is the author of “The India Collective: What India is Really All About”

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