For a country like India, forex reserves have long been treated as precautionary savings that the government acquires as a “rainy day” fund to tide over any sudden decrease in capital inflows.
In other words, it acts as a buffer against shocks to external wealth.
On the other hand, countries like China, the UAE, Norway, Saudi Arabia, Russia, Singapore and many others prefer higher returns to liquidity.
The precautionary savings in such countries manifest in the form of Sovereign wealth fund (SWF), a state owned investment fund that is riskier than traditional forex reserves.
Over the last two decades, India has exhibited robust macroeconomic fundamentals and is one of the most attractive destinations of foreign investment. This has resulted in an unprecedented accumulation of forex reserves. It may be noted here that India’s forex reserves accumulated to a record high of over $600 billion a few weeks back.
This makes us the fifth largest holder of forex reserves after China, Japan, Russia and Switzerland, according to RBI.
Such a high accumulation of reserves has prompted the government to explore an in vestment strategy whereby the accumulated reserves can be better utilised. It is imperative to unleash the catalytic power of government in vestment to offset the shadow of the Covid-19 pandemic on India’s growth story.
The newly announced Pradhan Mantri Gati-shakti National Master Plan for infrastructure and other mega infrastructure projects necessitate a careful appraisal of our financial firepower.
That brings us to the fundamental question:
Does India have “too much” reserve buildup and hence “surplus” reserves for the government to explore an in vestment strategy?
To answer this question, we look at two popular measures of reserve adequacy of a country.
- The first measure of a country’s susceptibility to currency crisis is the ratio of reserves to short term external debt. Also known as Guidotti–Greenspan rule, the critical value of this ratio is one, with a value below one being undesirable.
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The Guidotti–Greenspan rule states that a country’s reserves should equal short-term external debt (one-year or less maturity), implying a ratio of reserves-to-short term debt of 1. The rationale is that countries should have enough reserves to resist a massive withdrawal of short term foreign capital
- The second indicator of reserve adequacy is the ratio of reserves to M3 or broad money. This ratio is especially relevant for countries like India that are a haven for ‘hot money’ investment by large foreign institutional investors and hence are subject to a major risk of capital flight. It is suggested that a critical value of this ratio in the range of 520 per cent is desirable.
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M3 (broad money) is commonly used to measure the money supply. Among other things, this includes currency with public and demand deposits of banks. So, withdrawal of Rs.100,000 in cash does not make any difference to the aggregate money supply.
An analysis of time-series data on Indian economy for past three decades suggests that India comfortably fulfills both these measures.
With the ratio of reserves to short-term external debt exceeding one in all the years since 1991-92 and the ratio of reserves to broad money above 20 per cent for all the years since 200203, there is ample evidence of “too much” of reserves buildup for the Indian economy.
However, the following precautions may be noted.
First, creation of SWFs tends to be common practice among major fuel and commodity exporting countries. SWF creator countries, which are not intensive fuel exporters, otherwise possess large current account surpluses (namely, China). India is neither an oil exporting country, nor has current account surplus.
Secondly, India’s growing fiscal deficit has the potential to create adverse trade imbalances, popularly known as ‘twin deficit’, thereby prompting the government to adopt a cautious approach.
In addition, RBI has advised a pragmatic assessment of reserve adequacy in view of existing level of forex reserves being projected to cover less than 15 months of imports (while countries higher than us in forex reserves position boasting anywhere between 16 and 39 months of import cover).
It has been held — rightly so — that accumulated reserves are not ‘owned’, they are liabilities. Essentially, forex reserves are built up from in vestment flows and have long been used as a cushion to avert crises that cause precipitate outflows of foreign exchange.
Nonetheless, just as a bank lends out money from its liabilities (read deposits) while keeping aside a part that is deemed sufficient to take care of exigencies, forex reserves may be suitably subject to this calculus.
While it is apparent that RBI is already diversifying its forex investments in a basket of currencies to earn higher returns, some part of our reserves can be committed for longer term investments.
As India turns 75, it is time to assess whether our forex reserves can help further our geo-economic and strategic priorities while not disregarding the above expressed concerns. A wider consultation on the subject is the need of the hour.
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Steve Ovett, the famous British middle-distance athlete, won the 800-metres gold medal at the Moscow Olympics of 1980. Just a few days later, he was about to win a 5,000-metres race at London’s Crystal Palace. Known for his burst of acceleration on the home stretch, he had supreme confidence in his ability to out-sprint rivals. With the final 100 metres remaining,
[wptelegram-join-channel link=”https://t.me/s/upsctree” text=”Join @upsctree on Telegram”]Ovett waved to the crowd and raised a hand in triumph. But he had celebrated a bit too early. At the finishing line, Ireland’s John Treacy edged past Ovett. For those few moments, Ovett had lost his sense of reality and ignored the possibility of a negative event.
This analogy works well for the India story and our policy failures , including during the ongoing covid pandemic. While we have never been as well prepared or had significant successes in terms of growth stability as Ovett did in his illustrious running career, we tend to celebrate too early. Indeed, we have done so many times before.
It is as if we’re convinced that India is destined for greater heights, come what may, and so we never run through the finish line. Do we and our policymakers suffer from a collective optimism bias, which, as the Nobel Prize winner Daniel Kahneman once wrote, “may well be the most significant of the cognitive biases”? The optimism bias arises from mistaken beliefs which form expectations that are better than the reality. It makes us underestimate chances of a negative outcome and ignore warnings repeatedly.
The Indian economy had a dream run for five years from 2003-04 to 2007-08, with an average annual growth rate of around 9%. Many believed that India was on its way to clocking consistent double-digit growth and comparisons with China were rife. It was conveniently overlooked that this output expansion had come mainly came from a few sectors: automobiles, telecom and business services.
Indians were made to believe that we could sprint without high-quality education, healthcare, infrastructure or banking sectors, which form the backbone of any stable economy. The plan was to build them as we went along, but then in the euphoria of short-term success, it got lost.
India’s exports of goods grew from $20 billion in 1990-91 to over $310 billion in 2019-20. Looking at these absolute figures it would seem as if India has arrived on the world stage. However, India’s share of global trade has moved up only marginally. Even now, the country accounts for less than 2% of the world’s goods exports.
More importantly, hidden behind this performance was the role played by one sector that should have never made it to India’s list of exports—refined petroleum. The share of refined petroleum exports in India’s goods exports increased from 1.4% in 1996-97 to over 18% in 2011-12.
An import-intensive sector with low labour intensity, exports of refined petroleum zoomed because of the then policy regime of a retail price ceiling on petroleum products in the domestic market. While we have done well in the export of services, our share is still less than 4% of world exports.
India seemed to emerge from the 2008 global financial crisis relatively unscathed. But, a temporary demand push had played a role in the revival—the incomes of many households, both rural and urban, had shot up. Fiscal stimulus to the rural economy and implementation of the Sixth Pay Commission scales had led to the salaries of around 20% of organized-sector employees jumping up. We celebrated, but once again, neither did we resolve the crisis brewing elsewhere in India’s banking sector, nor did we improve our capacity for healthcare or quality education.
Employment saw little economy-wide growth in our boom years. Manufacturing jobs, if anything, shrank. But we continued to celebrate. Youth flocked to low-productivity service-sector jobs, such as those in hotels and restaurants, security and other services. The dependence on such jobs on one hand and high-skilled services on the other was bound to make Indian society more unequal.
And then, there is agriculture, an elephant in the room. If and when farm-sector reforms get implemented, celebrations would once again be premature. The vast majority of India’s farmers have small plots of land, and though these farms are at least as productive as larger ones, net absolute incomes from small plots can only be meagre.
A further rise in farm productivity and consequent increase in supply, if not matched by a demand rise, especially with access to export markets, would result in downward pressure on market prices for farm produce and a further decline in the net incomes of small farmers.
We should learn from what John Treacy did right. He didn’t give up, and pushed for the finish line like it was his only chance at winning. Treacy had years of long-distance practice. The same goes for our economy. A long grind is required to build up its base before we can win and celebrate. And Ovett did not blame anyone for his loss. We play the blame game. Everyone else, right from China and the US to ‘greedy corporates’, seems to be responsible for our failures.
We have lowered absolute poverty levels and had technology-based successes like Aadhaar and digital access to public services. But there are no short cuts to good quality and adequate healthcare and education services. We must remain optimistic but stay firmly away from the optimism bias.
In the end, it is not about how we start, but how we finish. The disastrous second wave of covid and our inability to manage it is a ghastly reminder of this fact.