India requires to shore up its reserves but the cost of shoring it up is high. The INR is still down over 30% against the USD from levels seen a few years ago and the country is still not out of the woods in terms of inflation. CPI (Consumer Price Index) inflation at 8.1% is higher than target levels of 6% for 2014-15 and a weak INR adds to inflation as cost of imports rise. Oil is the largest single component of India’s imports and a stronger INR is helpful to bring down import bill as well lower oil subsidy that is impacting fiscal deficit negatively. Net to net, RBI is best off leaving the INR alone and let it find its natural levels at this juncture.
The Indian Rupee (INR) is trading at eight months highs against the US Dollar (USD). The INR is up close to 13% from record lows seen in August 2008 and is up 3% in the first quarter of calendar year 2014. The INR has reversed its earlier weakness on the back of many factors including a fall of around 55% in the Current Account Deficit (CAD) in this fiscal, expectations of brighter economic prospects for India post 2014 general elections, fall in global risk aversion leading to FII’s buying over USD 6 billion of INR bonds in the first three months of calendar year 2014 and the strong inflows of USD 34 billion under the FCNR B swap window that has led to the country’s foreign exchange reserves rising by USD 20 billion since September 2013.
RBI was seen buying USD this week given the rally of over 1% in the INR. The central bank may have bought USD to curb volatility rather than any conscious decision to boost foreign exchange reserves. However the question on the market’s mind is whether the RBI will start accumulating USD to shore up its foreign exchange reserves.
Dr. Rajan the RBI Governor may voice his thoughts on buying USD to shore up reserves in his policy statement on the 1st of April 2014. But is there a need to shore up reserves and is buying of USD the right way to go about shoring up of reserves?
Is there a need to shore up foreign exchange (fx) reserves?
India’s external front has seen deterioration over the last few years. Import cover ratio that is the fx reserves to monthly imports has come off from over 14 months seen in 2008-09 to 7 months as of fiscal 2013-14. On the external debt front, short term external debt to fx reserves has doubled from 17.2% to 34.2% implying deterioration on the short term debt front. Fx reserves to total external debt has come off from 112% to 69%, a sharp deterioration from a very comfortable position. India has seen rise in external debt and rise in imports but has actually seen fx reserves come off from highs of USD 319 billion to USD 295 billion over the last three years.
Given the deteriorating external debt and import cover positions coupled with the country running current account deficit, there is a need to boost foreign exchange reserves.
Is buying of USD the best way to shore up reserves?
RBI intervention in currency markets has many side effects. One is that it prevents the INR from trading at market determined values and this encourages speculators to take large positions on directional trends given artificial value of the currency.
Two is that there is an effect on liquidity in the system. Buying of USD adds primary liquidity to the system that is inflationary in nature while selling of USD sucks out liquidity from the system that impacts interest rates and economic growth.
Three is apart from core INR value, there is an effect on other asset classes as well. Speculators would buy or sell equities, bonds and gold given the artificial value of the currency.
Four is central bank intervention in currency markets have never been successful. It is either a huge depletion of fx reserves if the central bank sells USD to protect currency value or a huge infusion of liquidity that leads to asset price bubbles if the central bank buys USD.
Five is a country protecting the value of its currency will have issues of currency wars and also trade wars with other currencies.