RBI Bulletin: Forex reserves the only reliable cushion against global volatility

A sturdy pile of foreign exchange reserves is the only reliable tool for an emerging market economy such as India to safeguard itself from the adverse effects of capital outflows, according to a study by the staff of the Reserve Bank of India (RBI).

In its monthly bulletin, the RBI has detailed an article on the risks emanating from capital outflows. “Applying a capital flows at risk approach, it is observed that in an adverse scenario, potential portfolio outflows can average up to 3.2 percent of GDP. In a black swan event comprising a combination of shocks, potential portfolio outflows can rise to 7.7 percent of GDP, highlighting the need for maintaining liquid reserves to quell such potential bouts of instability,” the article stated.

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At 3.2 percent of GDP, the potential outflows could amount to $100.6 billion in a year, the article elaborates. Given that such a large outflow could destabilise domestic markets and pressure the exchange rate, a significant pile of foreign exchange reserves could act as a critical cushion.

India’s forex reserves currently stand at roughly $600 billion and has been projected as a key factor in limiting the impact of global volatility on the domestic economy and markets. “All instruments, including prudential and other capital flow measures, are an integral part of the playbook, and often the measures of the first resort. In the ultimate analysis, spillovers can be global but the responsibility for macroeconomic and financial stability is national. This focuses attention on the role of international reserve accumulation as the only reliable safety net,” the bulletin said.

Positive economic growth differentials with advanced economies and higher term premium on local bonds are the key factors that attract capital inflows into India. On the other hand, global risk aversion is the single biggest factor in triggering capital outflows, the bulletin said.

Foreign investors have pulled out $26 billion from the domestic markets since January this year. The result has been a depreciation of 5 percent of the Indian rupee and a depletion of forex reserves.

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Reserves have fallen by $42 billion from the record high level in September 2021 as the RBI dipped into it to intervene in the market and limit the impact of global risk aversion on the exchange rate. Along with a swelling import bill due to high global crude oil prices, the import cover offered by the reserves has come down to 10 months from a high of 28 months in early 2020. Import cover and the ratio of reserves to short-term debt are key metrics through which the adequacy of reserves is gauged.

The bulletin highlighted that adequacy of reserves should also be judged by the probability of sharp outflows expected against the stockpile of total portfolio investment and short-term trade credit. As of December 2021, India’s short-term trade credit stood at $110.5 billion while total portfolio investment was $288 billion, the central bank said.

Former governors of the RBI have in the past highlighted the importance of reserves during crisis times. However, Governor Shaktikanta Das, in an interview to Business Standard newspaper last year, had said that India’s forex reserves are not through trade surplus but through capital flows. Therefore, these reserves have liabilities against them and carry a cost.