RBI likely to continue building forex reserves amid strong fund flows, say experts

The Reserve Bank of India (RBI) is expected to continue building a war chest of foreign exchange reserves at a time when foreign fund flows into India are on a strong footing.

As on July 9, the RBI’s foreign exchange reserves stood at a record high of $611.89 billion, driven largely by an increase in its foreign currency assets.

A slew of initial public offers (IPOs), including that of restaurant aggregator Zomato, are likely to see good participation from foreign portfolio investors (FPI) and that has kept the RBI on its toes.

Currency market experts said that in such a scenario, emerging market economies typically build up reserves to prevent volatility in their currencies. “The central bank is going to continue building reserves. The RBI strategy is absolutely clear that they are going to intervene whenever there is a lumpy flow,” said Anindya Banerjee, DVP, Currency Derivatives & Interest Rate Derivatives at Kotak Securities. The way the Chinese central bank accumulated $3 trillion of reserves between 2000 and 2012 is an example that could be playing on the RBI’s mind, Banerjee said.

In fact, the extent of reserves being built by the RBI may be well in excess of fund inflows, if last year’s numbers are anything to go by. According to one currency expert that Moneycontrol spoke to, in FY21 the total foreign fund inflows were around $64 billion and the RBI bought close to $87 billion just in the spot market.

The build-up in forex reserves places the RBI well to fight likely volatility once the US Federal Reserve moves towards rate hikes, said Kunal Sodhani, Assistant Vice President (Global Trading Center, FX and Rates Treasury) at Shinhan Bank. “Considering still uncertain times both on the global and domestic fronts, the RBI has fully covered its external debt of around $563 billion by accumulating FX reserves to the tune of $611 billion till date. This is important because at times countries build forex reserves by seeking recourse to large external borrowings," Sodhani added.

In its monthly bulletin for June 2021, the RBI itself hinted that it might further boost its reserves. “While foreign exchange reserves provide cushions against unforeseen external shocks, levels are often deceptive, and a better gauge of external vulnerability is an assessment of specific indicators,” the RBI said in the bulletin.

The bulletin said that in terms of projected imports for 2021-22, the current level of reserves provides cover for less than 15 months, which is lower than for other major reserve holders – Switzerland (39 months), Japan (22 months), Russia (20 months), and China (16 months). Furthermore, India’s reserves co-exist with a net international investment position of -12.9 percent of gross domestic product. “These factors warrant a pragmatic assessment of reserve adequacy on FX reserves, including exposure to valuation changes and market risk in a world of heightened global uncertainty,” the RBI said.

At the same time, there have been concerns around the impact of the RBI’s reserve accumulation on its balance sheet. Banerjee of Kotak Securities said that while there is no macroeconomic risk due to the high level of reserves, there could be a risk to the RBI’s balance sheet. “This is because the RBI earns almost nothing on its dollar holdings. At the same time, it is paying 3.35 percent on the reverse repo,” Banerjee said.

“Secondly, the RBI also has to set aside 4.5 percent of their asset size, as defined under the Bimal Jalan Committee report. So these can be handicaps for the RBI because they are a drag on the profits and the dividends the RBI can pay to the Government,” Banerjee added.

In its last monetary policy press conference, the RBI tried to dismiss concerns on this front, though. “Our forex operations are mainly driven by the consideration of maintaining the stability of the exchange rate, which we have been quite successful during this pandemic times, to maintain the stability of the exchange rate,” RBI Governor Shaktikanta Das said on June 4. The surplus transfer to the government must not be seen as a policy issue, Das added.

The low returns from the deployment of forex reserves is a problem that persists, though. Typically, the RBI deploys reserves only in Treasuries of advanced economies or agency bonds. The central bank is now consulting external experts to look at diversifying its investment avenues.