Understanding India’s Foreign Reserves and Global Risk

 

Understanding India’s Foreign Reserves and Global Risk

India’s foreign exchange reserves have been growing about its GDP. This article explores why central banks accumulate reserves, examining if they hold enough to guard against significant capital flow disruptions. Specifically, it evaluates if the benefits of having more reserves surpass the costs, within the Indian context.

Since 1991, India has built up a considerable amount of foreign exchange reserves (see Figure 1). This increase in reserves relative to GDP is part of a broader trend seen in many large emerging market economies (see Figure 2). The accumulation of reserves in these markets prompts questions about their use, adequacy for intended purposes, and whether the advantages of higher reserves justify the associated costs.

Figure 1. Foreign reserves for India, in millions of US$

Figure 2. Reserve accumulation in India and other Asian economies, in millions US$

In our research, we explore various aspects of India's foreign reserves. Our primary focus is on evaluating how additional reserves impact international capital flows over the global financial cycle and assessing the opportunity cost of holding these reserves for India.

In our research, we explore various aspects of India's foreign reserves. Our primary focus is on evaluating how additional reserves impact international capital flows over the global financial cycle and assess the opportunity cost of holding these reserves for India.

Why Accumulate Reserves?

Central banks typically hoard reserves for three main reasons:

1.      Self-Insurance: Reserves act as a protective buffer against sudden runs on domestic financial markets and institutions, whether caused by domestic or foreign asset holders. They serve as a precaution against abrupt capital outflows triggered by global or local financial shocks.

2.      Market Intervention: Reserves are used to intervene in the foreign currency exchange market to smooth out short-term fluctuations in exchange rates.

3.      Export Competitiveness: Accumulating reserves can help undervalue a country's currency, thereby supporting export competitiveness through systematic reserve purchases.

Reserves offer international liquidity, enabling central banks to act decisively during financial instability. Economies that are open to global capital flows are at risk of sudden reversals of foreign capital or capital flight by domestic investors. Foreign reserves also provide liquidity against domestic financial instability, as was evident in India in 1991, leading the Reserve Bank of India (RBI) to strengthen its foreign exchange reserves.

Determining Adequate Reserve Levels

A key question for monetary policy is how much reserve is sufficient as a safeguard against extreme capital outflows. The adequacy of reserves is generally defined by the potential demand for reserve currency in the short term. The International Monetary Fund (IMF) uses metrics such as the ratio of reserves to external debt, three months of import coverage, and the ratio of reserves to broad money to assess adequacy. However, these measures are somewhat arbitrary and may not fully capture a nation's vulnerability to financial shocks.

Weighing Benefits Against Costs

The benefits of holding reserves need to be balanced against their opportunity costs. These costs include the difference between the returns on foreign government debt held by the RBI and the yield on domestic government debt. The quasi-fiscal costs of holding reserves are mainly estimated from the interest rate differential between domestic and US government debt.

Evaluating India’s Reserves

Currently, India's reserves exceed the IMF's adequacy thresholds This brings up the question: how much is enough? Determining this involves understanding how additional reserves influence the risk of severe financial events and the associated opportunity costs. Maintaining reserves beyond what is necessary for sudden capital outflows and import needs can reassure creditors and market participants that the RBI is prepared to intervene as needed. Such reserves can mitigate the risks associated with global and domestic financial shocks, thus reducing the incidence of capital flow reversals and the risk premium on government debt.

Impact on Financial Stability

Traditional formulas for determining optimal reserves focus on the level needed to handle sudden outflows but do not consider the 'endogeneity' of risk. The availability of reserves to address financial shocks and sudden capital outflows can influence the amount and nature of foreign capital inflows. Reserves that enhance financial stability can lead to more efficient investment finance. By lowering financial fragility, higher reserves may increase the maturity of capital inflows and reduce exposure to short-term capital outflows. If reserves lessen capital outflows during adverse conditions, their marginal benefit increases, potentially justifying a higher reserve level.

Analyzing Capital Flows

We assess the effect of reserves on volatile capital flows in India across the entire probability distribution, rather than just the average. Our approach uses capital-at-risk analysis for international capital flows. Quantile regressions are employed to estimate how reserves influence gross capital flows under various external and internal shocks, considering global financial, growth, and monetary policy risks. Our focus is on foreign gross capital inflows, which are crucial for India's financial stability, as domestic gross capital outflows are minimal due to capital controls.

Balancing Benefits and Costs

Global financial instability and foreign monetary policy shocks significantly affect foreign capital outflows from India. We use the VIX index to represent global financial shocks and the relative monetary policy rates of India and the US to represent monetary shocks. Our findings indicate that additional reserves can substantially reduce large outflows that occur with a 5% probability. Reserves help mitigate capital outflows during global uncertainty and monetary policy shocks. While reserves stabilize foreign debt flows, they do not significantly impact equity flows.

Costs of Holding Reserves

We examine the costs associated with holding reserves, including the interest differential between the Government of India Securities and US Treasuries, the carry cost of foreign reserves, and other valuation effects. The carry cost reflects the profit or loss from reverse carry trades held by the RBI. Our model estimates the interest rate spread between 10-year Government Securities for India and 10-year US Treasuries, dividing it into currency risk premium and pure risk premium. The results show that reserves have a significant negative impact on spreads, indicating that the marginal opportunity cost of additional reserves is lower than the interest rate difference between RBI reserve assets and domestic government debt.

Conclusion

Our analysis suggests that accumulating reserves continues to offer significant precautionary benefits for India. Additional reserves help reduce gross outflows during adverse global financial and interest rate shocks, highlighting the positive marginal benefits of holding reserves for financial stability. The estimated reduction in the sovereign interest spread suggests that the opportunity cost of reserves for the RBI may be substantially lower than the simple spread, net of valuation costs.