Are India’s foreign exchange reserves adequate?
India has recorded outflows of $29 billion in 2022 year-to-date ($27 billion in equity and $2 billion in debt). Meanwhile, India’s foreign exchange reserves fell from a peak of $642 billion on October 29, 2021 to $590.50 billion in June 2022, a decline of $51.50 billion. It seems impossible to stop these trends in the immediate future.
While the sharp decline in foreign exchange reserves is comparable to that of previous crisis episodes (Table 1), there is a sense of comfort that the current level of foreign exchange reserves is large enough to cover nearly 12 months of imports , whereas in previous episodes in 2008, 2013 and 2018, he was between seven and nine months old.
However, the key question is whether the measure of import coverage reflects reserve adequacy? It is prudent to measure reserve adequacy by reference to the prevailing dynamics in reserve accretion.
India experienced a structural current account deficit which was financed by capital inflows. It is common knowledge that the increase in foreign exchange reserves is due to the surplus in the capital account.
India’s reserves built on net capital surpluses therefore present a double whammy, as reserves have to fund the import bill, with around 27% of imports by value made up of oil, and the steady stream of capital outflows .
Therefore, the use of import cover as a measure of reserve adequacy is not appropriate in the Indian context and one has to look at reserve adequacy from the perspective of the International Investment Position or IIP.
What is PII?
IIP is a summary statement of net financial position of a country viz. less the value of financial assets of residents of an economy that are claims on nonresidents and gold held in reserve assets and liabilities of residents of an economy to nonresidents.
Assets include direct and portfolio financial investments of residents outside India as well as reserve assets. Liabilities are direct and portfolio investments made by non-residents in India (Table 2). A positive IIP indicates that the country’s assets are greater than the liabilities, while a negative IIP means that the country’s liabilities are greater than the assets.
India is a negative net IIP country, with liabilities exceeding assets (Chart 1).
Not strong enough
Looking at the reserves to IIP ratio in India, it is observed that the current level is not as robust as it was at the time of the 2008 global financial crisis. Further, an examination of the reserves to liabilities ratio shows that it has been consistently below 50% since 2010 (Chart 2).
Of the $1.3 trillion in liabilities within the IIP, as of December 2021, approximately 30% is made up of short-term debt and portfolio investments. In absolute terms, outstanding portfolio investment is $277 billion and short-term debt is $110 billion. This brings the cumulative portfolio and short-term debt to approximately $390 billion.
Against the backdrop of $591 billion in reserves, it leaves a cushion of $199 billion, which at the current rate of $60-63 billion in imports leaves an import cover of about 3.25 months. .
Thus, import coverage is not an appropriate metric to measure reserve adequacy for a country like India. Import coverage should be considered in conjunction with the IIP, which provides a true picture of reserve adequacy.
In the current situation, thinking about a robust import cover by reserves alone without taking into account the IIP and liabilities indicates “a glass half full”.
The author is president of the SYFX Treasury Foundation. Views are personal
July 04, 2022
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