Explained: Why India needs to Expand Record Foreign Exchange Reserves?

The increase in India’s foreign exchange reserves to over $600 billion is might not sufficient to tackle the challenges for the country, as per several economists and bankers.

Last month, the pile touched a record of 608 billion dollars. This could happen mainly due to the Reserve Bank of India soaking up dollars flowing in as foreign direct investments, as wellas into the nation's booming stock market.

Despite the deteriorating fiscal outlook, the hoard can reassure investors and credit rating companies that the government is capable of fulfilling its debt obligations.

However, some analysts, including researchers at the central bank led by Deputy Governor Michael Patra say that headline numbers mask certain deficiencies. According to Mr. Patra and hiscolleagues at the RBI the “Levels are often deceptive”.

Here are the five reasons why India is vulnerable to external shocks despite the record reserves and needs to expand its record foreign exchange reserves of $608 billion.

• As per RBI researchers, the pile is the fifth largest in the world after China, Japan, Switzerland and Russia. It is enough to cover 15 months of imports and is well behind Switzerland’sreserves- which can pay for 39 months of imports, then Japan’s 22 months and Russia’s 20 months.

In the coming month, it is expected that the import demand would grow as the economy is recovering from the second wave of the pandemic.

• India’s foreign reserves are on the rise, however, the economy still has a net negative international investment position. This means that foreigners hold more Indian assets thanthe nation holds foreign assets. According to Radhika Rao, an economist at DBS Bank Ltd. in Singapore, the negative number is an imbalance that the central bank will want to fix.

"This imbalance is likely to keep the central bank keen to further strengthen the buffer, also providing key ammunition to fight off short-term volatility in global developments,"she said.

• Countries that run chronic current account deficits rely on foreign equity along with debt capital for the financing. Meanwhile, Indian policymakers are concerned about the country’sexposure to external shocks as the short-term foreign debt as a share of reserves has been steadily declining.

Debt investments, particularly those chasing high-yielding emerging assets such as those from India, can shift suddenly, causing volatility in local asset markets, especially to the partiallyconvertible rupee.

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• Meanwhile, foreign inflows have undoubtedly boosted India’s reserve build-up. However, the good day can be seen coming to an end as the US Federal Reserve moves to withdraw someof its extraordinary monetary stimuli potentially prompting outflows from emerging markets.

According to a recent working paper published in the Bank for International Settlements, India is vulnerable to monetary tightening by the Fed, with outflows affecting financial conditionsand the economy as a whole. The paper also demonstrated that when the US tightens monetary policy, financing conditions for non-financial firms worsen as net worth falls and access to credit deteriorates.

On the other hand, as per a BIS report, a weakening rupee combines with higher US interest rates cause a downturn in both domestic credit and the business cycle.

• Citing the Reserve Bank of India’s efforts to stabilize financial markets and liquidity conditions so that monetary policy can "pursue national objectives", Governor ShaktikantaDas stated that "Reserves accretion is a priority for the central bank.”

“Mr. Das' comments imply that RBI is trying to manage the so-called ‘Impossible Trinity’ says the analyst. RBI is trying to maintain monetary-policy independence, enablinga constant flow of foreign capital and keeping currency stable by opting for an independent rates policy.

"The upcoming Fed taper and hiking cycle thereafter will test the defense,” said DBS Bank's Mr. Rao.