Foreign Exchange Reserves refer to the international reserves held by a country’s central bank. RBI holds India’s foreign exchange reserves (“FX reserves”) in the form of foreign currency assets, gold, Special Drawing Rights (“SDRs”) and Reserve Tranche position in the IMF. India’s foreign reserves have been increasing since the beginning of this decade, reaching an all time high at $474660 Million as of April 10, 2020.
High foreign reserves are considered to be helpful for a developing economy like India which has a large Current Account Deficit. Adequate reserves ensure availability of foreign financial assets within the country and enhance its potential to survive shock waves in the economy. These are treated as backup funds to be used in the case of financial crisis. Foreign reserves play a crucial role in increasing international trade, controlling inflation and maintaining the value of local currency by buying and selling of reserves. During 2008, it was the reserves that came to India’s rescue after foreign institutional investors pulled out $12 billion out of stocks and foreign currency vanished. At that time, India’s import cover was 15 months and it might not be wrong to assume after observing the recent trends that RBI is moving towards the same direction. With reserves in account, investors remain confident that there won’t be much disruption if a crisis erupts.
The recent increase has been attributed to the government’s corporate tax cut which led to increase in investment from Foreign Portfolio Investors (FPIs) and also external factors such as US Federal bank’s interest rate cut. FX reserves are used to maintain stable exchange rate and prevent rupee from depreciating. FX reserves are also used to maintain balance of payments. When there is macroeconomic imbalance in the country i.e. when demand exceeds supply, FX reserves are released to pay for imports.
J CURVE THEORY and LAG
J curve theory states, after depreciation of currency of a particular country, its trade deficit will first increase for some time before decreasing. The reason behind this is, the country’s imports will not reduce overnight and it will take time for consumers to shift to local products and till that time, country will have to spend more to import goods because of depreciation of local currency. But after a point of time, consumers will start buying locally manufactured products as they will become cheaper, the imports will decrease. Exports will also increase at the same time as its goods will become cheaper for other countries as well.
There will be a time lag from the point depreciation or devaluation occurs and the point when country achieves trade surplus. This occurs because there are some contracts regarding the purchase of goods which have to be fulfilled. So, the trading of those goods already contracted for is not immediately stopped. The country will have to maintain its FX reserves according to the time lag it’s expected to face. In India, this time lag, through empirical research is found to be 18-24 months, which is a substantial time period. And to cover imports of about 2 years, India would need 1440 billion USD in reserves, with average monthly import bill in 2019 being $40 billion. Though all imports will not be funded from reserves but reserves will have to be enough to provide backup to importers and confidence to international markets. However to move to a trade surplus economy, a country also needs to satisfy the Marshall Lerner condition. It refers to a model which says a country’s balance of trade will become favorable only when the combined price elasticity of demand for imports and exports is more than one. In other words, if the imports are inelastic, the country’s imports will not decrease and it will have to pay a higher import bill and similarly if the demand of its goods is inelastic in the foreign markets, exports will not increase by much; further increasing the trade deficit. Therefore both the demand of imports and exports together needs to be elastic so that effect of depreciation is large enough to be visible in an economy.
THE CASE OF INDIA
The price elasticity of export and import demand in India is about 0.9 and 0.7 respectively which adds up to more than one. Thus, India satisfies the Marshall Lerner condition. This doesn’t mean RBI should let its currency depreciate. I say this because of following reasons.
First of all, there is no certainty over how much the rupee should depreciate. To depreciate the rupee it will have to increase its supply in the economy which could be done by buying dollars or other currencies from the market in exchange for rupee which will lead to increase in FX reserves. However, how much rupees to release is not certain. Even if it had been certain, depreciation could prove harmful for India as many entities who had borrowed from outside the country would find difficult to repay the loan which will impact the credit rating of India which is not very good even now.
There is also a possibility that exports may not rise even after depreciation. The fundamental rule behind export increase after depreciation is that goods of that country become cheaper for the foreign consumers, however the importing country might not let this happen by increasing tariffs on imports from that country. This was what led to US-China trade war.
If rupee depreciates, India will have to cover the time lag which is approximately 2 years according to some estimates. During this period, import bill will increase beyond reach and can pose serious problems for the economy. Also, if the crude oil prices increase in the international market, the import bill of India will further rise because India still doesn’t have any alternate resources which could replace oil to its full capacity. Oil constitutes 27% of India’s imports and paying a higher amount for oil would be a huge burden on the FX reserves.
WHAT SHOULD INDIA DO?
India has foreign exchange reserves of more than 461 billion, which according to the global standards are very high. Using the universally accepted Guidotti-Greenspan rule, the FX reserves should at least equal the short term external debt (STED) of a country. The reason given behind this is that countries should remain prepared for the outflow of short term foreign capital i.e. they should at least have the reserves to meet the liabilities of next one year. If India moves according to this its reserves should be 108.41 billion USD as it is the STED, as on March, 2019.
Most countries tend to reserve amount greater than the short term debt to remain on the safe side if any financial crisis erupts. However, there is an opportunity cost of holding reserves. The reserves kept in US treasury bills have a very low interest rate of about 2-4%, means it is hard to gain anything by keeping reserves. Also higher the reserves, higher are the opportunity costs. As the cost rises, the marginal utility from holding the reserves decreases. Therefore India should release some of its reserves for productive purposes.
In current situation, where government has rightly though arguably extended the lockdown to curb the spread of the disease, it has become necessary than ever to stabilize the economy. With huge disruptions on both the supply and demand side, there is a need for huge funding. Government at the same time cannot expand its fiscal deficit beyond a certain limit. At such time, FX reserves should come to the rescue; government should withdraw some of the reserves to provide for basic needs of millions of poor of India who are now left without any source of income. Keeping in mind, the opportunity cost of reserves, India should take a decision on releasing them at this crucial juncture when whole world is fighting the pandemic.