Reserves: The RARE model in India

The foreign exchange reserves (hereafter, reserves) in India are close to $620 billion. On July 28, a parliamentary panel and then on August 11, the Union Minister Nitin Gadkari, observed that the Reserve Bank of India (RBI) is possibly holding excessive reserves. Is this recent view on a long-term issue correct?

It appears that we have had, what I may call, the RARE model of reserves in India. The acronym RARE stands for Reserves for Atmanirbharta, Ratings, and Exchange rate stability. The first two of the three objectives are not explicit; only the third is. Let us consider these one by one.

First, the inflows on the capital account in India are large and these warrant a large deficit on the current account in a free market. However, there has been an emphasis on atmanirbharta (self-reliance) in one way or another. A part of this strategy is about pushing exports and discouraging imports. This policy is keeping the current account deficit in check but given the large capital inflows, there is a need then for the RBI to absorb the extra dollar inflow and increase its reserves. And, purchases of foreign currencies by the RBI keep the rupee on an average at a low level.

However, sustaining the rupee at a low level for long may not be practical in this time and age. In any case, even if it can be, it may not end well. Consider an example. In Japan, the policy of low yen was brought to an abrupt end through the Plaza Accord with the US in 1985. The rest is history, though the more familiar part is only the lost decade (1991-2001). The point is not to generalise from this extreme and complex experience but we need to be careful with any important “disequilibrium” price. And, India is already on the US list of possible currency manipulators.

Second, the fiscal situation in India is quite weak, which is why the international ratings of the Indian sovereign are consistently very low. In fact, if the RBI, a sister concern of the Government of India, was not holding a very large amount of reserves, the ratings could have been lower still. So, we have here another rationale for the huge reserves. Anything wrong?

Occasionally we may take a short cut but it should not be used year after year, given that reserves have a very high opportunity cost as a long-term measure. We need to raise the tax-gdp ratio, which is anyway quite low in India relative to many emerging economies. This is not an easy task but it is very much doable.

Third, if the dollar fluctuates significantly, the RBI can buy or sell dollars to ensure stability. In this context, reserves help. And, large reserves can avoid a collapse in the external value of the rupee. This is the usual narrative but an incomplete one.

Unlike 1966, 1991 and 2013, which is when we had a currency crisis or near-crisis, we now have flexible exchange rates and inflation targeting. Flexible exchange rates facilitate adjustment and inflation targeting prevents prices, including the exchange rate, from going haywire. So, we have a sea change now.

It is often argued that our reserves have not been built through current account surpluses, in which case we need to hold large reserves. However, the implication is only that in order to be able to service or settle our obligations in future, we should have adequate assets, not huge amount of liquid assets.

It is true that capital flows can be volatile. However, we need to distinguish between volatile capital flows in the aggregate and volatile capital flows at the margin. If it is the former case, there is indeed a need for very large reserves but then we should not have free capital mobility in the first case. Why? The gains from capital mobility are primarily for foreign investors, while the opportunity costs of holding very large reserves fall ultimately on the Indian public. Now, the data shows that if policies like flexible exchange rates and inflation targeting are in place, capital flows can be very volatile at the margin but they are hardly volatile in the aggregate.

In any case, for comfort, we can provide for a tax on sudden and large capital flows that can cause negative externalities. This tax may be invoked when necessary. Also, India can buy additional credit lines in normal times. A credit line is an option but not an obligation to borrow in future. The availability of such a credit line on reasonable terms has improved over time. So, there is no pressing need for large reserves.

Overall, India can do away with the prevailing RARE model of reserves, though in a phased manner.