Build up of forex reserves is actually dollar colonisation

It is amazing to note how history is quickly forgotten. Leave history, even current times are ignored just to fit one’s agenda. There is a huge belief that it is high forex reserves which are the safeguard for Indian economy. The same reserve building was criticised greatly pre-2008 period as RBI should only do inflation management and not intervene in forex markets, build up of forex reserves is inflationary, forex reserves distort economy as one issues MSS bills and so on. Even currently, China has the highest forex reserves in kitty and all via its current account surplus (unlike India’s forex reserves which are mainly via short term capital flows) but is unable to keep global threats away. And then post 2008-crisis, Korea could not keep off speculatiion fears away despite pretty high forex reserves as well.

In nut shell, India is safer not because of forex reserves but just because we have kept ourselves relatively closed to world economy. And then compared to world, our macros are not as bad (it is always a relative game). However, our policymakers and media prefer to sing their own tunes.

Infact, one should actually be questioning all this forex intervention business as India had opted for inflation targeting. Earlier, the view was we need to target multiple things as in an emerging economy we cannot just stand by and let certain things like exchange rate go awry. In IT, the first thing central bank does is give up exchange rate management. The forex assets begin to be piled up at banking level and not at central banks. Central banks can instead sign up swap lines with advanced countries in case there is a shock. A swap line ends up being a much cheaper option as well.

C Shivumar has a piece on how all this forex reserve build up is not really chest thumping. It is actually the opposite – it exposes you to dollar policy:

In 1971, the United States Treasury secretary John Connolly stunned European finance ministers after he famously commented, “the dollar is our currency, but your problem.”

For countries like India that have been accumulating US dollar reserves, that history is once again beginning to unfold. Unfortunately, the gravity of accumulating such dollar reserves does not appear to have sunk in with the political or bureaucratic leadership.  India’s foreign reserves are close to $355 billion. Foreign currency reserves are $330 billion. The numbers are undoubtedly records, but are they accomplishments that call for chest thumping?

Unlike China, India’s reserves build-up is essentially driven by short-term capital flows, inspired by foreign institutional investors. In the case of China reserves of $1.4 trillion were built up through merchandise trade surpluses. India’s approach has been to run a current account deficit, accompanied by a reluctance to impose restrictions on short-term inflows. The result is not just a hoard of “hot money” that could leave the country as easily as it entered. This aspect is well recognised in the mainstream discourse on India’s external account. What is less recognised is how the management of these inflows affects the finances of the Reserve Bank of India (RBI), the central government and the conduct of monetary policy.

The fact that our inflows as well as outward investments are largely denominated in dollars has seriously compromised our monetary independence in a manner that is not readily appreciated. While a high current account deficit is a primary factor in India’s external sector vulnerability, what makes matters worse is parking of capital flows in US securities, the valuations of which could change dramatically in the event of the US Federal Reserve raising interest rates. The bias towards “reserve assets” denominated in dollars must be called into question.

We have more foreign currency reserves than we need, thanks both to the US going for quantitative easing (QE) and India being unwilling to “throw sand in the wheels of finance.” There is no clarity on the desirable level of such reserves either.

The following part of the article explores the ramifications of India’s foreign reserves management in greater detail. This includes its surprisingly significant fiscal and monetary policy impact.

I mean look at China for instance. It remains more worried than US over latter’s interest rates as it has so much exposure to US assets.

But then anything goes as far as Indian central bank goes. Earlier, it was criticised whatever positive it did, and now it is just the opposite.

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