Should India hold US$400 billion of foreign exchange reserves?

Prof Gurbachan Singh of ISI has a piece. We are back to discussing utilisation of forex reserves debates as seen around 2007:

The RBI has been operating under flexible exchange rate regime since the early 1990s; prior to that it followed a fixed exchange rate regime (which is, in fact, an important reason why there was a balance of payments crisis in 1990-91). Furthermore, it has formally adopted inflation targeting since June 2016 (previously the RBI followed ‘multiple indicator approach’², which arguably played a role in the events culminating in, what may be viewed as, near-crisis in the currency market in India in 2013). 

Given the two important changes in policy regimes, there is no compelling need for the RBI to maintain very large reserves now. This is true not just of India but most other emerging economies. They are mostly going through a hangover of the currency crisis that they had experienced. It is usually forgotten that the context then was different; most emerging economies now have flexible exchange rates and (formal or informal) inflation targeting. 

The proposal here to cut down FE reserves is not new. It had been put forward earlier by the erstwhile Planning Commission in 2004-05 but it was criticised. However, the criticism of the proposed policy was not always valid. For example, the critique in Panagariya (2008) was actually about the short-run adjustment process involved in shifting from FE reserves to investments in infrastructure projects rather than about the issue of what is an optimal level of reserves in the long run. These arguments, to a great extent, missed the wood for the trees. It is worth revisiting the basic proposal again. 

Often there is a tendency to keep reserves equal to the value of six months of imports. The rationale for this is not clear. But if at all we must think on these lines, then FE reserves are, as Professor Kaushik Basu had emphasised, required to finance only the gap between imports and exports (current account deficit) and not imports as a whole. By this yardstick, the FE reserves with the RBI at present are huge. If we take 7.5% of GDP (gross domestic product) as a figure for current account deficit (which is extremely high), then there is a need of about US$85 billion of FE reserves³.  The actual reserves are US$400 billion.

At the end of March 2017, FE reserves were equal to 78.4% of India’s total external debt. This is a very large proportion. This is particularly true when short-term debt is only 23.8% of the total debt. There are some difficulties with the definitions and concepts used but the essential story that FE reserves are large relative to the flow of hot money⁴ remains unchanged – more so if other policies are also adopted. 

…..

If the RBI must have large foreign assets (though there is really no need), then it can be divided into two parts. One part can be the standard FE reserves which are liquid and give a low return. The other part can be a sovereign wealth fund, which is invested in a variety of long-term foreign assets and gives a high return. 

Hmm..

More than anything else, inflation targeting framework should have meant India discards its so called old thinking of maintaining these forex reserves.