For a Few Dollars More

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For a Few Dollars More

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• Ray of light in gloom: While all macroeconomic indicators of India are struggling (GDP, inflation, IIP), the foreign exchange reserves are rocking! In June 2021, reserves crossed $608 billion, making India the fifth-largest in the world. In March 1991, it was at just $5.8 b.
• Management of forex reserves: In this problem of excess (not deficit), the RBI is wondering how best to manage the vast pile of dollars. It is reaching out to external investment managers too! The temptation? Higher yields. But that is very wrong, both in law, and in practice.
• RBI, be cautious: The guiding principle of reserve management is - "better safe than sorry". RBI has never used external advisors to guide it, except for a while in the 1990s. 

1. Legal framework for reserve management - Sections 17(6A), 17(12), 17(12A), 17(13) and 33(6) of the RBI Act - permits only safe investments (Board has discretion)
2. So why the RBI about-turn? Because of the (i) very low sovereign bond yields due to excess liquidity and (ii) high govt. pressure to get more surplus transferred from RBI.
3. Hence, investment banks are approaching the RBI (they'll earn huge management fees) with proposed investment plans (possibly high-rate foreign corporate bonds!)

• Opportunity costs: India's foreign exchange reserves represent an opportunity cost - resources used to purchase reserves, rather than being invested in domestic sources. So this opportunity cost must be minimised for sure, keeping in mind the benefits of reserves.
• Benefits of holding reserves: High reserves give many advantages - 

1. They maintain confidence in monetary and exchange rate policies, 
2. They enhance RBI's ability to act in forex markets, 
3. They limit external shocks in crises times, 
4. They reduce fear in market participants' minds (esp. credit rating firms) 
5. They provide comfort that domestic rupee is backed by adequate foreign currency assets

• Forex is not other funds: Hence, while for other funds the goal is to earn maximum returns, here the goal is safety with liquidity, not primarily returns. If you hand over your forex reserves to private investment managers, they'll work to maximise returns only (so they earn more fees), and they lack all accountability. And RBI has reserves that look huge, but are only enough import cover for 15 months (Switzerland - 39 onths, Japan - 22 and China 16 months).
• Quality of forex reserves: Indian forex reserves are not built from current account surpluses (exports) like China's, but from portfolio inflows (FPI) and not even FDI. So a sudden change in Federal Reserve policies can be shock enough for the tide to turn suddenly. RBI itself said that "our forex reserve levels are deceptive".
• Summary: Don't involve private parties in forex management at all.

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