The upbeat mood was pervasive, and even infectious. A radiant smile, expanding into a wide grin was common on the faces of government and RBI officials about 10 years ago when conversations would gravitate towards the topic of foreign exchange reserves. Successive years of high and increasing positive overall balance of payments, occasioned by large portfolio capital inflows and RBI’s continuous buying of U.S. dollars from the local forex market resulted in a very rapid rise in foreign exchange reserves from about $60 billion in 2002 to a little over $160 billion by mid-2006. Although there were tough accompanying monetary issues and challenges to be tackled, a sense of achievement was palpable through all this, with a few triumphantly announcing that the country was facing a ‘problem of plenty.’ Some were quick to conclude that the reserves then were much in excess of what was needed to ensure an orderly forex market and for external stability and blamed RBI for running a faulty forex market intervention policy. There were still others who saw in this an opportunity to hive off the ‘excess reserves’ for setting up a sovereign wealth fund, on the lines of China, Russia etc. A few fortune-seekers offered to leverage their relationships and influence to the benefit of asset managers of the world eager to get a slice of the reserves for fee-based discretionary management and RBI seemed willing to play ball.
The issue of adequacy of reserves and the extent to which reserves could be used to prevent a sharp slide in the exchange rate of the rupee vis-a-vis U.S. dollar has resurfaced in recent months. On the back of the turmoil in China's financial markets and against the backdrop of a somewhat lacklustre domestic macroeconomic scene and banking sector woes, the rupee has been one of the worst performing Asian currencies this year. RBI has been selling U.S. dollars sporadically. Also, it has been cautious in easing the very tight liquidity condition that has been prevailing for sometime, perhaps being wary of providing ammunition to bet against the rupee. By its own admission, RBI has kept all the options open if it comes to dealing with severe selling pressure on the rupee, which includes exploring the possibility of co-ordination with other major emerging market economies whose currencies are also under threat.
Is the quantum of reserves sufficient now? The framework developed by the IMF reveals that adequacy for emerging market countries is best captured in a 100-150 per cent range around a metric comprising 30 per cent of short-term foreign debt, 15 per cent of equity and debt liabilities, 5per cent each of broad money and annual exports. This approach embodies the so-called precautionary purpose for holding reserves, with the main objectives being countering BoP pressures and maintenance of orderly market conditions. Following this approach, one gets a range of $ 255 – $383 billion. The current level of reserves at $ 350 billion as well foreign currency assets at $ 326 billion both fall within this range.
A comparison with China here is instructive in many respects. A similar computation leads to a range of $3 – $4.5 trillion. The current level of reserves at $3.23 trillion constitutes about 110 per cent of the lower bound. But there is a catch here. About one third of China's reserves are believed to be locked in illiquid assets such as investments in infrastructure. Even after making allowance for the possibility of overestimation in this regard, the usable reserves of China likely lie in the range of $2.8 – $3 trillion. This, coupled with the fact that the reserves are falling rapidly there explain why both residents and non-residents alike see the yuan much lower. They are either taking out capital from China at a ferocious pace or betting hard against the yuan at off-shore locations. The Chinese authorities are furious that the likes of Goerge Soros might be in their game again. A quick check on the real effective exchange rate data published by BIS (illustrated in chart A) indicate that the yuan is overvalued by 30 per cent, Hong Kong dollar by 23 per cent and the rupee by 4 per cent.
The Chinese situation holds out several takeaways for India. First, it confirms the view that residents take the lead in taking capital out of the country if they see the exchange rate to be seriously misaligned. The capital flight by local residents triggering a currency crisis has been a common factor seen in various emerging markets crises over the last several decades. Second, RBI has been prudent in agreeing to invest only a very small amount not exceeding $5 billion out of reserves for domestic purposes. Unlike in countries with consistent current account surplus, reserves do not represent national savings or wealth in India. The amount of political pressure that was brought to bear on RBI in the past for using reserves for ‘other developmental purposes’ was considerable. Third, market intervention, even in large quantities, will have limited effect even in curbing volatility, in the face of a general market pessimism that can be triggered by a sharp drop in yuan and emerging markets’ stocks and bonds. Importantly, RBI and government should avoid the communication slippages of the Chinese authorities. It is pointless on such occasions to say that the fundamentals of the Indian economy are strong and that the market has got it entirely wrong. The only effective way to convince the market is to demonstrate by actions to address the structural impediments to achieving higher growth and to pursue time-consistent monetary policy aiming for low inflation and inflationary expectation. Fourth, there are lingering doubts and confusion at home and abroad on the accuracy of the new GDP series. At times of stress, such concerns tend to have exaggerated impact on market sentiment. The headline economic numbers of China have come under intense scrutiny of late, with a credible and reputable agency like the Conference Board of U.S. suggesting that the Chinese growth this year is closer to 4 per cent than the official figure of 7.7 per cent.
Not much is publicly known about the portfolio management policy in respect of RBI's reserves. One is not very sure whether a well-researched policy exists in the first place. Still, an issue that warrants a thorough revisit is the RBI's reported plan to deploy a part of reserves in yuan assets.
This was apparently done in the wake of yuan's inclusion in SDR basket last year, giving it a reserve currency status and amid reports that over $1 trillion of global reserves would move into yuan soon. The subsequent events make the IMF's decision look a bit premature. In particular, the departure from the important condition of convertibility by coining a new term 'freely usable' was smart and expedient but not fully convincing. Some analysts are of the view that IMF's decision even defies basic economic logic in this regard.
A reserve currency needs three critical qualities: confidence, liquidity and adjustment. Yuan lacks all the three. Capital controls are still very much a part China's policy tools, with administrative measures playing a significant role at times in the formation of yuan's exchange rate. Economic policy-making is still opaque and authorities are not open about communicating the aims and objectives of what they are doing even in major areas.
Also, the policies with regard to yuan from the point of view of the economy seem to be at variance with those driven by geopolitical and diplomatic considerations. These aspects are hardly the hallmark of a reserve currency. A noteworthy fact is that Chinese A shares are not yet in the benchmark MSCI emerging market index despite intense Chinese lobbying.
A hasty diversification of reserves into yuan may cost Asia and the world dearly in the months to come.
The chances of a further meltdown in the Chinese financial markets are real. If the yuan falls sharply and breaches the level 7 against dollar, the rupee will also come under intense pressure. Further, if Hong Kong were to adjust or abandon its U.S. dollar peg, the event will send shock waves all around. It may turn out to be worse in terms of its impact on India than the global financial crisis of 2008-10.
Sivaprakasam Sivakumar is Managing Director, Argonaut Global Capital LLC, U.S. and Himadri Bhattacharya is Senior Advisor, Riskontroller Global
