India’s rising forex reserves a safeguard against flight of capital, global uncertainties: NCAER Paper

“Global financial turbulence and foreign monetary policy shocks are significant drivers of foreign capital outflows from India. Additional reserves can significantly reduce large outflows. The precautionary benefits of reserves could well increase as India becomes further integrated into international financial markets,” says a paper of National Council of Applied Economic Research (NCAER).

“The empirical analysis of India’s external portfolio capital flows finds that reserves lower outflows in the event of global financial distress. Reserve holdings reduce the volatility of portfolio debt flows,” says the paper, authored by Prof Chetan Ghate (Indian Statistical Institute and Institute of Economic Growth), Prof Kenneth Kletzer (University of California) and Mahima Yadav (formerly Indian Statistical Institute) and presented at NCAER’s India Policy Forum conclave.

The IMF assesses reserve adequacy based on threshold of one year of external debt amortization; three months of imports; and the ratio of reserves to broad money (money supply).

Suggesting that benefits of having reserves must be weighed against the opportunity costs of holding them, the authors argue that good reserves boost foreign inflows.

“The anticipation that reserves will be available to mitigate the effects of global financial shocks and to meet sudden outflows of capital is likely to affect the amount and nature of foreign capital inflows. By reducing financial fragility, higher reserves might increase the maturity of capital inflows reducing the exposure to short-term capital outflows,” they say.

India’s net foreign portfolio inflows touched USD 5 billion by June-end.

So, what is the optimal level of reserves that India should hold? “If reserves reduce the size of capital outflows in adverse global or domestic events, the optimal levels of reserves may be higher,” says the NCAER paper.

The authors say the costs of holding reserves include the interest differential between Government of India Securities and US Treasuries, the carry cost of foreign reserves, and other valuation effects. They point out that the “marginal opportunity cost of additions to reserves is less than the interest rate difference on RBI reserve assets and government debt”.

“Reserve accumulation may continue to provide a precautionary benefit to India. The estimated reduction in the sovereign interest spread implies that the opportunity cost of reserves for the RBI may be substantially less than the simple spread, net of valuation costs,” says the paper.