Higher forex reserves lower cost of foreign borrowings, hedging cost: RBI article

Mumbai: Higher foreign exchange reserves have lowered the cost of foreign borrowings and also the hedging cost for companies, according to a paper published in RBI’s monthly bulletin.

Since 2019, the RBI has been accumulating forex reserves that peaked at USD 642.453 billion in the week ended September 3, 2021, which was more than double the reserves at the end of December 2018.

At the peak, the reserves were good enough to cover 18 months of imports. Forex reserves were measured in terms of import cover, which no longer is the criteria.

However, the reserves plunged by USD 14.272 billion in March 2022 alone as the rupee came under pressure due to capital outflow following a rise in interest rates in advanced economies and the Russia-Ukraine conflict.

”For India, higher reserve cover is observed to lower the cost of foreign borrowings and also the hedging cost,” the article – Foreign Exchange Reserves Buffer in Emerging Market Economies: Drivers, Motives and Implications, said.

It’s been authored by Dirghau Keshao Raut and Deepika Rawat from the RBI’s Department of Economic and Policy Research. The central bank said the views expressed in the article are those of the authors and do not represent its perspective.

Accretion to India’s reserves buffer in recent years had been an outcome of modest levels of current account deficit (CAD) relative to the size of net capital inflows. This is broadly in line with the trend observed across select emerging market economies (EMEs) in the post-Covid period, partly reflecting the impact of ultra-accommodative monetary policies in major advanced economies (AEs) in pushing capital to flow out in search of higher return, the article said.

The country’s CAD recorded a sharp decline in 2019-20 and a surplus in 2020-21. On the other hand, the capital account recorded a surplus in both these years led by foreign direct investment (FDI). Consequently, there was an accretion to foreign exchange reserves to the tune of USD 147 billion (on a BoP basis) during 2019-20 and 2020-21. In 2021-22, reserve accretion (including valuation effect) has been of the order of USD 30 billion.

Foreign exchange reserves include foreign currency assets (which include investment in foreign government treasury bills, deposits with other central banks), gold, special drawing rights (SDR) and reserve tranche position (RTP).

The article said there have been portfolio outflows since October 2021 due to the reversal of monetary policy stances in major AEs followed by the Russia-Ukraine conflict. This has been reflected in a depletion of foreign exchange reserves during the past few months.

The article further said that EMEs accumulated reserves during the COVID-19 period benefitting from abundant global liquidity propelled by ultra-accommodative monetary policies pursued in major advanced economies.

Several EMEs witnessed an increase in reserves to GDP ratios and reserve adequacy levels.

The report said the empirical analysis shows that in the long-run reserve accumulation of EMEs is determined by the precautionary motive rather than any mercantilist motive.

According to the mercantilist view, reserves are accumulated to promote export-led economic growth. As per this approach, economies undervalue their currencies using reserves to support exports.

In the precautionary motive of holding reserves, countries maintain a reserve buffer to avoid output and consumption losses during ‘sudden stops’ of capital flows.

The article noted that reserves are found to be helping EMEs in curbing volatility of exchange rates, as evident from the negative relationship between exchange rate volatility and reserve cover of imports. An increase in reserves reduces the probability of a currency crisis, thereby implying a positive externality of holding reserves, it added.