India has been hit especially hard, with the rupee hovering near its lowest levels in 14 months. Photo: Hemant Mishra/Mint
Mumbai: Two weeks ago, the US treasury added India to its “watch list” of countries that may be manipulating their currencies, citing persistent forex interventions by India’s central bank. The move triggered criticism about the Reserve Bank of India’s (RBI) forex interventions over the past few years. However, events since then seem to have vindicated RBI’s policy of building buffer reserves for rainy days.
As concerns over rising oil prices and the unwinding of monetary stimulus in the US have gained ground, foreign investors have pulled out funds from emerging markets.
India has been hit especially hard, with the rupee hovering near its lowest levels in 14 months (see Chart 1).
At a time when the weakness in the currency market is expected to persist amid a rise in India’s current account deficit, the buffer of relatively high forex reserves acts as an insurance against a free fall for the rupee.
We do not need to look too far into history to learn about this. In mid-2013, similar fears about unwinding of monetary stimulus in the US—the so-called “taper tantrum”—triggered massive capital outflows from emerging markets, hitting India particularly hard.
In the run-up to the taper tantrum, India’s foreign exchange reserves actually declined from around $315 billion in mid-2011 to around $285 billion by mid-2013. Thus, the import cover provided by India’s foreign exchange reserves declined to around six months (see Chart 2).
This was one of the statistics highlighted in the commentary around the Indian economy at that time. India found itself among the “fragile five” emerging economies along with Indonesia, Turkey, South Africa and Brazil that year.
One of the lessons from that mini-crisis was to raise our import cover so that we are better equipped to deal with such global shocks. As a result, India’s external vulnerability indicators look much stronger today compared to 2013. India’s foreign exchange reserves now stand at around $424 billion, which provide around 10 months of import cover, compared to six in 2013 (see Chart 3).
The need for currency intervention during times of crisis underscores the importance of building up forex reserves. These lessons were learnt by emerging markets in the wake of the 1997 Asian crisis. Following stringent conditions imposed by the International Monetary Fund (IMF) to bail out affected countries, those countries realized the need for self-insurance if they were to avoid such humiliation in the future.
Subsequently, the IMF has also recognized the desirability of building up foreign exchange reserves during good times (bit.ly/2vXI7v4).
While some emerging markets such as China have accumulated forex reserves on the back of a current account surplus (excess of export earnings over imports), India’s reserves have accumulated owing to capital inflows. The total external debt of India exceeds RBI’s forex reserves, while in case of China, it amounts to less than half of the reserves held by its central bank. Thus, there can’t be any comparison even with China on this.
It is also worth noting that the unconventional monetary policies of several central banks of advanced economies also distort currency markets. The massive bond-purchase programmes of the US Fed and the European Central Bank in effect ensure a cheaper currency. We must also remember that between 2011 and 2015, the Swiss National Bank (SNB) had publicly committed to intervene in the currency market to prevent appreciation in the Swiss Franc beyond a declared ceiling.
In stark contrast, RBI’s defensive manoeuvres in the currency market appear fairly benign. Emerging markets which build up reserves when faced with capital inflows are not currency manipulators. They are merely trying to learn from history, and attempting to protect their future.