For A Few Dollars More

Context: Trusting private parties with foreign exchange reserves is a risky path to pursue.

Background: 
     
      

• Amid pandemic, while almost every macroeconomic indicator is adverse, GDP growth rate, inflation, industrial production, employment and government’s finances, the forex reserves touched a record high of $608 billion making. India the world’s fifth-largest reserve holding country.
• RBI has initiated the management of forex reserves in a desire to earn a high return by involving private parties. This is because of the following reasons – 
• Falling yields on sovereign bonds - likely to remain low as central banks flood the world with liquidity.  
• Surplus transfer to the GoI.

Anticipated benefits of holding forex reserves: As listed down by former RBI governor Y V Reddy in 2004 - 

      

• Maintaining confidence in monetary and exchange rate policies.
• Enhancing RBI’s capacity to intervene in forex markets.
• Limiting external vulnerability to shocks during times of crisis.
• Providing confidence to markets, especially credit rating agencies, that external obligations can always be met, thus reducing cost at which forex resources are available to market participants
• Providing comfort to markets that the domestic currency is backed by foreign currency assets.

Issues with the management of forex reserves by private parties:

• At odds with both law and practice: While the guiding principle of reserve management has always been ‘Better safe than sorry, RBI’s temptation to pursue higher yields is at odds with law and practice
• Basic objective of reserve management must be to minimise opportunity costs (the resources could have been used for domestic investment instead) against the benefits of holding reserves.
• Sections 17 (6A),17 (12),17 (12A),17 (13), and 33 (6) of the RBI Act permits investment only in safe avenues, although with a provision that allows some discretion by the central board.

• Question of accountability: Unlike in-house RBI officials, an investment manager who is with one firm today and another tomorrow can hardly be held accountable for broken investment.
• Not ample for import cover: Our import cover of about 15 months is lower than for other major reserve holders like Switzerland (39 months), Japan (22), Russia (20) and China (16).
• Concerns regarding quality of forex reserves: Unlike China, whose forex reserves are built from current account surpluses, ours are largely built from portfolio flows rather than long-term inflows like FDI.
• A sudden withdrawal by investors is a likely prospect in the event of the US Federal Reserve signalling a reversal of its ultra-easy money policy can cause reserves to deplete rapidly.

Conclusion: RBI calls the high level of our forex reserves ‘deceptive’. And there is enough reason to refrain from entrusting the management of forex reserves to private parties.