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Fixed Income

The Three Distinct Phases of India’s Forex Reserves

India’s foreign exchange reserves have been through wild rides recently. But if you look at the reserves since 2001, here’s where we went. There are three distinct phases.

India Forex Reserves

Phase 1: 2001 to 2008

India built a massive forex reserve chest. We went all the way to 300 billion. Remember that buying currency at this obscene quantity would have required printing of a lot of rupees. Some of those rupees were kept as “MSS” or a Market Stabilization Scheme where the rupees were taken by the RBI and the government paid some interest on them. This was temporary sterilization which ensured there was less inflation then,but obviously those rupees would come back into the system someday, and cause inflation. (They have, and inflation is here now).

This was the period of extremely cheap money in the US. We effectively financed that cheap money, by buying US treasuries along with other economies. (Most of those other economies, though, were net exporters. We weren’t.)

Even with such massive buying of the dollar, mainly done to build reserves and keep the rupee from appreciating too much, the rupee DID appreciate, from Rs. 46 to about Rs. 39 to a dollar.

My view: We shouldn’t have bought this much. We flooded our market with rupees. In fact from 2006, We should have let the rupee go up much more – say to 25 – and then we would have corrected to better levels. Eventually this has come to haunt us.

Phase 2: From Lehman to 2011 – Volatility

India then saw what a crisis really meant. With the Lehman crisis, the RBI had to resort to selling its precious reserves, and we saw the rupee hit 50.

Then, as the US did multiple rounds of quantitative easing, India saw the dollars come back, and by 2011, we had seen the rupee back at the 45 level.

Incredibly, even after the Lehman crisis, we continued to buy dollars. I believe if the RBI stopped its purchases, we would have gone all the way down to 40, and again, the course correction would have been smarter and shorter.

My views: This was the time we could have opened up the rupee to capital convertibility. We already had the volatility, and countries were iffy about the dollar. India’s growth was strong even if you considered the temporary drop. We should have allowed trade with our partners in the rupee, and for them to hold rupees as a convertible currency. We didn’t. So we’ll have to do it in the worst time ever, in a crisis that will appear in Phase 3.

Phase 3: The Continuing Crisis

From mid-2011, India has seen a consistent and continuing exodus of foreign investors. First, this was due to a fear of extreme corruption and inaction. That took the rupee to 55.And in 2013, the fear of a US “taper” showed you what the underlying situation really was – we depended on fund flows to finance our “net import” situation.

Note: I haven’t mapped the recent turnaround from 66 to 63.

The RBI has been selling dollars, but not nearly at the pace it was buying earlier. You can see the steady slope of the recent downmove in the reserves, versus the steep upslope in the 2006-07 area. The feeling that we need reserves no matter what, is a fear that drives the slow selling. However, even with that selling, we have seen the rupee drop more than 40%.

(I know some people think this is wrong semantics and it should be a different percentage, but I don’t care. For me, the dollar denominated stuff costs 40% more, so that’s the number we care about)

The Distribution of Reserves

Distribution of Reserves

Indian forex reserves are mostly in USD, and there’s some Yen, Euro and Pounds. These form the currency portion which is between 88% and 96% of our forex reserves.

We increased the amount of gold in 2009 when we bought 200 tonnes from the IMF, and the increasing value of gold (in dollars) made that position larger. However, with the recent fall in gold prices (in $) we have seen that proportion dip.

We also have a small amount of Special Drawing Rights (SDRs) and  a Reserve Tranch Position in the IMF.

India’s reserves lowest since 2010

Reserves as of September 6 were $274 billion, the lowest in three years. We don’t know what has happened in the last week (to Sep 13) when the rupee has gone back up to 63. We’ll find out next week!

I don’t really believe in the concept of measuring reserves as “import cover”, so I won’t go there. But I am kind of happy we are losing reserves rapidly, because it will facilitate the move to a freer rupee.

Impact: Rupee Squeeze

In the next two years, if we see more dollar outflows we are likely to see the rupee depreciate more, and the RBI will likely sell more dollars. When it does, it buys rupees, and those rupees go out of circulation. Now the RBI has two choices.

It can use OMOs (bond purchases through open market operations) to put rupees back in. This is a bad idea in my opinion but we are knee jerk nation and some of this will happen and a lot of words like “calibrated” will be bandied about.

To keep fund flows attractive, India will need to increase interest rates.

If the OMOs are not high, we will see a contraction in money supply. This with the interest rate hikes will cause a contraction in credit. In addition short term rates will spike up. This could create corporate defaults.

The Potential Opportunity

  • None of the above is good for banks. Plus there are new banks coming. So I would use any rise to get on to a short opportunity.
  • If the rupee keeps sliding, exporters will benefit. But so will the manufacturing industry as their output will be more immune to substitution by imports. Exporters are overbought now, in comparison, and there’s hardly any enthusiasm for local manufacturers, who in a two-three year period will make money.
  • A contraction in money supply will give us about three month lead into an economic crash of sorts.
  • The continuing drop in forex reserves could make the rupee “free”, which will be very good for the economy eventually, though it will cause a lot of volatility initially. There will be good trading and investing opportunities, one after the other.
  • Placement of cash in ultra-short-term and liquid debt funds will be a good idea. Short term rates can spike up even more. I’m seeing over 10.5% to 11% returns in such funds in the last week (annualized) and that’s way better than anything in a bank deposit.
  • vishal says:

    In last few years RBI is financing close to a fifth of government’s borrowings through OMOs. Unless there’s substantial dip in reserves, rupees taken out of system by selling dollars will be circulated back into the system through OMOs. With borrowing costs rising, we may even see a higher portion of fiscal deficit being financed by RBI through back door. It may give some comfort to government but what will be likely effect on inflation and confidence in currency?

  • Leo says:

    The continuing drop in forex reserves could make the rupee “free”, which will be very good for the economy eventually, though it will cause a lot of volatility initially. There will be good trading and investing opportunities, one after the other.
    ———————————–
    THis is totally insane …. if it drops to 80 all the unhedged loans will really hit us really bad…to add to the problems imagine CRUDE 200 dollors (It has broken out)
    I read a nice article on import of capital goods (half a trillion in last 10 years ) we need to cut this really fast .CRUDE GOLD IS not the culprit it is the cap goods .
    ———————————————
    ALSO the problem of this rupee lira real is contraction of the world economy …the core(USA) blows last but once u see all the debts together i dont think there is any place to hide … from 2008 to 2013 problems have gone up parabolic.REMEMBER complexity is what no one understands on how things will react…
    THE Five PILLARS of the world are shaking (YEN YUAN EURO USA UK)
    THE ONLY way out is the RED pill take it let people go bust who are levered start fresh.
    Which means REform of the monetary system.I see war as the only way out coz no politician will agree to monetary reform.

  • dheeraj says:

    Deepak,
    Just a few thoughts here.
    1) I think you meant 300 billion and not 300 million in your first para.
    2) You advocate that we should have allowed the rupee to appreciate when we had an influx of foreign money instead of building reserves and (as you correctly state) increase monetisation. However you begin your description of Phase 2 by saying that RBI had to sell it’s “precious” reserves to contain the depreciation in rupee. If on one hand reserve build up itself was undesirable I do not understand how it become “precious” when the time comes to sell.
    3) I don’t really think that RBI was buying dollars aggressively during the period 2008-2011. In fact economists like Arvind Panagriya have castigated former RBI governor D Subba Rao for not doing enough to build up reserves. There is another aspect to foreign exchange reserves that you havent spoken about. Not all of India’s (non gold) foreign exchange reserves are deployed in dollar denominated assets. In fact RBI had followed a conscious policy of diversifying the reserves asset base (which you have also shown in your next chart). So the reserve build up during 2009-2011 includes the revaluation of non dollar assets into dollars. During this period the dollar was relatively weak (not just against the rupee but also against other major currencies and gold) and so non dollar assets when revalued in dollar terms would appreciate. This includes gold which we bought at about $1100 which then appreciated sharply afterwards. That’s the effect we see when reserves have grown during the post Lehman period.

    • 1. You’re right – fixed, thanks!
      2. It was a snarky remark 🙂
      3. We did go on forex reserves (non gold non SDR etc. from $238 bn to $268 bn) in the 2008 to 2011 periods. Some of that was US treasuries and some in other currencies (we currently hold about $61 billion of US treasuries). The problem with RBI is that it doesn’t tell us what these reserves actually consist of (how much are T-Bills, US bonds, deposits in US or European banks, JPY bonds etc) But the revaluation couldn’t really result in a $50 bn increase, could it? They did buy $5 to $10 billion of US securities (from US data). I don’t know about European data – btw, do you have a way to get at those? RBI isn’t giving.

      • dheeraj says:

        I think they do come out with a report on the sources as well as composition of reserves. Will have to check.

      • dheeraj says:

        Here’s their report on fx reserves
        http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14933#7
        Unfortunately, they do not give a detailed break-up. I even checked the Annual Report. That too doesnt have the detailed breakup.
        Their earnings on fx assets last year had been about 1.5%. Needless to say, bulk of the deployment is in currency with low interest rates (dollar, yen etc.)
        I agree the entire reserve build up during 2008-2011 cannot be attributed to revaluation alone. What I meant was that the reserve build up cannot be attributed to dollar purchases alone. Revaluation would also have played a significant role.

  • Sanjay says:

    Traders like you (and finance industry) might like volatility. Real economy does not like volatility.
    RBI, by playing contrarian, has controlled volatility in the forex market. RBI has done a good job.

    • The consequences of thinking you can control volatility is that you get even more volatility later, and you can’t control it, and then you cry. The same way we can’t control fuel prices through stupid fuel subsidy and then when the shit hits the fan we have to recalibrate so much that it hurts everyone even more than if we did have regular volatility. A system finds its equilibrium if you don’t overly interfere in it, and a volatile system will find its mark. RBI did a lousy job in my opinion.

    • DJ says:

      Why don’t we think about why the natural volatility is so high in the first place, rather than to ask for palliative measures?
      Real economy does not like many, many things. How about addressing the underlying fundamentals, rather than asking for alleviation of symptoms? High volatility is a symptom. The solution is not to hide the symptom, but to improve the underlying condition. As Deepak pointed out, hiding the symptom only prolongs the problem, as the underlying issue is ignored and it gets worse.
      This is the main reason why free markets are useful. They give good price signals so the economy can correct on its own. If prices are high in a free market, you can bet that producers will increase supply. If instead we give subsidies, then the supply will stay the same. Its a sub-optimal outcome. We should not be afraid of high prices in a free market, as the solution to high prices is high prices and it is usually a temporary situation until supply increases as producers try to profit from the high prices.
      Additionally, I don’t understand why people ask for one branch of the govt to fix a problem that another branch of the govt creates, without first assigning initial responsibility.

  • Sunny says:

    I have a question. Does all the money sent by NRIs to get deposited into Indian banks or buy real-estate in India contribute to increased Rupee money supply ? If yes, whats the proportion of it in the overall scheme of things ?

    • dheeraj says:

      Sunny,
      Any money coming from abroad (as long as it is not Rupee funds) is a source for money supply.
      It results in an increase in foreign exchange assets of the banking sector.
      Take a look at the latest figures for sources and components of money supply
      http://www.rbi.org.in/scripts/WSSView.aspx?Id=18520
      Out of total money supply of 87.7 lac crores, 18.3 lac crores came from net foreign exchange assets of the banking system. So that’s a ratio of about 21%
      Hope this helps

      • Dheeraj – from an M0 perspective, it is only a source if the RBI buys dollars. Otherwise it doesn’t add to “reserve” money supply. If for instance a bank bought dollars and gave rupees, then the total rupee M0 money supply does not increase since the RBI isn’t printing more rupees.
        It does impact M3 through (which is a sum total of rupees created by banks, through the money multiplier impact). Effectively, a bank will give you rupees that sit in a bank account, and the increase will add to both liabilities of the bank (the rupees it gave that now sit in a deposit account) and assets (which are the dollars it’s bought)
        of course a systemic increase will result in huge rupee appreciation and the RBI may buy dollars to reduce the impact.

        • dheeraj says:

          Yes. I was talking of “total money stock” M3 not Reserve Money.
          Reserve Money increases if RBI buys dollars (or any other foreign currency).

        • Sunny says:

          Thank you both for your responses.
          So its the multiplier effect that increases the money supply (by cheap loans etc) but not the rupee converted foreign currency inflows into the countrys’ banks.
          A depreciating rupee may trigger more inflows (? only from optimists though..) to counteract but again looks like this is only a minor proportion compared to the big investments that usually pull out money during this phase.
          Is there a chart out there that can explain this complicated inter connected web showing atleast in theory on what should act as a plus & what doesnt, for a currency.
          As you may have understood by now that Im not a financial person but what continues to puzzle me is how can a country like US just continue to print (reflate) money this way and still the dollar remains stronger. Is it only coz the dollar, in relative terms is better than other currencies or is it a temporary thing until dollar eventually will get replaced as a reserve currency (is there really anything out there that is capable to replace ?)

  • Leo says:

    i think it is totally nuts has the population gone up 7 fold in the last 10 years… from 90 lakh crores if the system collapses to 30 lakh crores what equity will be left in banks…
    M3 is not reducing .some people have to get hurt to change course of this madness. In today s world even the coins are changed .Today 2 rs coin is like 25 paise 10 years back.That is huge inflation.
    Taper not taper …world can contract very very fast .May be Ben is jumping the titanic >the other person Yellen is totally crazy person. She says quote “we should have -10% interest on deposit”
    If i am not wrong she said this.MADness has no boundries it shows

  • Sunny says:

    Thank you both for your responses.
    So its the multiplier effect that increases the money supply (by cheap loans etc) but not the rupee converted foreign currency inflows into the countrys’ banks.
    A depreciating rupee may trigger more inflows (? only from optimists though..) to counteract but again looks like this is only a minor proportion compared to the big investments that usually pull out money during this phase.
    Is there a chart out there that can explain this complicated inter connected web showing atleast in theory on what should act as a plus & what doesnt, for a currency.
    As you may have understood by now that Im not a financial person but what continues to puzzle me is how can a country like US just continue to print (reflate) money this way and still the dollar remains stronger. Is it only coz the dollar, in relative terms is better than other currencies or is it a temporary thing until dollar eventually will get replaced as a reserve currency (is there really anything out there that is capable to replace ?)