M.ULTIPLE indicators reveal that pre-pandemic deceleration in growth was segmented into a deep recession that persists six months after the first reported COVID-19 case. But official optimism has not waned. Some spokespersons promise a V-shaped improvement. Others connect at each straw in sight. One such is evidence of record and rising levels of foreign exchange reserves (gold, foreign currency assets and SDRs) with Indian Reserve Bank (RBI). On 7 August, total reserves amounted to DKK 538.2 billion. Dollars, which would be sufficient to cover imports of almost a year, even if the economy was not in the midst of the ongoing recession.
Reserves provide insurance against an exit from foreign investors, as happened in the first months of the pandemic, which could trigger a collapse in the currency. They also allow the central bank to intervene in the foreign exchange markets to stabilize the rupee when there is an increase in the currency inflow. In fact, the problem in recent times has been an excess supply in relation to foreign exchange demand in the market. Part of the reason why reserves have risen to record levels is the RBI’s intervention to buy dollars and prevent the strengthening of the rupee given the excess supply of foreign currency. Rupee appreciation would hurt exporters already adversely affected by the global economic contraction.
Thus, the high levels of reserves are the result of increased currency availability and an acceleration in reserve accumulation following the start of the COVID-19 pandemic. Between the end of March and May 8 this year, the total reserves of the RBI had increased by $ 7.5 billion. About a month later, on June 12, the increase in total reserves compared to the end of March had shot up to $ 29.8 billion. Over the next two months, the increase in reserves at the end of March affected $ 38.6 billion (July 10) and $ 60.4 billion (August 7). Thus, in the three-month period ending August 7, India’s foreign reserves had increased by $ 52.9 billion. This compares with a decrease in the reserve level of $ 11.7 billion over the financial year 2018-19 and an increase of $ 64.9 billion over the financial year 2019-20 as a whole.
Needless to say, part of the increase can be explained by valuation effects, especially those resulting from the rise in the gold price, which raised the value of the central bank’s gold damage. The increase in the value of gold held by the central bank during the three-month period ending August 7 was only $ 7.5 billion, while the increase in the value of foreign currency assets held by the RBI , amounted to $ 44.7 billion. The accumulation of reserves in the central bank is essentially the result of its operations, which aim to stabilize the exchange rate of the rupee when there is an excess supply of currency.
This raises the question: What explains the excess supply of currency in the economy? An obvious explanation is the decline in demand for currency due to the sharp fall in global oil prices and the fall in demand for imported oil and non-oil goods and services due to the severe economic recession. The price of Brent crude oil in July was a third lower than a year ago, and the bill for oil imports in April-July was $ 19.61 billion, 56 percent lower than in the corresponding period the year before. Non-oil imports have also shrunk, so total imports were 40 percent lower in April-July compared to the same period in 2019. As a result, the deficit on merchandise from April to July narrowed to $ 14 billion from $ 59 billion in the same year. period of the previous financial year. After accounting for profits in trade in services, India’s total trade deficit of $ 33.5 billion in April-July 2019 has been transformed into a profit of $ 14 billion in the four months ending July 2020. While the total current account figures have not yet been released, there is no doubt that the demand for exchange rates has shrunk significantly.
Paradoxically, this recession and COVID crisis-induced shrinkage in demand for currency have been accompanied by an increased flow of foreign currency into the country. Originally, a panic bear ride resulted in a large net outflow of foreign institutional investment (FIIs), in particular of debt. During the five months ending May, the total net outflow of FII investments was $ 17.4 billion, of which $ 14.2 billion was due to the debt outflow. But things have changed since then due to the large infusion of liquidity from the US Federal Reserve and the European Central Bank in response to the COVID-induced crisis. The availability of cheap money has diverted attention from risks of real economy all over the world, also in emerging markets like India. The Indian markets recorded a net FII inflow of 3.4 billion. Dollars in June, 450 million. $ In July and 4.2 billion. Dollars in just the first half of August.
Maturity or dollars
But in addition to FII flows, the surplus of dollars in the Indian market is also due to a rate of global liquidity for direct purchase of equity in Indian companies, including banks. The most visible of such inflows was the one that financed the acquisition of a total stake of 33 percent in Reliance JIO from Reliance Industries by 14 different global investors, with Facebook and Google getting 9.9 and 7.7 percent, respectively. These investments, which took place between mid-April and mid-July, amounted to Rs. 1.52,055 crore, or more than $ 20 billion. In the case of banks, ICICI Bank, Axis Bank and HDFC reportedly mobilized 4.7 billion. Dollars through stock sales in the first half of August, BlackRock has acquired a stake worth about $ 1.4 billion. Dollars in Bandhan Bank, and other investors have bought into various smaller players.
A combination of factors thus accounts for India’s strength on the external front, which is reflected in its foreign exchange reserves, which are now the third largest in Asia after China and Japan. Of these factors, there is only one that is an unreservedly positive contributor from India’s point of view: the fall in oil prices that has reduced the country’s oil import bill quite significantly. Although the oil market is likely to remain depressed for some time to come, some possibility of an increase in oil prices driven by production cuts jointly enforced by the Organization of the Petroleum Exporting Countries (OPEC) plus grouping, which includes Russia, can not be ruled out.
The other contributing factors all have negative consequences associated with them. The contribution of the reduced trade deficit and the total trade surplus, which includes the benefits of the fall in oil prices, is also a reflection of the recession and the decline in production that accompanies the crisis before and after COVID-19. Thus, any increase in the reserve level due to this factor is more a reflection of weakness rather than of strength.
It would have been different if surpluses on trading and current accounts during periods of normal or strong growth had contributed to the addition of reserves. Reserves accumulated through profits on trading and current accounts are reserves earned and accumulated and are therefore available to the central bank without any obligation for associated payments or repayment of capital. The International Monetary Fund defines reserves as external assets readily available to and controlled by monetary authorities for the direct financing of imbalances in external payments, for indirectly regulating the size of such imbalances through intervention in foreign exchange markets to influence the exchange rate and / or to other purposes.
When assets are liable, they are not readily available, as the central bank may need to access these assets at short notice to meet these liabilities. This is the case with inflows due to portfolio investments that have associated current liabilities, insofar as any interest, dividends or capital gains associated with these assets can be transferred to the holder abroad in foreign currency, and the asset itself can be redeemed, and the capital is withdrawn, as the net outflow in the months prior to June this year illustrated. What this implies is that any increase in reserves as a result of such an inflow is borrowed reserves and unearned reserves such as In case of positive net exports.
An element of commitment is also associated with foreign direct investment (FDI) for two reasons. To begin with, the distinction between direct and portfolio investment is blurred, as any investment of more than 10 per cent. Of a company’s equity by a single investor is treated as FDI, although some of these investors may not have a long-term interest in targets and the investments can be made for the purpose of extracting capital gains rather than dividends.
Second, dividends can be repatriated in foreign currency, and the investor has the right to sell his assets and repatriate the value in foreign currency. So there is an obligation to meet foreign exchange obligations associated with this investment, also in the case of FDI. This makes FDI a less preferred way than net exports as a way of attracting capital that helps build up reserves, even without taking into account the consequences of non-resident control over parts of the domestic economy.
In summary, the sudden and sharp rise in India’s foreign exchange reserves in recent months is the result of recessionary conditions and the speculative rush from investors driving cheap capital into Indian stock and debt markets in search of quick and high interest rates. It can hardly be a cause for consolation, not least celebration, and must not be used as a means of diverting attention from the severe crisis that has hurt the economy.