Building and managing currency reserves in the new world

(A version of the following article appeared in Business Standard on March 28, 2022, per link below: 

https://www.business-standard.com/article/opinion/building-currency-buffers-in-the-new-world-122032700842_1.html )

Building and managing currency reserves in the new world

 

In February 2022, Bank of Russia (BOR, Russia's central bank) seemed prepared for severe financial sanctions from the USA. 

BOR had grown its foreign exchange war chest from USD 350 bn in 2015 to USD 643 bn in December 2021. As of June 2021, it held just 7% of its assets in the United States. Instead, it denominated 32% of its reserves in EUR, 22% in Gold, and 13% in Chinese Yuan.

However, in the aftermath of Russia's military strike on Ukraine, in a breathtaking show of unity, the western world froze BOR’s access to its reserves in all major currencies including the US Dollar, Euro, Pound Sterling, Japanese Yen, and Australian Dollar. BOR now finds that much of its reserves are inaccessible. Between this and other sanctions, Russia’s economy is now under immense strain. 

 

Reserve Bank of India (RBI) holds a record USD 682 bn of foreign exchange buffer. Are there learnings for us from this BOR experience? Does RBI hold ‘too much’ of reserves? Should it review where it deploys these assets?

 

India’s need for a foreign exchange buffer

 

India has a volatile goods trade deficit, dominated by import of consumption goods such as crude oil, gold, electronics, and manufactured products. This deficit is heading to a record USD 200 bn in fiscal year 2021-22 (FY22). About USD 150 bn of this deficit will be bridged by healthy, growing services trade surpluses and remittances. That would still leave an overall energy and consumption-oriented Current Account Deficit (CAD), to be funded by capital inflows. 

 

Figure 1 traces India’s CAD and Brent crude oil prices over time. Crude oil averaged USD 102/ barrel between FY09 and FY14, when our CAD stayed high at 3.1% of GDP. With crude oil prices averaging USD 55/ barrel between FY16 and FY21, CAD then dropped below 1% of GDP. 

 

If FY23 crude oil prices were to average USD 120/ barrel, our CAD could rise again to 3.8% of GDP.

 

 

Source: Bloomberg, RBI, Observatory Group 

 

Till the quality of our external balance improves, we need currency buffers. 

 

Figure 2 charts India’s foreign exchange buffers (as percentage of GDP) alongside USDINR. Despite the 2009 global financial crisis and high energy prices, high exchange buffers over 20% of GDP kept markets reasonably stable between FY09 and FY11. However, as currency buffers dipped below 15% of GDP in 2013, our financial stability was threatened.

 

Today, thankfully, our foreign exchange buffers are again in the green. This gives us immense degrees of monetary and fiscal policy freedom and buys us time - as it did during FY09-FY11. During this time, we must either hope that energy markets calm down - or create jobs, output, and exports. As 2013 showed us, hope is not a great strategy. We now need Atmanirbhar Bharat to succeed.

 

Source: Bloomberg, RBI, Observatory Group

 

Deployment of currency buffers

 

Considering BOR’s experience, how should RBI deploy these much-needed buffers?

 

There is a lot of handwringing about western weaponization of trade and finance. However, what options remain outside of western currencies? China is the other large economy, accounting for 15% of global trade. But do we really want to hold assets in Chinese Yuan?

 

To paraphrase Winston Churchill, fiat currencies issued by democracies are the least reliable, except for those issued by all other forms of government. 

Separately, while there are ideas for an alternative exchange system, it is unlikely that the west will relinquish status quo easily.  

 

The other option that is periodically floated is that RBI should deploy its exchange buffers into funding India’s infrastructure investments. Such suggestions reflect a lack of understanding of how foreign exchange reserves work. In any case, there is a whole financial services ecosystem available to provide commercial credit and foreign exchange, without dragging the RBI into it.

 

What about diversifying reserves away from currencies? While gold is an option, without access to other currencies, BOR finds that its own large gold reserves may be of limited use. In any case, Indian households reportedly hold USD 1.5 trillion of gold. We hardly need the RBI to add to our weakness for this non-productive asset.

 

One option that we should consider is to use some currency buffers towards building a strategic crude oil reserve. While the value of crude oil holdings would be volatile, this would serve as a ‘right-way’ hedge for India’s underlying economic risk. Unlike gold, oil can also be deployed in the real economy if needed.

 

There are objections to this proposal, of course - which is why it hasn't been done so far. For one, IMF does not recognize oil holdings as part of central bank reserves. There is also the question of overall ownership and accountability – between the RBI, the government, and the oil majors. If these largely operational issues are addressed, we may find that it makes much more risk management sense for RBI and the country to hold USD 44 bn worth of crude oil in its FX buffers, than USD 44 bn of gold.