Foreign exchange reserves are usually most visible when they are falling. In quieter periods, they sit in the background as a reassuring number, rarely attracting much attention. But when the rupee comes under pressure, that number suddenly becomes a measure of how much room policymakers have to manage a turbulent external environment. The reported USD 18.34 billion decline in India’s foreign exchange reserves in a single week has thus attracted attention for more than its size. It raises a broader question about the pressures moving through India’s external accounts, the role of the Reserve Bank of India in absorbing them, and the trade-offs that accompany prolonged intervention.
The figure itself needs some unpacking. A decline in headline reserves does not mean that the RBI physically sold USD 18.34 billion in the foreign exchange market. India’s reserves include assets denominated in different currencies as well as gold. Changes in their dollar value can thus affect the headline number even without an equivalent amount of intervention.
Advertisement – Scroll to continue
The important question is, therefore, how much of the movement reflects valuation changes and how much reflects active intervention by the RBI.
The Pressure Behind The Number
It is useful to take a step back from the currency market and consider the balance of payments, which reflects the economy’s transactions with the rest of the world. This is a familiar structural vulnerability in India. Its trade deficit in goods is vulnerable to crude oil, fertilizers, and key electronic components. These are not areas in which demand can easily drop due to price increases or the depreciation of the rupee. The import bill can thus rise before domestic demand can catch up. This is partially balanced by services exports and remittances in India. The foreign exchange earnings from software and other business services are significant, and remittances are an important source of external income. Historically, these flows have been used to moderate the pressure generated by the merchandise trade deficit.
Advertisement – Scroll to continue
But these buffers are themselves exposed to the global cycle. Slowdown in technology spending in the West, or a slowdown in the labour market in major economies, can slow down services exports and remittance growth. This is particularly the case when it coincides with a high import bill, which makes the current account more vulnerable.
Things get more complicated when the flow of money reverses. Foreign portfolio investment can turn around quickly if global investors change their risk assessment of emerging markets. The nation could then experience increased demand for dollars to import goods at the very time when fewer dollars are flowing into the financial markets.
This is where reserves come in. They enable the central bank to take up a portion of that imbalance and avoid a sudden adjustment of the exchange rate. However, they do not remove the external pressures that cause them.
RBI’s Balancing Act
Domestic monetary operations include currency intervention. If the RBI sells dollars and buys rupees, it is taking rupee liquidity out of the banking system. Policymakers can counteract that effect by using other instruments to inject liquidity. This is called sterilisation and enables the central bank to intervene in the foreign exchange market without necessarily tightening domestic financial conditions.
However, there are trade-offs to sterilisation. Liquidity conditions affect bond yields, credit availability, and borrowing costs. The relative attractiveness of Indian financial assets to foreign investors can also be influenced by domestic monetary conditions.
This is the old conundrum of the impossible trinity. It is impossible for a country to have an independent monetary policy, a tightly managed exchange rate, and unrestricted capital mobility. The partial capital account convertibility in India provides the RBI with more policy space than a fully open financial system would provide. But today’s financial markets still carry the global dollar message quickly via portfolio movements, derivatives, and offshore markets.
Demand for dollars can also be self-reinforcing.
If an Indian company has an unhedged foreign-currency liability, it could hasten its dollar purchases if it thinks the dollar will continue to fall. Importers can make advance payments. Exporters can postpone the conversion of their dollar earnings. Global dollar liquidity tightening could lead to banks being more cautious about extending foreign-currency credit. Each answer on its own might make sense. Together, they can push up the demand for dollar just when the market is feeling the strain.
This is how a currency movement can gain momentum after the initial shock.
What Reserves Do Not Tell Us
The headline reserve number has another blind spot.
Forward transactions may affect the central bank’s future foreign-currency obligations without causing an immediate change in headline reserves. Foreign exchange reserves are thus not a complete indicator of the central bank’s foreign exchange position. Other liabilities, such as forward commitments, should be taken into account with the headline stock.
International experience is a good lesson to learn, but not a blueprint for India. Episodes in Turkey and Egypt illustrated how difficult it is to maintain external imbalances, volatile capital flows, and currency stabilisation when global financial conditions tighten. The situation in India is different, especially with its high buffer stock and unique external financing arrangement.
The lesson is that the speed of the pressure is as important as the quantity of the pressure stock.
Even if a country has large foreign exchange reserves, it may have to make tough decisions if the demand for foreign exchange becomes persistent.
The Resilience Test
When currency pressures are high, there is a tendency to focus on the exchange rate as the issue. The more important question for policymakers is what the exchange rate is saying about the economy below the surface.
Intervention can help smooth an adjustment and avoid disorderly market conditions, especially when financial markets become expectation-driven and start displaying herd behaviour. However, a long period of suppressed currency volatility can also cause a lag in adjustment as firms and investors can delay reacting to external conditions.
Sometimes, a gradual depreciation can serve a useful economic purpose. It increases the cost of imports, strengthens the rupee value of foreign earnings, and informs businesses of the change in external conditions. The policy dilemma is how to tell the difference between orderly depreciation and disorderly depreciation. One can serve as a shock absorber. The other can be destabilising.
The long-term answer for India is thus not at the intervention desk at Mint Road. A more resilient external account needs to be more diversified and more resilient in terms of exports, and more resilient in terms of domestic production of key intermediate goods, and less vulnerable to energy price shocks and less vulnerable to capital inflows that can suddenly reverse.
The USD 18.34 billion number could be a short-term swing. Its importance will be determined by the cause and consequences.
Foreign exchange reserves are ultimately a form of macroeconomic insurance. They are saved up during relatively peaceful times, and an economy has a viable cushion when the world gets turbulent. The issue for India is not whether that insurance should be utilised. It is whether the pressures that call for it are short-term shocks or indicators of vulnerabilities that policy needs to tackle more permanently.
That is the more important question behind the movement in the rupee. A robust reserve position can buffer an economy during rough times. However, the strength of that cushion relies on the strength of the external account underneath it.
(Deepanshu Mohan is Dean and Professor of Economics, O.P. Jindal Global University. He is a Visiting Professor at the London School of Economics (LSE) and a Visiting Research Fellow at the University of Oxford)
Disclaimer: These are the personal opinions of the author
