India’s foreign reserves and global risk

India’s foreign exchange reserves, relative to GDP, have been on the rise. This article examines the motives behind the hoarding of reserves by central banks, and if adequate reserves are held for purposes such as precaution against extreme capital flows. Focusing on the Indian context, it assesses whether the marginal benefit of greater reserves outweighs the cost of holding reserves.

This is the second article in the Ideas@IPF2024 series.

Since 1991, India has accumulated a substantial stock of foreign exchange reserves (Figure 1). This rise in reserves relative to GDP (gross domestic product) is part of a pattern of reserve accumulation by many large emerging market economies (Figure 2). The hoarding of reserves by the emerging markets raises several questions about how these countries use their reserves, whether they hold adequate reserves for appropriate purposes, and if the marginal benefit of greater reserves outweighs the cost.

Figure 1. Foreign reserves for India, in million US$

Figure 2. Reserve accumulation in India and other Asian economies, in million US$

In our research, we consider each of these issues for India. We focus on the third issue and seek to measure the effect of additional reserves on international capital flows over the global financial cycle and on the opportunity cost of holding reserves for India.

Why hoard reserves, and how much?

There are three primary motives for central banks to hoard reserves. First, a stock of reserves provides self-insurance against runs on domestic financial markets and institutions by foreign and domestic asset-holders. Reserves can be held as a precautionary measure against sudden capital outflows related to global financial or domestic shocks. Second, reserves are used for intervention in the foreign exchange market to reduce short-term exchange rate volatility. A third motive seeks to maintain export competitiveness through systematic purchases of reserves aimed at undervaluing the exchange rate.

Reserves provide international liquidity to central banks to intervene readily in times of financial turbulence to maintain stability. Financially open economies face the risk of sudden reversals of foreign capital inflows or capital flight by domestic residents. Foreign reserves can also provide central bank liquidity against purely domestic runs when confidence in home currency collateral assets fails. A financially closed economy is not subject to runs but can be short of trade credit to pay for imports – India faced this situation in 1991 prompting a concerted effort by the Reserve Bank of India (RBI) to build up foreign exchange reserves.

Determining the appropriate size of reserves to hold as a precaution against extreme capital outflows is an important concern for monetary policy. The adequacy of precautionary reserves is typically defined in terms of the potential demand for reserve currency in the short run. The International Monetary Fund (IMF) assesses reserve adequacy using a metric based on rule-of-thumb ratios of reserves to a country’s exposure to sudden capital outflows or shortfalls of inflows. These include a threshold of one year of external debt amortisation (that is, periodically reduce the value of debt), the conventional threshold of three months of imports, and the ratio of reserves to broad money¹. Adequacy metrics, however, are ad hoc measures of the national economy’s exposure to global financial shocks and sudden stops.

The benefits of having reserves must be weighed against the opportunity costs of holding them. These costs are associated with the difference between the RBI’s earnings on reserve assets held in foreign government debt and the yield on the alternative asset, domestic government debt. These quasi-fiscal costs of holding reserves are largely estimated by the interest differential between domestic government debt and US Treasury debt, although not entirely.

Examining India’s reserves

At present, India’s reserves surpass IMF adequacy thresholds. A natural policy question arises: when does the RBI have enough reserves? Answering this requires an understanding of how additional reserves affect the risk of crisis-level events and opportunity cost of reserves. Holding reserves beyond what is needed to cover potential sudden capital outflows and import needs can provide assurance to creditors and other market participants that the central bank will not hesitate to intervene as much and as long as necessary. Reserves may reduce the risks due to global and domestic financial shocks, hence lowering the incidence of capital flow reversals and the risk premium on government debt whether denominated in domestic currency or foreign currency.

Standard formulas (such as in Jeanne and Ranciere (2011)) for the optimal reserves to be held as a precaution against exceptional capital outflows measure the level of reserves necessary to meet a sudden outflow. These do not account for the ‘endogeneity’ of risk. The anticipation that reserves will be available to mitigate the effects of global financial shocks and to meet sudden outflows of foreign capital is likely to affect the amount and nature of foreign capital inflows. Holdings that improve financial stability should enable more efficient investment finance. By reducing financial fragility, higher reserves might increase the maturity of capital inflows reducing the exposure to short-term capital outflows. If reserves reduce the size of capital outflows in adverse global or domestic events, the marginal benefit of reserves is larger, and the optimal level of reserves may be higher.

We estimate the effect of reserves on volatile capital flows for India over the entire probability distribution of foreign capital flows rather than just at the mean (average). Our method follows recent research applying capital-at-risk analysis to international capital flows.² Quantile regressions³ for India are used to estimate the marginal effect of reserves on gross capital flows over the distribution of external and internal shocks given global financial, growth, and monetary policy risks. Our analysis focusses on foreign gross capital inflows because these are most salient for financial stability concerns for India. Unlike most emerging markets, domestic gross capital outflows are subject to capital controls and are very small. Exceptional foreign gross portfolio outflows tend to exceed 1% of GDP.

Weighing benefits and opportunity costs

Global financial turbulence and foreign monetary policy shocks are significant drivers of foreign capital outflows from India. Global financial shocks are proxied by the VIX index⁴, and relative India and US monetary policy rates proxy monetary shocks. We find that additional reserves can significantly reduce large outflows occurring with 5% probability. Interacting risks with reserve holdings shows how additional reserves reduce capital outflows given global uncertainty shocks or monetary policy shocks. Using the quantile regressions to estimate a probability distribution for foreign portfolio capital flows allows prediction of how an increase in reserves mitigates a global uncertainty shock or monetary policy shock.

Monetary shocks affect foreign portfolio debt and equity flows differently. An increase in reserves significantly reduces the volatility of portfolio debt flows. Reserves reduce capital outflows following a rise in the federal funds rate and lower capital inflows with US monetary easing. While reserves have a stabilising effect on foreign debt flows, they do not significantly affect equity flows, as expected.

We next look at the cost of holding reserves. These costs include the interest differential between Government of India Securities and US Treasuries, the carry cost of foreign reserves, and other valuation effects. The carry cost of holding foreign reserves are the profit or loss on the reverse carry trade held by the RBI. These are ex-post losses or gains along with other valuation costs. Both can be positive for India. We estimate a model of the interest rate spread between 10-year Government Securities for India, issued in rupees, and 10-year US Treasuries. The spread is divided between a currency risk premium and a pure risk premium⁵. The effect of additional reserves on the India-US 10-year spread, currency risk premium, and pure credit risk is estimated. The results show that reserves have a negative and significant effect on spreads. This means that marginal opportunity cost of additions to reserves are less than the interest rate difference on RBI reserve assets and own government debt.

Conclusion

The effects of reserves on foreign portfolio capital inflows found by the analysis, suggest that reserve accumulation may continue to provide a precautionary reserve benefit to India. The results shows that additional reserves continue to reduce gross outflows against adverse global financial shocks and interest rate shocks, suggesting that there are positive marginal benefits to accumulating reserves for financial stability functions. This points to the stabilising effect of reserves in the case of monetary policy shocks. The estimated reduction in the sovereign interest spread implies that the opportunity cost of reserves for the RBI may be substantially less than the simple spread, net of valuation costs.

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Notes:

Broad money includes highly liquid 'narrow money' (currency notes and coins), as well as less liquid forms of money such as bank balances and other assets that can be easily converted into currency.
We follow the approach used by Gelos et al. (2022) and Muduli, Behera and Patra (2022)
Quantile regression models the relationship between a set of explanatory variables and specific percentiles (or 'quantiles') of the outcome variable. Quantile regression is used to estimate the conditional median of the outcome variable.
The Chicago Board Options Exchange's (CBOE) Volatility Index (VIX) is a leading measure of global financial volatility.
The currency risk premium, measured by cross-currency swaps, is equivalent to the forward premium (measured as the difference between the current spot rate and the forward rate, or expected future price for a currency). The pure risk premium is the equivalent interest spread between a hypothetical 10-year Government of India dollar bond and the 10-year US Treasury bond.