Over the past year, the foreign exchange reserves of India, maintained by its Central Bank, have consistently managed to surpass their own all-time-high benchmarks. Since the COVID-19 crisis, the frequency of this phenomenon has risen to as often as every alternate week. As of writing this piece, the last surge recorded in the week ending November 6, 2020, was of $7.78 billion, pushing the forex reserves to touch a record high of $568.5 billion. The week prior, the reserves had risen by $183 million. While some renowned (pseudo) economists have celebrated these figures as a mark of the rising relative strength of the Indian rupee, this stance couldn’t be farther from the truth, and is therefore misleading and perhaps even partisan.

The foreign exchange reserves are maintained by the Central Bank of an economy for the sake of convenience for liquidity and currency value management, as well as for non-prosaic purposes such as maintaining favourable exchange rates for export competitiveness. They tend to be constituted of foreign currency assets (FCAs), Treasury bills, US government securities, gold reserves, special drawing rights, etc. To put it in quite a crude way, these assets are exchanged for the domestic currency of a country, by its Central Bank, in order to regulate its value relative to these assets. Therefore, the forex operations affect the exchange rate, and consequently the trade balances as well. Since the exchange of the Indian rupee, for or against the forex reserves, takes place between the Central Bank and the domestic financial institutions (which receive forex assets through market-driven influx), these operations also affect the domestic liquidity status. The status of special drawing rights (denoted by the acronym XDRs) in this mechanism is weak and disputed. They are maintained by the International Monetary Fund (IMF) and were created to overcome the shortcomings of the Bretton Woods System, which was in effect from 1945 to 1972. The monetary system which pegged every currency to the US Dollar, which in turn was pegged to gold at the rate of $35/ounce, practically mandated the use of USD as the global reserve currency. However, owing to the conservative monetary policy of the USA at that point, the XDRs acted as a debt instrument to cover for the shortfall of USD and provide sufficient liquidity globally. After the apparently invariable transition of the USA’s policy stance to profligate practices, the system came to an end in 1972, rendering the XDRs as mere foreign exchange reserve assets, on which interest is payable or receivable if they are kept below or beyond (respectively) the level allocated by the IMF.

India, over the past three decades, has transitioned from the pre-liberalisation levels of $5 billion of foreign exchange reserves to exceeding $560 billion last October, registering a 10,000% increase, which makes it the fifth-largest reserves accumulated by any economy. The fact that the status of the low reserve mapped with the 1991 economic crisis, does not by any chance imply that the all-time high reserves are indicative of economic prosperity. Although the level of foreign exchange reserves impacts the domestic liquidity status, it is not actively used as a monetary policy tool. More so, it is used to regulate the foreign exchange rate, through which it impacts the domestic liquidity. So an increase in the reserves is a response to mitigate unruly upward fluctuation in the value of the domestic currency. By increasing the forex reserves, usually done by increasing the FCAs, the relative demand for the foreign currency rises, bringing down the value of the domestic currency relative to the chosen forex asset. Whether the increase in an economy’s forex reserves is good news or not depends on what the source of the appreciation is. India’s balance of payments (BoP) status usually follows the pattern of a current account deficit, i.e., a trade deficit, and a capital account surplus, indicating investment inflows. Due to India’s popular Emerging Market Economy (EME) status, the capital inflows spiked amidst the dovish environment in the developed economies last year. Such inflows cause an appreciation of the Indian rupee, which can adversely affect the trade balance by making the exports less competitive in the global economy. The increase in forex reserves to avoid the appreciation involves purchasing USD from the local banks in exchange for the Indian rupee. As a result, domestic liquidity rises even if the economy does not need it. 

This is the classic impossible trinity issue India faces, where in order to retain near-fixed exchange rates and a free flow in capital markets, the economy must partially let go of the independence of its monetary policy. This excess liquidity in domestic markets would be inflationary and could create macro-level imbalances. Of course, many argue that this liquidity can be merely sterilised. Sterilisation involves soaking up the excess liquidity without involving the forex assets so that the original purpose of exchange rate stability does not get defeated. So the RBI could simply sell government bonds through open market operations (OMOs) and take back the rupees that the markets were flooded with. But this would be counterproductive. By selling government securities through OMOs, their market supply rises and the prices fall, which results in a reduction in the domestic rates, thus discouraging the inflow of foreign investment. This would render the entire exercise futile. Clearly, there is no evident pathway towards resolving the trilemma.

However, in the current scenario, something much graver is under effect. The BoP surplus is a consequence of both investment inflows, as well as a (once in a blue moon) trade surplus that was registered due to feeble global demand. In order to prevent the exacerbation of the trade imbalances through appreciation, the forex reserves have been rising at an all-time high pace. As opposed to the previous scenario, this would mean that the resultant increase in domestic liquidity is not a major issue because the domestic economy is also recessionary and therefore could use this liquidity. This is also why we have not seen the policy rates being slashed despite the tight situation. Any more liquidity would mean risking inflationary pressures. Additionally, most economists would agree that the recessionary situation needs to be dealt with in a more targeted way, i.e. through fiscal policy. The problem is, how would the government finance its expenditure?  

India’s fiscal response to the situation, despite all its cautiousness, has been projected to take the fiscal deficit to 13.1% of GDP in the fiscal year 2020-21. This increase in deficits, though in line with the average increase registered by Emerging Market Economies, remains insufficient in the case of India. This is primarily due to the composition of the deficits. A major chunk of the deficits is owed to the reduction in collection of GST, and other automatic cyclical responses. Only a small proportion, 1.8% of the GDP, is the fiscal deficit owed to discretionary fiscal response, one that arises due to an increase in the expenditure or reduction of taxes. In order to get the economic cycle running again, more discretionary expenditure needs to be undertaken, which will not be possible unless the Reserve Bank of India manages to finance it by creating demand for government securities via OMO. But that would mean adding further liquidity to an economy where the fires of inflationary pressures have already been stoked by the forex operations. With nearly two lost years to get to pre-pandemic levels of output, the economy must make a choice between securing its interests in the international markets or getting the internal demand cycle running first.