The RBI annual report points to high investments in dollar assets and illiquid securities, raising currency and liquidity risks
India’s foreign exchange reserves are now a touch below $400 billion. If one adds the RBI’s forward buying commitments of US dollars, the reserves are about $410 billion. In more senses than one, this is a landmark attainment that encapsulates the validity and success of the economic reform process that began in the wake of the BoP crisis in 1990-91 when the reserves had fallen to less than $1 billion. It also portrays the good quality of overall macroeconomic management, especially of the external sector, in the post-reform years. India has now overtaken Brazil as the top holder of foreign exchange reserves among countries with current account deficit.
The economic costs and benefits of higher reserves for a country like India are complex. It gets even more intricate if one brings in external security and strategic issues. Economic Survey 2014-15 made good use of a mordant utterance of the Cold War era to drive home a crucial point in this regard: “If power used to flow from the barrel of a gun, in an increasingly inter-dependent economic world, hard and soft power derive from a war-chest of foreign exchange reserves.” It concluded the discussion saying, “The question for India, as a rising economic and political power, is whether it too should consider a substantial addition to its reserves, preferably its own reserves acquired though running cumulative current account surpluses, possibly targeting a level of US$ 750 billion-1 trillion over the long run.”
Forex reserves are likely to increase further in the coming years, although the accumulation being driven by current account surplus may not happen soon. Nonetheless, the focus henceforth will possibly be on the quality of portfolio management of reserves, especially on the risk-return profile and performance of foreign currency assets (FCA). Does the RBI have the requisite vision, leadership, professional know-how and experience for this? From whatever can be gleaned from the very frugal disclosure made by the RBI, it is apparent that the professional quality and standards of deployment of FCA has not kept pace with its growth over the last two decades.
The overarching legal space for deployment of FCA is wide, enabling the RBI to invest in a large variety of debt instruments in all major foreign currencies, including in their derivatives, such as swaps, futures and options. This affords, inter alia, managing the exposures to main investment risk categories, namely currency, liquidity, credit and interest rate risks in a flexible and inexpensive manner.
By all indications, the currency risk is very high and dwarfs the other three types, with liquidity risk coming next. Since the forex reserves are denominated and expressed in only US dollars, the larger the proportion of currencies other than the US dollar in the FCA the higher the currency risk. It appears that this proportion is close to 50 per cent thereby entailing significant risk. As it has turned out, the aggregate mark-to-market valuation loss caused by this risk exposure over the last five years has been close to $45 billion.
Since the RBI purchases forex through market intervention exclusively in US dollars, currency diversification of FCA is not an offshoot of monetary and exchange rate policies and operations of the RBI. It is presumably guided by other strategic considerations of the RBI as a financial institution, although one hardly finds any disclosure in this regard. One is also not sure if the considerations are based on comprehensive and rich analysis of all the relevant factors and proper ratiocination. If the currency diversification of FCA is sought to mirror that of the forex-denominated external debt of the country in order to hedge, to some extent, the currency risk on the so-called national balance sheet, as some countries do, there is still a significant mismatch here. The US dollar share of the forex-denominated external debt is close to 85 per cent .
The broad division between investment in securities and deposits in central banks, BIS, IMF and foreign commercial banks is 66:34. Liquidity risk, indicated by the ability to generate cash by selling securities but without incurring large transaction costs is seemingly high, since a good part of the holding of securities is non-current and illiquid. Since the onset of the global financial crisis in 2007, the RBI drastically brought down its credit exposure to foreign commercial banks from around 24.4 per cent of FCA to 6.3 per cent currently. Interest rate risk, approximately measured by the weighted average residual maturity of FCA appears to be low — at around 15 months, as a back-of-the-envelope calculation on the basis of the valuation drop of about ₹170 billion in 2016-17 would suggest.
An important upshot is that currency risk is very high, followed by high liquidity risk. Both credit risk and interest rate risk exposures are relatively low. The rationale for this imbalance is not clear, though.
An important inference from the year-to-year variation in the valuation of securities holding is that there is no mechanism to take profit when valuations are high, such as in 2015-16. There seems to be very little use of repo transactions and of derivatives for risk extension/reduction or for exploiting arbitrage opportunities in the market. It is unlikely that investment and risk decisions are entirely driven by policy and guidelines. There are possibly dysfunctional bureaucratic layers impeding portfolio management of reserves.
One wonders if the RBI has a professionally prepared and adopted policy document as well as a set of investment guidelines for deployment of FCA and gold, as is the case with most central banks and monetary authorities. Also, there does not seem to be a well-defined and documented decision-making structure and process. In the absence of these three documents, there are likely to be different views and perceptions and even confusion about the policy stance on key issues relating to the portfolio management of reserves.
Poor return performance
Neither the RBI’s annual reports nor the six-monthly reports on forex reserves disclose any useful information on portfolio and risk management of forex reserves. The RBI provides a metric — earnings from FCA as per cent of average FCA — in its annual reports, which does not conform to any standard definition of portfolio return. However, making use of this and a few other disclosed numbers, it seems that the rate of return on FCA in 2016-17 was negative. To be sure, the high cost of massive liquidity absorption in the wake of demonetisation was not the only reason for much lower RBI profit in 2016-17.
The writer is a former central banker and consultant to the IMF (Via The Billion Press)
(This article was published on September 4, 2017)
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