$500 billion and counting: If the dollar does indeed fall over time, India’s reserves will also enjoy huge passive swelling

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Published: June 19, 2020 4:25 AM

Over the long term (10 years) the correlation between USD-INR and EUR-USD was as high as 81%; over a shorter horizon, the correlation is much lower (20-25%).

Thus, while the $500 bn number is certainly something to celebrate, we need to understand that $8.4 bn did NOT flow into India during that week.Thus, while the $500 bn number is certainly something to celebrate, we need to understand that $8.4 bn did NOT flow into India during that week.

The news that India’s FX reserves crossed $500 bn for the first time ever on June 5 has excited a lot of people—importers are hoping that this huge level of reserves will protect the rupee from significant further decline; people who believe in India’s future point to this for validation.

I was more curious about the fact that in the week to June 5, the reserves rose by $8.4 bn, taking the total over $500 bn. This is the highest the reserves have risen since the week ending September 28, 2007 (and, indeed, the second-highest ever). With economic activity largely closed at the end of May, it was hard to figure out where this huge amount of money came from—the Reliance money is not expected till July. To be sure, FPI’s did bring in about $2.6 bn during the week (May 29 to June 5), but to see net exports (???) or net FDI or even services income bloat to that level—over $5 bn—in a week was not plausible.

So, it left only one little-discussed window-revaluation of the existing reserves. RBI’s reserves are held in different currencies—USD, EUR, GBP, JPY, CNY and some non-SDR currencies. A research analysis we published in December 2008 (before CNY became part of the SDR) suggested that only 50% of RBI’s reserves were held in USD; this was quite radical at the time since developed economies had (on average) 64% of their reserves in USD, and other emerging markets averaged 57%. If we assume this ratio continues to hold and that the change in the value of EURUSD during the week replicates the behaviour of the non-USD part of the reserves, we could effectively square the circle.

Total foreign currency assets (part of the reserves) were valued at $455.2 bn on May 29; during the week USD weakened (against EUR) by 2.3%—multiplying it out shows that the revaluation of the reserves (assumed 50% in non-USD) contributed $5.2 bn during the week, which more or less makes up the gap. It is conceivable that with CNY now an important currency, both in terms of being part of the SDR and, more particularly, to India’s trade, the ratio of USD in the reserves may be even lower than 50%, which would bring the revaluation number even closer to eliminating the gap.

Thus, while the $500 bn number is certainly something to celebrate, we need to understand that $8.4 bn did NOT flow into India during that week.

For comparison, the last time we had a blowout number—$11.4 bn in the week ended September 29, 2007—the impact of revaluation was very modest. With just $228 bn of reserves at the time and USD weakening by just 0.8% during that week, more than $10 bn actually flowed into the country in one week! It drove the rupee stronger than 40 to the dollar, which, as many will recall, created considerable trauma in the Indian market, particularly since banks were outselling exotic products in spades.

Globally, the dollar was very weak (EUR-USD was 1.40) and, indeed continued to weaken further for about a year, hitting a low of 1.60, before the 2008 financial crisis hit and the dollar became hugely volatile and began its long climb to as high as 1.04 (a rise of 35%). And, wouldn’t you know it, there are now several respected global analysts (??) forecasting a much weaker dollar, including one who is looking for a 35% decline from its current level of around 1.10, which would take it up to 1.48-1.50 to the Euro.

If this does transpire—and, of course, anything is possible—it would likely take a reasonably long time. The dollar rose by 35% took over 12 years (and a hugely volatile 12 years, including as many as six 15-30% declines); so it would seem that the dollar’s decline, too, could take at least 8-10 years, again with a lot of volatility.

The rupee would, of course, benefit from the dollar’s weakness. Over the long term (10 years) the correlation between USD-INR and EUR-USD was as high as 81%; over a shorter horizon, the correlation is much lower (20-25%). Of course, this does not mean the rupee will appreciate by 35%—RBI will certainly have a lot to say about that and will buy dollars to prevent “too much” rupee appreciation, pushing the reserves still higher. Note that the path(s) will all be volatile since it is conceivable (likely?) that the risk-on mood, which favours the rupee, will fall sharply out of favour at various points in time, particularly if/when the underlying instability in global equity markets precipitates.

Again, if the dollar does indeed, fall over time, India’s reserves will also enjoy huge passive swelling as the dollar value of the non-USD part of the reserves gets pumped up by $87.5 bn (35% of 50% of $500 bn).

$600 bn, here we come!

The author is CEO, Mecklai Financial. Views are personal

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