To manage balance-of-payments (BOP) pressures so far this year, the Reserve Bank of India (RBI) has allowed currency depreciation and drawn down around $25 billion from its FX reserves (currently $401 billion) as a first line of defence. We think drawing down FX reserves is an effective strategy, provided pressures on the BOP are only short term in nature, but if they persist and the central bank continues to use its FX reserves, then non-linear effects can set in—falling reserves set into motion a vicious cycle of denting investor confidence and triggering capital outflows, in turn leading to a more-than-proportional currency depreciation, and so on.
In this note, we look to uncover the threshold beyond which RBI would be hesitant to burn its FX reserves further, preferring to use its second line of defence and hike interest rates, among other tools. We conclude that RBI probably has space to burn through $20-30 billion more of forex reserves, before it seriously starts considering other measures.
Measuring reserve adequacy
There are many rules of thumb (thresholds) to measure the adequacy of FX reserves. In international trade, three months of import cover is used to gauge adequacy. Given financial integration, reserve adequacy thresholds also look at full coverage of the current account and short-term debt (residual maturity). To gauge the risk from domestic capital flight, FX reserves equivalent to 20% of broad money supply (M3) are another thumb rule.
For this exercise, we measure adequacy using RBI’s foreign currency assets (FX assets) only, and exclude FX reserves held in gold as these would only ever be liquidated as a last resort.
n Months of import cover: FX assets currently cover 8.2 months of imports, higher than the standard prescribed threshold of three months, above the 2013 low of around six months, but down from nearly 12 months in 2016 (see graphic).
* Short-term debt by residual maturity: India’s short-term debt by residual maturity (short-term debt by original maturity, plus long-term debt due in the next one year) stood at $222 billion in Q1 2018. This is an important leading indicator of external vulnerability as it illustrates a country’s coming refinancing needs. Hence, a country should maintain at least enough reserves to cover its coming debt obligations. India’s FX assets are about 1.8x its short-term external debt, offering more than one year’s cover, but down from nearly 3x in 2008 (see graphic).
* Guidotti rule: According to this rule, reserves should cover both the current account and short-term residual debt obligations. On this metric, India’s cover is 1.4x—above the Guidotti rule threshold (1x current account and short-term residual debt) and better than the 1x in 2013 (see graphic).
* Money supply: Money-based indicators (ratio of FX assets to M3 money supply) look at the potential for an internal drain associated with capital flight by residents; a low and declining ratio is often a leading indicator of a BOP crisis. In India’s case, the proportion of FX assets to M3 has fallen from a peak of 30% in 2008 to around 18.5%, just under the 20% range considered optimal (see graphic).
Reserve adequacy: More an art than science
No single reserve adequacy measure is perfect, and without strong macro fundamentals, no amount of FX reserves would ever be sufficient. However, these measures do offer an objective way of analysing FX reserve adequacy.
* Bare minimum: An average of the above four adequacy indicators suggests India requires at least $267 billion to be held in FX assets. We see this as a minimum threshold, with countries typically holding greater reserves as a cushion.
* Comfort zone: If the last 10 years are taken as a benchmark, then based on India’s current macro parameters (current account, short-term residual maturity debt, money supply, imports), we estimate RBI should hold about $420 billion in FX assets. This could set a potential maximum.
We draw two conclusions from this analysis. First, India has more than adequate FX reserves, but they have fallen below the last 10-year average. Given ongoing EM risk aversion, we would say policymakers should ideally aim to hold at least an average of the two measures (bare minimum, comfort zone), i.e. about $350 billion of FX assets. FX assets of $377 billion currently suggest RBI probably has space to burn through $20-30 billion more of forex reserves, before it seriously starts considering other emergency measures. The risk of allowing reserves to dwindle beyond this level is that non-linear effects may be triggered. Second, as FX assets start to fall closer to optimal thresholds, it is possible that RBI will adopt a relatively less interventionist approach, and importantly, shift focus to adopting stronger monetary (rate hikes) and non-monetary (administrative/swaps/capital account) measures—the second line of defence in protecting the currency.
(Excerpted from Nomura Asia Insights ‘India: Enough forex reserves for a rainy day?’ report)