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The foreign exchange reserves of the country, which the Reserve Bank of India (RBI) is custodian of, have depleted for the fifth straight week to April 8. The cumulative reduction over these weeks was a considerable $28.5 billion. This has raised some concerns, especially since a prolonged Russia-Ukraine crisis could potentially sustain or even accentuate the trend and cause a significant erosion of the reserves, weakening the country’s balance of payments.

India’s forex reserves, consisting largely of holdings of foreign currency assets, had grown at a remarkably steady pace between 2019 and September 2021. Some 35-40% of India’s foreign currency reserves are US dollar assets and the balance are holdings in other global currencies like euro, pound and yen, though expressed in dollar terms.

The forex reserves peaked at $642.5 billion in the week ended September 3; the component of foreign currency assets touched $580 billion around that point. As against that, the size of the reserves on August 8 was a little over $604 billion, with currency assets of around $537 billion, meaning the shrinking of the reserves was primarily because of valuation loss caused by the strengthening of the US dollar against other advanced-economy currencies and RBI’s sale of dollars to support the rupee in recent weeks.

“The loss of valuation may be around $14 billion (since early September). That leaves us with a gap of around $29 billion, to be explained by the currency swap deals and other interventions by the RBI,” says Anindya Banerjee, vice president for currency derivatives and interest rate derivatives at Kotak Securities. “Given that the RBI has done a swap deal of around $10 billion, the reserves stock indicates it may have sold around $18-20 billion in the spot market on net basis, adjusting for any conversions that they have made on long forwards to spot,” he added.

Until the cycle of net FPI outflows from the Indian market turns, the RBI could retain its current strategy versus the currency market. So long as oil prices remain stable, further big depletion of the reserves might not happen, Banerjee said, but added that if the oil surges to $140/barrel and the capital outflows accelerate, a quicker depletion of India’s reserves could not be ruled out.

“FPIs would remain away from Indian assets for the time being as high oil prices, rising US bond yields and US dollar overseas make Indian assets unattractive. However, attractive relative real yields on rupee over the US dollar is keeping the carry traders invested in rupee. At the same time, aggressive interventions by the RBI is aiding investors to keep faith in the rupee.” The central bank had earlier said it won’t let the market to dictate the value of rupee.
“If oil prices remain near $100, then the RBI can help keep the rupee stable. However, if oil prices were to rise sharply from here, then the pressure on the rupee to depreciate can be quite significant,” Banerjee said.

While modest current account deficits and robust net capital inflows buttressed India’s reserves position for several quarters till Q2FY22, a high merchandise trade deficit and pulling out of the FPIs from Indian markets have since modified the situation significantly.

Looking ahead, in terms of current account deficit (CAD), we expect the average quarterly level in FY2023 to be modestly higher than H2 FY2022 (around $21 billion). Accordingly, forex reserves may see outflows in some periods, depending on the escalation in tensions, and the associated impact on FPI as well as FDI flows,” Icra chief economist Aditi Nayar said.

Merchandise trade deficit in the second half of FY22 grew dramatically, especially in the third quarter, as domestic demand had rebounded sharply before the Omicron onslaught in January, pressuring the current account. From as much as $60.6 billion in the third quarter of FY22, goods trade deficit eased in the March quarter but still remained elevated at $55.4 billion. This was way above the deficit of $31.8 billion in the first quarter of FY22 and $44.8 billion in the second quarter. Nayar expects the CAD to recede under $20 billion in the March quarter from $23 billion (2.7% of GDP) in the previous three months.

However, given the global commodity rally in the wake of the Ukraine crisis, some analysts expect the pressure on the current account to remain elevated in the June quarter, driven by an inflated oil import bill. However, the CAD could ease thereafter, once the geo-political conflict abates and global supply chain disruptions ease.

Foreign portfolio investors have been selling risky emerging market assets, thanks to actions by their central banks back home, while retail investors have been picking up stocks every time the markets corrected. Overseas investors have sold Indian equities in every month since October whereas four out of seven months through March saw their pulling out money from debt as well. FPIs have pulled out $14.2 billion from equity and debt markets between January and March and have withdrawn another $760 million till 19th of this month.

According to Kotak Institutional Equities, low return expectations from high valuation is the key reason for FPI selling. Moreover, earnings may see limited upgrades as the positive impact of higher commodity prices on earnings of commodity sectors may be offset by negative impact of higher input prices on earnings of consumption sectors. “FPIs have decent ownership of Indian stocks and their future action in terms of buying and selling will be largely determined by return expectations, linked to valuations of the market and stocks,” wrote the domestic brokerage in an investor note.

The country’s CAD recorded a sharp decline in 2019-20 and a surplus in 2020-21. On the other hand, the capital account recorded a surplus in both these years led by foreign direct investment. While there was an accretion to foreign exchange reserves to the tune of $147 billion on on a BoP basis during 2019-20 and 2020-21, in 2021-22, reserve accretion (including valuation effect) has been of the order of $30 billion.

Foreign exchange reserves include foreign currency assets, government treasury bills, deposits with other central banks, gold, special drawing rights and reserve tranche position.



Author: Howard Caldwell