As India’s foreign exchange reserves march toward the unprecedented $400 billion mark, its central bank faces a costly conundrum.
To keep the rupee stable and exports competitive, it is having to mop up inflows that’s adding cash to the local banking system. Problem is, banks are flush with money following prime minister Narendra Modi’s demonetisation move last year, leaving them struggling to pay interest on deposits in an environment where loans are not picking up.
The resulting need to absorb both dollar- and rupee-liquidity is stretching RBI range of tools and complicating policy. Costs to mop up these inflows have eroded RBI’s earnings, halving its annual dividend to the government. “RBI would be paying more on its sterilisation bills than it gets on its reserve assets, so it would cut into its profits,” said Brad W Setser, senior fellow at New York-based think-tank Council on Foreign Relations. “Selling sterilisation paper in a country with a relatively high nominal interest rate like India is costly,” Setser said.
RBI governor Urjit Patel aims to revert to neutral liquidity in the coming months from the current surplus. Lenders parked an average Rs 29,00,000 crore ($45 billion) of excess cash with the central bank each day this month compared with Rs 25,900 crore the same time last year. This peaked at Rs 55,00,000 crore in March.
The surge in liquidity has pushed RBI to resume open-market bond sales as well as auctions of longer duration repos besides imposing costs on the government for special instruments such as cash management bills and market stabilisation scheme bonds.
Meanwhile, foreign investors have poured $18.5 billion into Indian equities and bonds in the year through June, during which period RBI has added $23.4 billion to its reserves. Its forward dollar book has also increased to a net long position of $17.1 billion end-June from a net short $7.4 billion a year ago.
“My guess is reserves over 20 per cent of GDP would start to raise questions about cost – but that is just a guess,” said Setser.
India’s reserves have ranged between 15 per cent and 20 per cent of GDP since 2008 global crisis – a level that’s neither too low to create vulnerability or too high indicating excess intervention, he said.
Consistent buildup in the forward book may have cost RBI some Rs 7,000 crore, while total liquidity-absorption costs due to the demonetisation deluge from November to June were Rs 10,000 crore, according to calculations by Kotak Mahindra Bank. RBI paid another Rs 5,000 crore to Rs 7,000 crore to print banknotes, the bank estimates.
A weakening dollar would also have led to losses due to the foreign currency cash pile, which has traditionally been dominated by the greenback. The Bloomberg Dollar Index has fallen 8.7 per cent this year.
After all these expenses, RBI paid Rs 3,06,600 crore as annual dividend to the government, against Rs 74,900 crore budgeted to come from RBI and financial institutions. More clarity will emerge with the RBI’s annual report typically published in the final week of August.
“This disturbs the fiscal math for FY18,” said KMB economist Madhavi Arora. Assuming everything else stays constant, she estimates the budget deficit may come in at 3.4 per cent of gross domestic product rather than the government’s goal of 3.2 per cent.