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High forex reserves are no guarantee of monetary policy independence


From UPSC perspective, the following things are important :

Prelims level: CAD

Mains level: Paper 3- Forex reserves and its significance


The ascending stock of forex reserves has led to the view this will enable the sole devotion of monetary policy to domestic objectives.

Assessing the significance of forex reserves

Let’s look into the experinec of China and India in this regard.

1) Learning from China’s experience

  • In 2016, China had a strong external position—current account surplus and more than $3tn forex reserves.
  • However, investors’ expectations on renminbi (RMB) value began to shift due to rising concerns about its growth outlook, domestic rate cuts and eventual depreciation, and imminent tightening of US monetary policy, resulting in net capital outflows of $725 billio (bn) over the year.
  • This put sustained pressure upon the RMB.
  • Eventually, China resorted to capital control measures, which slowed the outflow and supported the RMB in the first half of 2017.

2) India’s own historical record

  • India’s own historical record shows that, high or low, forex reserves didn’t prevent investors from reappraising positions.
  • India experienced this in case of oil prices (2018) or taper fears (2013).
  • The CAD was moderate, at 1.1% and 1.4% of GDP in two quarters to December 2017.
  • But as oil prices climbed, current account projections were rapidly revised to 2.5-3% of GDP in less than a quarter seeing the jump in the import bill, lagging exports and continuous outflow of portfolio capital.
  •  Reserves totalled $424 bn then (end-March 2018); foreign currency assets were $399 billion.
  • Against a mere $9 bn capital outflow, the peak-to-trough decline in reserves was $19 bn in April-June 2018, with 5% depreciation of the rupee.
  • The sharper, $21 bn fall in mid-April to July 20, 2018 equalled the reserves decline in April-August 2013 taper episode when the rupee depreciated three times more or 15%!
  • Forex reserves were much lower in 2013 ($255 bn range) and it had taken only a quarter for the current account gap to widen from 4.0% of GDP in April-June 2012 to 5.4% and a record 6.7% in subsequent two quarters to December 2012!

Key takeaways

  • History shows that no level of reserves is a foolproof guarantee for macroeconomic stability or interest rate immunity.
  • The important lesson these episodes hold is that repressive attempts do not always convince markets or prevent shifts in expectations and often compel large, abrupt adjustment.
  • Investors reassess positions, including global factors, whatever the reserves’ stock.
  • The crucial role of reserves is psychological, i.e. market confidence and liquidity insurance that is immediate and unconditional that allows central banks to buy time, whether for a gradual adjustment, soft landing, or as the case may be.

Distortion in bond market and RBI’s role in it

  • RBI has been systematically suppressing bond yields, particularly the 10-year benchmark, the reference rate for banks.
  • So effective was the repression that the bond market became irrelevant as yields altogether stopped responding to inflation or fiscal developments.
  • The 207-basis-point jump in retail inflation in a month in May, which exceeded expectations, caused not even a flicker in the yield premium for example.
  • This did not prevent responses elsewhere though – the overnight indexed swap (OIS), which signals future interest rate movements, increased 20-30 basis points at different tenures with fresh inflation risks.
  • Clearly, the market reading was inconsistent with RBI’s, whose rigid adherence to a particular level (6% in the case of the old, 10-year bond) was disregarded outright.
  • The monetary policy cue was not being accepted, failing to soothe ruffled feathers about inflation.

Risk involved in RBI’s policy

  • If the global financial cycle were to suddenly turn, risk-aversion set in, or oil prices shoot up to risky levels, investors will undoubtedly look at actual differentials, not the one set in stone by RBI.
  • There will be exchange rate pressures, which RBI can no doubt manage with liberal reserves.
  • But the duration and degree of adjustment is not in RBI’s control, identically to the bond market one, where it has infinite capacity to keep local yields where it wants.
  • There’s a limit to how much foreign currency it can sell—the $609bn reserve holding is finite.
  • Currency depreciation can, therefore, worsen a bad situation as higher inflation pressurises domestic interest rates to rise.
  • RBI’s issuance of the new 10-year benchmark bond at 6.10%, which came as a surprise against its previous inflexibility, indicates RBI has internalised the above risks.
  • The disparate movements were undermining RBI,  whose commitment to continue the accommodative monetary policy as long as necessary to revive and sustain growth has been reassuring.


When the economy is open, financially integrated and subject to cross-country dynamics, it is more prudent to let market forces play out a bit than persist with a stance that could turn unsustainable despite the high reserves.

Back2Basics: What is Current Account Deficit (CAD) ?

  • The current account deficit is a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the products it exports.
  • The current account includes net income, such as interest and dividends, and transfers, such as foreign aid, although these components make up only a small percentage of the total current account.
  • The current account represents a country’s foreign transactions and, like the capital account, is a component of a country’s balance of payments (BOP).


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