High forex reserves are no guarantee of monetary policy independence

History shows that no level of reserves is a foolproof guarantee for macroeconomic stability or interest rate immunity.

The ascending stock of forex reserves has led to the view this will enable the sole devotion of monetary policy to domestic objectives. That is, the central bank can maintain low interest rates in pursuit of growth even if global monetary conditions reverse. This is illusory. 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.

An outstanding example is China’s battle with massive drain of foreign capital in 2016 as 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. Net capital outflows were $725 billio (bn) over the year, putting sustained pressure upon the RMB despite a strong external position—current account surplus and more than $3tn forex reserves. China’s reserves depleting at an alarming rate in attempts to stem the tide, with about $1 trillion (tn) spent over mid-2016–early-2017. Eventually, China resorted to capital control measures, which slowed the outflow and supported the RMB in the first half of 2017.

India’s own historical record shows that, high or low, forex reserves didn’t prevent investors from reappraising positions, whether it was 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.

Some even predicted a $20-22bn NRI deposit issuance later in the year to offset the external financing shortfall! 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!

The two episodes, with different reserves’ levels and triggers, drive the understanding that 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. That is not to say fundamentals do not matter. They do, but in relation to current or sudden developments affecting key metrics, and if the policy settings are sustainable.

The important takeaway is investors reassess positions, including global factors, whatever the reserves’ stock. This brings up the intense discord in bond and swap markets, one repressed and the other free. RBI has been systematically suppressing bond yields, particularly the 10-year benchmark, the reference rate for banks. It variously called off/devolved bond auctions, paid higher fees/commissions, fluctuated between camaraderie and combat, anyhow managing to the point of completely drying out bond supply to keep borrowing costs low. 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.

Such large divergence can be dangerous and indefensible. 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 a game it can play 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. Larger the divergence, larger could be the adjustment forced. A big, discrete shock would only undercut growth, which deserves larger weight now.

The RBI Governor’s interview last week and subsequent 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 somewhat undermining RBI, whose commitment to continue the accommodative monetary policy as long as necessary to revive and sustain growth has been reassuring, as reiterated by the Governor last week.

A bit more flexibility also helps avoid volatility that had recently emerged as uncertainty is bad for a recovery. 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.