To counter the challenges from key vulnerabilities such as unhedged external commercial debt, short term external debt and portfolio outflows, India needs an additional $60 billion of reserves, which would take the overall holdings to $420 billion, notes HSBC.
Pranjul Bhandari and Prithviraj Srinivas of HSBC in their June 26, 2015 research note titled: “How much is too much? point out that India’s main vulnerability has gradually transitioned from trade imbalance to indebtedness.
India’s three recent episodes of turmoil
Bhandari and Srinivas start off with a note that traditional metrics and benchmarks indicate India has adequate reserves. With its current reserves of about $360 billion, India boasts of an import cover which is three times as large as the IMF’s recommended value of three months. However, the authors point out that traditional benchmarks have lost relevance and nearly 60% of countries hold reserves beyond what they suggest.
Of note, India has experienced reserve losses over three recent episodes, viz.: the global financial crisis, debt crisis and taper tantrum. However, despite these three recent episodes, thanks to its rapid reserve accumulation policy, India’s FX reserves have touched record levels:
However, pointing to an NBER Working Paper titled: “Crowding out redefined: The role of reserve accumulation”, the HSBC analysts note rapid reserve accumulation by Asian countries following the Asian crisis led to a decade of sustained declined in investments:
India is well buffered
The HSBC analysts note from traditional reserve adequacy metrics, India seems suitably buffered. For instance, the country is well buffered vis-à-vis traditional short-term external debt cover benchmarks:
The analysts note a cover of 20% has been used in the past to capture the risk of capital flight. They note on this metric too, India is just about well buffered, though the cover has been falling over time:
Bhandari and Srinivas point out that India is better known for its persistent current account deficit and reliance on external financing. However, the analysts note India’s lesser known aspects such as external corporate exposure, and high proportion of unhedged corporates could necessitate India to maintain higher buffers.
The analysts point out that if stress rises to the levels faced during recent turmoil episodes, India may become vulnerable, at least on the external debt metrics:
They also note that India’s current account deficit is not likely to narrow further. Besides capital inflows could begin to slow as the U.S. Fed rate hike looms. The analysts note while the balance of payments is expected to remain in healthy surplus, it may not be as conducive to reserve accumulation as the prior year.
Finally, the HSBC team emphasizes the need to keep the macro house in order. They note lowering the twin deficits and inflation sustainably and increasing potential growth is more important than reserve accumulation, as this makes the economy more resilient to shocks.