Be it forex or food, having a war chest helps in difficult times

What happened then…

2013 was a crisis year and so is 2022. But the current crisis is worse than nine years ago.

During 2013, the United States Federal Reserve kept its funds rate unchanged at 0-0.25%. The European Central Bank (ECB) even slashed its main refinancing rate from 0.75% to 0.25% between May and November of that year. Consumer price inflation in 2013 averaged 1.47% in the US and 1.35% in Europe.

The 2013 crisis was largely triggered by the US Fed proposing a phased reduction (“taper”) in its purchases of bonds and other assets amounting to $85 billion a month. While the plan was revealed by then Fed chairman Ben Bernanke on May 22, 2013, actual tapering did not start until the end of that year.

Yet, that announcement — which was only about a gradual unwinding of monetary stimulus (read the printing of dollars) as opposed to tightening — had a huge impact on India, basically due to the large current account deficits (CAD) in its external balance of payments. These touched record levels of $78.16 billion in 2011-12 and $88.16 billion in 2012-13 (April-March). As the “taper tantrum” led to capital flows drying up — and with forex reserves already dwindling from the previous high of $320.79 billion attained on September 2, 2011 — it created doubts over the country’s ability to finance its massive CADs.

The result: a run on the rupee. The RBI was forced to defend the currency against speculative attacks by selling dollars from its reserves, as well as by jacking up interest rates.

…What is happening now

In 2013, the big central banks were only phasing out monetary stimulus or slowing the rate of injecting liquidity into their economies. Today, they are tightening by reducing money supply and raising interest rates.

Since mid-March, the US Fed has increased its funds rate from 0-0.25% to 2.25-2.5%, and is expected to take this further up to a 3-3.25% target range on September 20-21. The ECB has also hiked its key refinancing rate from 0 to 1.25%. They are unlikely to stop — for the simple reason that annual retail inflation is now ruling at 8.3% in the US and 10.1% in the European Union. These are price increases that people in those countries last saw in the early 1980s. The commitment of their central banks to target inflation at 2% would entail real monetary tightening and high interest rates for a sustained time — unlike in 2013.

That has obvious implications for capital inflows into India. Rising interest rates in the US and Europe are, if anything, sucking away capital from emerging markets. This isn’t helped by India’s CAD, which is projected to top $120 billion in 2022-23, surpassing even the levels of 2011-12 and 2012-13. The situation is thus worse on both counts — external capital flows and CAD.

India’s war chest

But despite the far more hostile external environment, the rupee hasn’t been in free fall, and the RBI has not had to resort to exceptional monetary measures like it did during the taper tantrum period. It may still raise rates, but more to control inflation than depreciation. In other words, to defend the rupee’s “internal” rather than “external” value.

The primary reason why things have been different is that India entered this crisis with a much bigger war chest than it had in 2013. The forex reserves of $642.02 billion on October 29 last year was sufficient ammunition to deter any speculator from taking short positions on the rupee — selling expecting it to fall against another currency and booking profits by repurchasing later at a lower exchange rate — including through “non-deliverable forward contracts” in offshore markets such as Singapore and Hong Kong.

Accumulating large forex stockpiles is a strategy many countries have employed, especially after the lessons learnt from the 1992 “shorting” of the pound by the currency speculator George Soros, the 1997-98 Asian financial crisis, and the 2013 taper tantrum.

It is true that India’s forex reserves have suffered a drawdown of over $91 billion from its peak of less than 11 months ago. But reserves are meant for use in a crisis, like arms and ammunition in war. And it makes a difference when one starts with a nearly $650-billion stockpile than with under $300 billion.

The other ‘F’: food

A parallel can be drawn here with food, where stocks of rice and wheat in government godowns scaled an all-time-high of 109.47 million tonnes (mt) on July 1, 2021. They have since dropped to 60.11 mt on September 1, while at a five-year-low on a like-period comparison (see table).

In this case too, the Food Corporation of India’s grain mountain came useful precisely during a crisis. The public distribution system (PDS) not only delivered, but turned out to be the only effective social safety net in the wake of the Covid-induced economic disruptions. The value of that surplus grain is also being realised now, when stocks are at barely comfortable levels; one more bad harvest could well do to cereal prices what the taper tantrum did to the rupee.

That said, there are costs involved in accumulating reserves of both food and foreign exchange. In food, it is essentially the cost of holding and maintaining stocks above the operational requirement for the PDS. This buffer “carrying cost” was estimated at Rs 5.6 per kg for 2021-22. Given that the FCI’s average stocks during the year were about 60 mt more than necessary, it would have translated into roughly Rs 33,600 crore.

It’s more complicated in forex reserves, where the RBI’s purchase of excess dollars leads to a corresponding issuance of domestic currency. The need to mop up (“sterilise”) this rupee liquidity (in order to prevent inflation) then, results in its selling government bonds. If the interest payable on these exceeds what the RBI earns from deploying its forex assets in overseas securities and banks, there is a fiscal cost to reserve build-up.

But the cost of holding forex and food reserves is similar to spending on defence and having a standing army. Their utility is proved only in economic crises or when war breaks out. Whether, and how much, governments would bear these costs is both a fiscal and strategic calculation.

The unresolved ‘F’

India’s economic growth has traditionally been hobbled by the three ‘Fs’: forex, food and fuel. The first two were the bugbears in the 1960s, the third in the 1970s, and the first and third in the run-up to the 1991 payments crisis. Stockpiling has helped mitigate problems from the first two, but there’s no solution yet to the vulnerabilities from oil, gas, and coal.