India’s FX reserves are above traditional norms

But India’s peculiar characteristics and experience in recent crises suggest …

… about USD60bn more could buffer sufficiently against prolonged global financial tightness

More art than science What is the optimal level of foreign exchange reserves? There is no right answer. There are

certainly benefits associated with higher reserves, such as cushion against global shocks

and enhanced confidence in the currency. But there are also considerable costs, primarily

the fiscal cost of sterilization and a possible ‘crowding out’ of domestic activity over time.

In thinking about optimal reserves, one needs to be cognizant of India’s peculiarities. Its

better known ones are a persistent current account deficit and reliance on external

financing; lesser known are its external corporate exposure, which could be higher than

official data suggests, and high proportion of unhedged corporates. Furthermore, the

potential turmoil caused by the Fed’s exit could have some unique characteristics. It could

be a prolonged affair, followed by exits from other central banks as well. Under such

circumstances, maintaining higher buffers for countries like India may not be a bad idea.

Traditional metrics and benchmarks suggest India has adequate reserves. Goods and services

import cover is well beyond the well-known three month norm and, short term and overall

external debt is fully covered. However, traditional benchmarks have lost relevance and nearly

60% of countries hold reserves beyond what they suggest. We, too, look at reserve adequacy in

a different light. We marry traditional metrics with India’s peculiarities. Our study of India’s

reserve losses over three recent episodes (the global financial crisis, debt crisis and taper

tantrum) suggest that if similar losses were to hit again, the import cover of reserves would

remain adequate but the short term external debt cover could fall notably. And indeed, India’s

main vulnerability has gradually transited from trade imbalance to indebtedness.

We estimate an additional USD60bn of reserves, taking overall holdings to USD420bn,

could take care of key vulnerabilities (such as unhedged external commercial debt, short-

term external debt and portfolio outflows). This fits nicely into our FX strategist’s

expectation of a gradually depreciating rupee (see INR: Modifying our enthusiasm, 12 May

2015, Paul Mackel). However, having said this, we don’t want to overstress the importance

of FX reserves. Other lines of defense, notably swap line arrangements with other

countries, can prove as effective. And most effective of all is keeping the macro house in

order. That single-handedly can insulate the economy against shocks.

26 June 2015

Pranjul Bhandari Chief Economist India HSBC Securities and Capital Markets (India) Private Limited +91 22 22681841 pranjul.bhandari@hsbc.co.in

Prithviraj Srinivas Economist HSBC Securities and Capital Markets (India) Private Limited +91 22 22681076 prithvirajsrinivas@hsbc.co.in

View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report: HSBC Securities and Capital Markets (India) Private Limited

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Macro India

Flashnote

How much is too much? The adequacy of India’s foreign exchange reserves

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India lost USD20bn of foreign exchange reserves over the taper tantrum months of 2013. Since then, it

has built up more than four times that amount. Currently with about USD360bn (including USD5.2bn of

net forward position) in reserves, India boasts of an import cover which is three times as large as the

IMF’s recommended value of three months. And yet it may not be enough in the face of India’s peculiar

vulnerabilities and a likely long and painful period over which a host of developed-economy central

banks will gradually exit from loose monetary policy, tightening financial conditions across the world.

Foreign exchange reserves are not costless and single-minded rapid reserve accumulation is not the

simple answer to cushion oneself. In this note we describe the fine line India needs to tread and quantify

what level of foreign exchange reserves will be enough and yet not too costly.

The importance of being buffered

Traditional motivations. Building adequate foreign exchange reserves has many motivations, ranging

from precautionary buffers against income and commodity price shocks (for instance those associated

with Fed’s likely exit from loose monetary policy), protecting the domestic banking sector and credit

markets from external turmoil, smoothening exchange rate volatility and enhancing confidence in the

currency (see chart 2). IMF (2011) shows that during crisis-like episodes, EMs with higher reserves were

able to maintain more stable consumption and also expand fiscal policy to offset adverse effects of crisis.

A country with peculiar characteristics. Higher reserves are particularly important for India. It runs a

perpetual current account deficit which is vulnerable to commodity price changes and the capital account

is prone to volatility, sudden stops and reversal in flows. Over time, a growing vulnerability caused by

unhedged corporate debt also warrants a suitable reserve cover. RBI estimates that the hedge ratio for

corporates was only about 34% in 2013/14. But that is not where it ends …

The taper tantrum months of 2013 were puzzling. Despite India’s overall external debt being relatively

small (22% of GDP), the impact of tighter global financial conditions on local currencies and markets

was disproportionately large. An Asian Development Bank study (Firms as surrogate intermediaries:

Evidence from emerging economies, Shin and Zhao, December 2013) provides a compelling explanation

Chart 1. Rapid reserve accumulation (despite three recent episodes of turmoil) have led to record FX reserves

Source: CEIC, HSBC

-400

4080

120160200240280320360

FX reserves: Net forward position FX reserves: Others (gold, SDR, reserve position in IMF)

FX reserves: Foreign exchange

Current holding: nearly USD 360bn

Global financial crisis (lost USD 76bn)

Debt crisis(lost USD 40bn)

Taper tantrum(lost USD 21bn)

India's overall foreign exchange reservesUSD bn

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for this: when corporate balance sheets straddle borders, measuring exposure simply at the border may

not reveal all the strains on consolidated balance sheets.

As a case in point, if an Indian company’s subsidiary in London takes on a USD debt, while the company

continues to hold rupee assets at its headquarter, the company will be affected by global currency

movements, even if there is no cross-border exposure registered in the external debt data. And when (non-

USD) currencies come under sudden pressure, for instance during tighter USD funding conditions, these

non-financial firms leveraged abroad withdraw cash from domestic banks to service foreign liabilities,

thereby transmitting pressures of a weak currency into the banking system, and further amplifying the

initial weakness in the currency.

This suggests that when corporate balance sheets straddle borders, and available external debt data does not

capture all the exposure corporates have, reserve cover should be higher than what traditional metrics suggest.

A ‘crisis’ with unique characteristics. The primary external event against which India needs to be

buffered is the Fed’s exit from loose monetary policy. This may be a gradual and prolonged affair with

the pain to emerging markets lasting for longer. Furthermore, while markets are focused singularly on the

Fed, exit plans (or even the mere hint of it in communications) by the ECB and BOJ over the next few

years could keep financial conditions tight.

As such, estimates of adequate or optimal foreign exchange reserves should not simply be based on

‘event studies’ which account for one particular event at a time, but on vulnerabilities arising from a

series on successive stress situations.

The importance of not being excessively buffered

But this does not mean India should single-mindedly focus on reserve accumulation. There are costs to

rapid reserve accumulation, which need to be weighed. For instance, buying foreign exchange reserves

can have meaningful fiscal cost, either directly (through sterilization bonds) or indirectly (through

reduced dividend transfers from the central bank to government). Back-of-envelope calculations suggest

Chart 2. FX reserves have a variety of uses Chart 3. Sustained reserve accumulation over long periods can lead to lower investments, as seen in Asian countries

Source: IMF Assessing Reserve Adequacy, 2013. Original source - IMF survey of membership on reserves

* Average for Indonesia, Japan, Korea, Malaysia, Philippines, Singapore and Thailand. Correlation of investment and reserve ratio is -0.7

Source: Reinhart and Tashiro (2013), World Bank, HSBC

01020304050607080

Precautionaryliquidity needs

Exchange rate levelor volatility

management

Other

Reasons for building reserves

% of respondends

202224262830323436

10

20

30

40

50

80 85 90 95 00 05 10

Reserves (minus gold)* / GDP, LHSInvestment / GDP*, RHS

Inverse relationship between rapid reserve accumulation and investment

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How much is too much? Macro 26 June 2015

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that for every USD1bn of FX reserves that the RBI buys, the fiscal cost could be about USD54m1. Rapid

accumulation can therefore become fiscally painful.

Sustained accumulation over a prolonged period can also be costly. As discussed in an NBER Working

Paper (Crowding out redefined: The role of reserve accumulation, Reinhart and Tashiro, 2013), if

persistent reserve accumulation by a central bank is sterilized to some degree by selling government

bonds or the central banks own bonds, it can be tantamount to ‘crowding out’ of the private sector. The

authors of the paper go on to discuss that rapid accumulation by Asian countries following the Asian

crisis led to a decade of sustained decline in investments (see chart 3)2 .

While India has not yet entered a period of such sustained reserve accumulation that it would interfere

with investment, it is useful to be cognizant of the trade-offs it could face someday.

The elusive concept of optimality

Given the pros and cons of acquiring foreign exchange reserves, we try to pin a number to the optimal

reserve stock India should accumulate, as it arms itself for possible disruptions caused by the Fed (and

other central banks) exiting. There are many approaches and no one clear winning rule. We therefore look

at this complex question from a variety of angles. Some international rules of thumb suggest India is well

armed. But given India’s peculiar characteristics, we also look at its own experience during recent crises.

Traditional reserve adequacy metrics. There are simple rules of thumb which are transparent and

intuitive, but also rather arbitrary. In light of them, India seems suitably buffered:

Import cover – This measures the number of months of imports that can be sustained if all inflows

cease. Traditionally, three months coverage is deemed to be appropriate, but there is little empirical

evidence backing it. At over 10 months of goods import cover, India seems well armoured (see chart 4).

______________________________________ 1 This is based on the assumption that India 10year bond yield is 7.6% and US 10 year yield is 2.2% 2 The one exception to this was China, which was able to increase investment during the period of rapid reserve accumulation, by compressing consumption

Chart 4. India is well buffered vis-à-vis traditional import cover norms

Chart 5. India is also well buffered vis-a-vis traditional short-term external debt cover benchmarks, although the ratio has fallen over time

Source: CEIC, HSBC Source: CEIC, HSBC

-2

3

8

13

18

00 02 04 06 08 10 12 14

Import cover ( in months)

goods import covergoods and services import coverIMF benchmark

0

2

4

6

8

06 07 08 09 10 11 12 13 14

Short-term external debt cover (ratio)

FX reserves / short term external debtIMF benchmark

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Short term external debt – This measure of 100% short-term debt cover, commonly known as the

‘Greenspan-Guidotti’ rule, is particularly useful for market-access countries and determines whether a

country can stay out of the market for about a year. Again, the one-year cut off is arbitrary. India seems

well buffered according to this cut-off, although the cover has been falling since 2009 (see chart 5).

Combination measures – A combination metric of short-term external debt plus current account

deficit cover reflects the full 12-month financing need. Here, while India’s cover has fallen over time,

it remains well above 100% (see chart 6).

Broad money – A cover of 20% has been used in the past to capture the risk of capital flight. This

measure has the advantage of capturing outflows of domestic resident deposits. On this metric, India is

(just about) well buffered, though the cover has been falling over time (see chart 7). Marrying India’s experience in recent crises with traditional metrics. While the rules are simple, they

may not be sufficient. In fact, nearly 60% countries hold higher reserves than these rules require,

implying that there is more that needs to be considered; perhaps much higher thresholds for the reserve

adequacy metrics.

Given India’s peculiarities and the fact that traditional rules don’t seem to be sufficient, we conduct a

scenario analysis of India’s experience during recent turmoil and marry it with newly defined thresholds

for reserve adequacy metrics. This approach has the benefit of capturing India’s peculiarities while still

adhering to internationally accepted metrics.

Our exercise entails the following steps -

We look at how the simple adequacy metrics (such as months of import cover and reserves to

short term external debt cover) have fared in India over time and chalk out two thresholds points,

namely the 10th percentile the 20th percentile range, as indicators of minimum standards, below

which the country could be vulnerable3. The threshold approach has the advantage of capturing

India’s unique experience with international metrics over time.

______________________________________ 3 We sort India’s adequacy cover across measures from the smallest to largest, and mark out the lowest 10th and 20th percentile readings. The 10th percentile threshold leaves out 10 percent of the weakest cover India has had, while the 20th percentile leaves out 20 percent of the weakest cover. This methodology follows the approach of Kaminsky, Lizondo and Reinhart (1998).

Chart 6. This powerful combination metric of reserve cover suggests India is in safe territory, although the cover ratio has fallen over time

Chart 7. On broad money cover, India is (just about) well buffered

Source: CEIC, HSBC Source: CEIC, HSBC

0.0

2.0

4.0

6.0

06 07 08 09 10 11 12 13 14

Short-term external debt + CAD cover (ratio)

FX reserves / Short term external debt + CAD100% cover benchmark

10

15

20

25

30

35

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Broad money cover (ratio)

FX reserves / broad money (M3)

IMF benchmark

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Table 1. In terms of the thresholds we have defined, India seems well buffered for now …

Goods import cover

Goods & services

import cover

Short term external debt

cover

Total external debt cover

Short term external debt + CAD cover

Broad money cover

months of reserve cover

months of reserve cover

reserves / debt, ratio

reserves / debt, ratio

reserves / (STD+CAD),

ratio

reserves / M3, ratio

1 10th percentile threshold 6.9 5.8 3.0 0.4 1.7 14.6 2 20th percentile threshold 7.4 6.1 3.5 0.6 2.2 17.7 3 Latest 10.2 8.5 3.8 0.7 2.9 21.2 4 Above threshold? Yes Yes Yes Yes Yes Yes

Note: ‘Partly’ means reserve cover falls between 10th and 20th percentile range. Source: HSBC estimates

We gauge how current adequacy ratios match up to these thresholds. As per each of the

adequacy measure, India seems sufficiently buffered (see table 1).

Next, we look closely at three episodes of recent turmoil when India lost at least USD20bn of

reserves – global financial crisis (September 2008 to March 2009), the debt crisis (September

2011 to June 2012) and taper tantrum (March to December 2013).

We calculate how much ammunition (in terms of adequacy ratios) India lost during each of the

three episodes. We take an agnostic approach and average across the three episodes to get a sense

of average loss that India could face going forward (see rows 1-4 in table 2).

Finally we shock current adequacy ratios with average losses calculated above to see whether India

would remain sufficiently buffered if it were to face a similar turmoil (see rows 5-7 in table 2).

Looking through the different adequacy metrics we find that India would perhaps remain adequately buffered

on the basis of import cover, while not so on the basis of short-term external debt cover (see row 7 in table 2).

India’s Achilles’ heel. And indeed, India’s main vulnerability has gradually transitioned from trade

imbalance to indebtedness. The reserve cover of external debt has fallen over time (see chart 5) and it

may not stand the test of another crisis with as much ease. To make matters even more challenging, the

external debt numbers may not even cover the entire foreign exposure of corporates. Recall the section

above on consolidated corporate balance sheets that straddle borders.

Table 2. … but if stress rises to the levels faced during recent turmoil episodes, India may become vulnerable, at least on the external debt metrics

Goods import cover

Goods & services import

cover

Short term external debt

cover

Total external debt cover

Short term external debt +

CAD cover

Broad money cover

months of reserve cover

months of reserve cover

reserves / debt, ratio

reserves / debt, ratio

reserves / (STD+CAD), ratio

reserves / M3, ratio

loss during (in months or in percentage pts) …

1 Global Financial crisis -2.5 -2.1 -1.1 -0.3 -1.6 -7.1 2 Debt crisis -1.0 -1.0 -1.6 -0.2 -0.9 -1.9 3 Taper tantrum 0.1 0.0 -0.2 -0.1 0.3 -1.5 4 Average loss -1.1 -1.0 -1.0 -0.2 -0.7 -3.5 5 Latest reserve cover 10.2 8.5 3.8 0.7 2.9 21.2

6 (4 + 5) Latest reserve cover under possible stress

9.1 7.5 2.9 0.5 2.2 17.7

Threshold range (10th – 20th percentile)

6.9-7.4 5.8-6.1 3.0-3.5 0.4-0.6 1.7-2.2 14.6-17.7

7 Above threshold following stress? Yes Yes No Partly Partly Partly

Note: ‘Partly’ means reserve cover falls between 10th and 20th percentile range. Source: HSBC estimates

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On the basis of precisely this external debt vulnerability, it may be appropriate to focus on building more

reserves over the next few months.

How much more in reserves?

Having established that it may be prudent for India to build reserves further, we take a stab at how much

more would be needed. Our approach is rather simple. We identify and quantify four vulnerabilities that

could put pressure on reserves and rupee confidence during stress situations.

First, at all points we hope to maintain a minimum 5 months of (goods and services) import cover. At no

point over the last decade has India gone below 5 months. Second, RBI estimates that about 65% of long

term corporate debt is unhedged. That amounts to USD111 bn. Third, short term external debt payable over

the next year amounts to USD86bn. And finally, we assume that about half the USD46bn portfolio flows

that India has welcomed over the last year flows out. All of these add up to USD420bn, suggesting India

could stretch further and build an additional USD60bn of reserves from here (see chart 8). This fits nicely

into our FX strategist’s expectation of a gradually depreciating rupee (see INR: Modifying our enthusiasm,

12 May 2015, Paul Mackel).

Broadly speaking, buying USD60bn of additional reserves would cost USD3.2bn (0.15% of GDP).

Anything more than this could really start hurting the fiscal balance.

What else could cushion India?

We estimate that from here on the current account deficit is not likely to narrow further, although we

don’t expect it to balloon either (see: Ships stranded at home - Domestic bottlenecks are slowing India’s

exports, 26 May 2015). We are also aware that as we approach a likely Fed exit, capital inflows could

begin to slow. As such, while the balance of payments is expected to remain in healthy surplus, it may not

be as conducive to reserve accumulation as the year that went by. The RBI’s FX accumulation may

continue, but perhaps at a slower clip.

Chart 8. USD60bn more in FX reserves, taking India to an overall reserve stock of USD420bn could help cushion against India’s biggest external sector vulnerabilities

Source: HSBC estimate

200 111 86 14 9

0 100 200 300 400

1

5-month import cover

long-term unhedgedcommercial debt

short-term external debt

debt portfolio outflow

equity portfolio outflow

An estimate of 'sufficient' foreign exchange reserves

Where we could aim to be: USD 420 bn

Where we are: USD 360 bn

USD bn

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How much is too much? Macro 26 June 2015

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FX reserves are not the only line of defence available. Technically speaking, ‘adequacy’ should include

all resources available. Here, swap lines deserve a special mention. In the summer of 2013, India

increased its swap lines with Japan from USD15bn to USD50bn. As a second line of defence to FX

reserves, swap arrangements with bilateral and regional partners, and similar mechanisms with G20

countries and multilateral organizations should be actively explored.

Ultimately keeping the macro house in order, i.e. lowering the twin deficits and inflation sustainably and

increasing potential growth, is more important than reserve accumulation, as it can single-handedly make

the economy resilient to shocks.

References:

Kaminsky, Lizondo and Reinhart (1998): Leading indicators of currency crises, IMF Staff Papers, March

Ministry of Finance (2015): India’s external debt as at end-December 2014, March

Moghadam, Ostry and Sheehy (2011): Assessing reserve adequacy, IMF, February

Reinhart and Tashiro (2013): Crowding out redefined: The role of reserve accumulation, NBER Working

Paper 19652, November

Shin and Zhao (2013): Firms as surrogate intermediaries: Evidence from emerging economies, Asian

Development Bank, December

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Disclosure appendix Analyst Certification The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Pranjul Bhandari and Prithviraj Srinivas

Important Disclosures This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means.

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