Record reserves turn costly cash pile for Indian central bank

Reuters

As India’s foreign-exchange
reserves march towards the unprecedented $400 billion mark, its central bank faces a costly conundrum.
To keep the rupee stable and exports competitive, it is having to mop up inflows that’s adding cash to the local banking system. Problem is, banks are flush with money following Prime Minister Narendra Modi’s demonetisation programme last year, leaving them already struggling to pay interest on the deposits in an environment where loans aren’t picking up.
The resulting need to absorb both dollar- and rupee-liquidity is stretching the Reserve Bank of India’s range of tools and complicating policy. Costs to mop up these inflows have eroded the RBI’s earnings, halving its annual dividend to the government.
“The RBI would be paying more on its sterilisation bills than it gets on its reserve assets, so it would cut into its profits,” said Brad W. Setser, senior fellow at New York-based thinktank Council on Foreign Relations. “Selling sterilisation paper in a country with a relatively high nominal interest rate like India is costly.”
Governor Urjit Patel aims to revert to neutral liquidity in the coming months from the current surplus. Lenders parked an average $45 billion of excess cash with the central bank each day this month compared with 259 billion rupees the same time last year. This peaked at 5.5 trillion in March.
The surge in liquidity has pushed the RBI to resume open-market bond sales as well as auctions of longer duration repos besides imposing costs on the government for special instruments such as cash management bills and market stabilisation scheme bonds.
Meanwhile foreign investors have poured $18.5 billion into Indian equities and bonds in the year through June, during which period the RBI has added $23.4 billion to its reserves. Its forward dollar book has also increased to a net long position of $17.1 billion end-June from a net short $7.4 billion a year ago.
“My guess is reserves over 20 percent of GDP would start to raise questions about cost – but that is just a guess,” said Setser. India’s reserves have ranged between 15 and 20 percent of GDP since 2008 global crisis—a level that’s neither too low to create vulnerability or too high indicating excess intervention, he said.
Consistent buildup in the forward book may have cost the RBI some 70 billion rupees, while total liquidity-absorption costs due to the demonetisation deluge from November to June were 100 billion rupees, according to calculations by Kotak Mahindra Bank Ltd. The RBI paid another 50 billion rupees to 70 billion rupees to print banknotes, the bank estimates.
A weakening dollar would also have led to losses due to the foreign-currency cash pile, which has traditionally been dominated by the greenback.