Opinion: Higher forex reserves and weaker currency, India is going China way

Foreign cash flows into India are over Rs.1,000 crores a day. In the last 2 months, more than $16B foreign funds have hit Indian markets. (Link: http://economictimes.indiatimes.com/markets/stocks/news/over-rs-1000-crore-a-day-foreign-inflows-cross-11-billion-mark-in-2-months/articleshow/46491347.cms)

Such an inflow would have caused Indian currency to gain but it hardly saw any improvement because most of those foreign funds ended up as reserves at RBI. Indian central bank’s intentions are clear; it does not want a stronger Rupee. But how does it finance those dollar buys? Simple, it has printing machines at command. Look at below charts. You will see that both forex reserves and M3 money supply have hit  all-time high.

India's Forex Reserves and M3 Money Supply (Source: http://www.tradingeconomics.com/)

That’s what China did too. Its central bank bought all those dollars coming in as trade surplus to increase its reserves, at the same time it expanded its balance sheet. It printed domestic currency to pay for those dollars. Now its forex reserves are at $3 trillion – plus. So it could keep its currency valuation low and use the newly printed money for its infrastructure investments. Unlike China, India does not have trade surplus (we have deficit) but there is an investment interest which is bringing in dollars into India. All those dollars are now sucked by RBI and it is turning them into Indian Rupees. This would mean stable currency for India as RBI has built a war chest and making it further strong.

Will it cause inflation?

It is not the balance sheet expansion or the new money hitting markets causes inflation but how this new money is being used creates inflation. Let us say money supply is increased in the same proportion our economy is expanding, or it is used to fund good investments, it would not lose value through inflation. But let us assume, new money is used for wasteful expenditure and for projects with negative return (our Govt. has many of them including Air India, subsidy payments, welfare schemes), or to fund trade deficit, then it acts as an indirect tax in the form of inflation.

India's Fiscal Deficit and Balance of Trade (Source: http://www.tradingeconomics.com/)

Inflation in India (Source: http://www.tradingeconomics.com/)

Inflation is always proportional to money wasted and the deficits funded. It sounds like an awful hypothesis. But take a look at charts. In 2009 and 2010, it was fiscal deficit, which led to run-away inflation. And the trade deficits in 2011 & 2012 helped it remain high. But in 2014, thanks to prudent spending and lower commodity prices, both fiscal deficit and trade deficit were low, so was the inflation.

For 2015-16, Govt. in its recent budget aimed to limit it fiscal deficit numbers, and RBI is able to maintain Rupee in a range, so inflation also is expected to remain in a lower range. Expansion of balance sheet by RBI would do no harm unless it ends up as wasteful expenditure. With fiscal prudence in place, money is more likely flow to deserved projects. And the increasing liquidity will put pressure on interest rates. Though RBI sets policy rates, only way it can influence call market rates to match with policy rates is by managing liquidity. Whenever it reduces rates, it has to pump-in more cash into system and the forex inflows are a good reason for it to print more money.

What-if things go wrong?

Let us say some of these foreign funds will want to leave India when US raises its interest rates that would put pressure on Rupee. RBI will be able to curb that volatility by selling its forex reserves. And for the resulting contraction in liquidity in Rupee terms, it can reduce SLR or CRR, which would increase money supply in the banking system balancing out the liquidity situation again.

What-if things get better from here?

We will see continuation in the trend of RBI increasing its forex reserves and proportionately printing new money in Rupees. That increases liquidity and pushes down interest rates. Lower finance costs will help businesses do better and trigger consumption resulting in quick expansion of the economy. We will see GDP numbers which will be lot better than many are anticipating now.

So time to say good days are here for India? I believe so.

How do I profit from it? From 1-2 years perspectives, by playing the spread in INR-USD. For those looking for long term gains, owning the house you live in (if you do not own it yet) or buying commercial land (at affordable prices) would help. Not from the perspective of holding and selling it but in terms of valuation and the future returns from it.