23-07-2025
Hard money: RBI must enlarge its buffer of foreign exchange reserves
Kaushik Das Today's level doesn't look adequate in the context of risks arising from capital flows more than trade gaps. Look at India's international investment position, not just import cover and current account deficit. The Indian rupee has lately been under stress not because of a wide current account deficit, but because of capital outflows.
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On 27 June, the Reserve Bank of India (RBI) released balance-of-payments data for the January-March quarter and full year 2024-25. One notable point was the sharp drop in foreign direct investment (FDI) inflows in 2024-25. Gross inflows/investments into India stood at $81 billion, or 2.1% of gross domestic product (GDP), last fiscal year.
On 27 June, the Reserve Bank of India (RBI) released balance-of-payments data for the January-March quarter and full year 2024-25. One notable point was the sharp drop in foreign direct investment (FDI) inflows in 2024-25. Gross inflows/investments into India stood at $81 billion, or 2.1% of gross domestic product (GDP), last fiscal year.
This figure was lower than the peak of $85 billion (2.7% of GDP) attained in 2021-22. But gross FDI inflows excluding repatriation of equity and other capital fell significantly to $29.6 billion (0.8% of GDP) from a peak of $56.2 billion in 2021-22 (1.8% of GDP).
Essentially, the repatriation of equity and other capital has increased from $28.6 billion (0.9% of GDP) in 2021-22 to a hefty $51.5 billion (1.3% of GDP) in 2024-25, thereby lowering gross FDI inflows substantially.
But why? We find strong evidence that a sharp increase in US interest rates since 2022 is the main driving factor. India's long-term structural and investment story is positive, but higher US interest rates have led to a surge in repatriation to that country.
This should then support gross FDI flows into the Indian economy, which have long helped finance India's current account deficit. But RBI will be mindful of maintaining a sufficiently wide interest-rate spread with the US Fed Funds rate to disincentivize the repatriation of capital back to the US.
The Fed has cut interest rates by 100 basis points (bps) in 2024, and may cut by another 75-100bps.
Assuming 175-200bps of total cuts in this cycle, we think RBI's 100bps front-loaded rate cut is appropriate and that the repo rate should not be lowered further from its current level of 5.5%—taking into consideration the need to maintain a real interest-rate gap of some 100-150bps on a forward-looking basis, which would be a sufficient differential with the US to attract growth-critical capital.
After all, interest differentials do matter over the medium-term.
With gross FDI having come off sharply, net FDI has collapsed to under $1 billion in 2024-25, a record low, from a peak of $44 billion (1.6% of GDP) in 2020-21, when interest rates were close to zero globally. This is on account of Indian outbound investments maintaining a steady incline.
In 2024-25, outbound FDI stood at $29.2 billion, much higher than $17.6 billion in 2021-22, but as a proportion of GDP, the increase is marginal (0.7% of GDP in 2024-25 versus 0.6% earlier).
Increasing outbound FDI should not be seen negatively. Indeed, we see this as a testament to the Indian corporate sector's footprint expanding across the global economy in line with its global ambitions.
This trend will likely continue in the coming years, but as the repatriation of equity subsides with US interest rates coming down and interest differentials widening with India, gross and net FDI flows should once again look healthy. Also read: India's FDI inflows offset by outflows: Blip or worry?
Even so, interest rate differentials will continue to matter. The country needs a delicate balance between supporting domestic growth and attracting foreign capital, which RBI and its monetary policy committee members should take into consideration.
While net FDI flows will take some time to recover, RBI would do well to shore up its foreign exchange reserves to the extent possible whenever opportunities arise.
Currently, gross forex reserves stand at about $700 billion, but net of short forward positions of about $65 billion, they stand at $635 billion, which is lower than the $645 billion (spot plus forwards) India had at the end of March 2024.
Over the last year, nominal GDP, imports, external debt (at end-March 2025, India's external debt was $736.3 billion, an increase of $67.5 billion over its end-March 2024 level) and other variables have all have gone up, thereby reducing the adequacy strength of forex reserves as calculated in terms of ratios.
Another key indicator of this strength—short-term external debt (with one-year residual maturity)—increased to $303 billion by end-March 2025 from $285 billion a year earlier.
If RBI does not add to its forex reserves at these levels, then its ability to defend the currency in times of sharp depreciation will likely be constrained. Recent events have highlighted how the global geopolitical backdrop can change swiftly, pushing the macroeconomic position of economies into stress at very short notice.
While RBI's $700 billion in forex reserves may seem comfortable as a buffer, the actual buffer net of short forward positions is only $635 billion, as mentioned earlier.
Note that India counts among countries with a negative net International Investment Position, with its liabilities (of $1,469.2 billion) exceeding assets ($1,139.2 billion) by more than $300 billion. Also, India's reserves-to-liabilities ratio has been consistently below 50% in the last 15 years. Also read: Rework India's investment treaty framework to attract FDI flows
The Indian rupee has lately been under stress not because of a wide current account deficit, but because of capital outflows. Therefore, reserves adequacy calculated in relation to India's current account deficit and import cover may not reveal the true extent of vulnerability.
Indeed, calculating reserves adequacy from the point of view of India's International Investment Position may make more sense. This points to the need for a build-up of foreign exchange reserves in the days to come.
The author is chief economist, India, Malaysia and South Asia at Deutsche Bank AG Topics You May Be Interested In
