The United States (US), European Union (EU) and several countries have imposed a raft of punitive measures on Russia for invading Ukraine. One of the more serious forms of sanctions has been the freezing of the Russian central bank’s assets held in foreign-denominated currencies. When a country earns more foreign exchange (forex) than it spends, it moves the surplus into its reserve account for future contingencies. These reserves are not held in physical currency, but in different forms of financial assets such as gold and debt instruments (bonds and bills) of foreign governments. Countries prefer to invest in currencies that are liquid (easily convertible), widely accepted and trustworthy. The US dollar fits all these criteria.
Russia built up its forex reserves since 2014 to the tune of $630 billion and around $300 billion was held in assets denominated in dollars, euros, and pounds. After two rounds of relatively mild sanctions, the West decided to freeze the Russian forex reserves held abroad so that the country cannot access funds for conducting trade. While it seems proportionate to the offensive carried out by Russia, this is unprecedented and is equivalent to a refusal to honour debt obligations.
This action has had unintended consequences. Other central banks’ trust in the US dollar as the safest investment option has taken a hit. They are scrambling to diversify their portfolios by holding assets of other currencies (euros, pounds, yen, Chinese yuan, Australian dollar) and gold. Unwittingly, the US has given a fillip to China’s ambition of internationalising the renminbi.
The Reserve Bank of India (RBI) has $620 billion as forex reserves (about 15 months of import cover) and it is mostly held in dollars ($200 billion), while gold and other major currencies form the remaining amount. While the probability of India facing sanctions from the West is low, there could be other geopolitical risks.
However, RBI’s options for diversification are limited. It can rebalance its portfolio by holding other currencies, but the geopolitical risks are similar (the sanctions on Russia were jointly enforced by the US, the United Kingdom, and EU). Clearly, India would not want to hold a large amount of renminbi as part of its reserves for geopolitical reasons. Finally, the amount of gold that can be held is limited because it is not easily convertible to foreign currency for trade.
India should look at other options. One such is to invest in and build a strategic commodity basket, of which oil can constitute a major portion. India imports nearly 80% of its oil requirements, and energy security is one of the main reasons for holding large forex reserves.
It would make sense for RBI to hold oil reserves directly as part of its balance sheet. India has about 5.33 million metric tonnes (MMT) of oil (equivalent to 10 days of oil import cover) in underground reserves as part of its strategic petroleum reserves and is planning to add another 6.5 MMT in the next phase.
These underground reserves are expensive to build and maintain and RBI’s forex reserves can come in handy. Apart from oil, RBI can also focus on building a strategic reserve of rare earth elements (such as lithium and palladium) essential in producing batteries and electronic products.
Finally, the time is ripe for India to establish a Sovereign Wealth Fund (SWF), a State-owned investment fund that can be partly funded through the forex reserves, to make strategic long-term investments and asset acquisitions. In both cases, there is undoubtedly an element of price volatility risk, which central bankers dislike. However, as the present Russian scenario has shown, the nature of risk has changed from purely financial to one of geoeconomics. India must divide its forex reserve into two components — a safe component with the traditional sovereign debt plus gold and a strategic component. This will help India to diversify and mitigate geopolitical risk, and also provide a long-term strategic alternative.
Anupam Manur is professor of economics, Takshashila Institution, an independent and non-partisan think tank and school of public policy The views expressed are personal