India's Foreign Reserves and Global Risk

India has accumulated a sizable stock of foreign exchange reserves over the past three decades, common with many other emerging economies. Its current reserves surpass several thresholds for adequacy used by the International Monetary Fund and others. An assessment of whether the stock of reserves is appropriate depends on an evaluation of the benefits and costs of reserves. An important precautionary benefit is the role that reserves provide in terms of self-insurance against sudden financial outflows by non-resident investors or resident savers. Following the at-Risk literature to study the size of reserves and capital flows, we estimate probability densities of future gross capital flows for India, as a function of global financial conditions, policy frameworks, reserves, and domestic structural characteristics. We find that foreign exchange reserves play a significant role in shifting the empirical distribution of gross flows wherein the probability of large (negative) outflows is substantially reduced. Higher reserves reduce both extreme inflows and outflows of foreign capital. Following the approach in Devereux and Wu (2022), we find that an increase in the reserves to GDP reduces the risk premium on reserves, so that the sovereign interest rate spread over-estimates the marginal cost of reserves in India. This suggests that additional reserves reduce currency risk. Our results suggest that reserve accumulation continues to provide a precautionary reserve benefit for India. The precautionary benefits of reserves could well increase as India becomes further integrated to international financial markets.