Nexus between external commercial borrowings and foreign exchange reserves in India: mercantilism or moral hazard?

Abstract

We examine the nexus between the staggering rise in the central bank’s forex reserves and corporate borrowings denominated in foreign currency. We use dynamic panel data models by drawing novel data of Indian firms to probe the moral hazard hypothesis. Our investigation shows no evidence that forex reserves act as an implicit guarantee for the corporate sectors to borrow in foreign currency in the long run. The ARDL reinforces our firm-level estimates. Albeit, the VAR analysis does not rule out causality between forex reserves and ECB in the short run. We show that forex reserves mainly help manage capital flows into the economy and maintain domestic monetary stability. The accumulation of forex reserves implies mercantilist motives of the central bank to reduce imbalances in the economy by keeping the exchange rate depreciated and domestic exports competitive.