1. INDIA’S BLOATING FOREX RESERVES: AN ANALYTICAL STUDY
- Ms. Deepti Piplani
Liberalization has transformed India's external sector and a direct beneficiary of this has been the foreign exchange market in India. From a foreign exchange-starved country with barely one week of import cover in July 1991, India is today more comfortably placed with international reserves of US $289.7 billion as on June 7, 2013. On the other hand, the country is currently grappling with major economic problems such as persistent inflation, faltering exports, falling GDP growth, and ballooning fiscal and high current account deficits. Hence, RBI emphasis has shifted from growth to reining Current Account Deficit as inflated CAD will lead to an unpleasant impact on rupee. Rupee, which is currently hovering at around 58 per USD, has a possibility of depreciating to 60 in the long term, as opined by many economists. RBI's intervention can only provide a short term solution to address the rupee depreciation, but the need of the hour is to mend the fundamentals of the economy. This paper addresses the basic questions: What are forex reserves? What is the objective of holding forex reserves? How was the movement of forex over the decade? What is the appropriate level of reserves? Are forex reserves a double edged sword?
Keywords: Forex reserves; Foreign Exchange Market; Special Drawing Rights; Foreign Currency Assets; Reserve Tranche Position; Gold; Keynesian Theory; RBI Act.
JEL Classifications: B22, F31, F41
Foreign- exchange reserves, are commonly known as forex reserves or FX reserves. They consist of Foreign Currency Assets (FCAs), Gold, Special Drawing Rights, and the Reserve Tranche Position (RTP) in the IMF, held by central banks & monetary authorities in order to back their liabilities. Although, FCAs are kept in multiple currencies, such as, US dollar, Euro, Pound sterling, Japanese yen, etc., but because of dominance of US dollars, they are valued in US dollars only. The Reserve Bank of India (RBI) occupies the role of custodian and manager of forex reserves, and works within the overall policy framework agreed upon with Government of India, priority being liquidity rather than returns.
Indian economy got up from its slumber & realized the importance of holding ample forex reserves only after experiencing a classic balance of payment crisis in the year 1991. This was the time when in July 1991, India's forex reserves had bottomed out and went below $1bn, & it could hardly finance a week of imports. National sentiments were outraged as India had to secure emergency loan of $ 500 million from
International Monetary Fund (IMF), Union Bank of Switzerland & Bank of England by pledging tons of its gold reserves as collateral. It also had to seek loans from other friendly countries like Japan and the US. This financial support provided a relief to India which was facing a serious economic trouble. This had happened as we were a closed economy and hence faced the problem of lack of capital. The very fact that the country was on the verge of bankruptcy was a major humiliation to the country's pride. Thereafter, efforts & policies were made to accumulate Foreign Exchange Reserves which have bloated to a good figure of US$ 290bn.
Although Indian foreign exchange market originated in the year 1978 with the banks undertaking intraday positions in the foreign exchange market, but the turnover was very minimal. The 1991 crisis brought with it unprecedented structural reforms such as: devaluation of the Indian rupee, cutting subsidies, partial liberalization of the India's domestic financial sector, and steady opening up of the external sector. To this end, we started witnessing a huge amount of capital inflows & outflows, more number of participants, reduction in transaction costs and an efficient method of transfer of risks. India also adopted a managed floating exchange rate regime in March 1993 & announced Current Account convertibility of the Rupee in August 1994. Thereafter, since last decade, the fast pace of economic growth & progressive policy liberalization has made India an attractive destination for world's investments. We saw a surge in the international capital in the form of FDI & FII. Indian companies were able to raise cheap finance from other parts of the world in the form of External Commercial Borrowings (ECB) as well as through other instruments such as ADRs & GDRs. Our increased integration with the world economy offers opportunities and challenges. It does not permit the luxury of inaction, much less wrong actions. It also brings to the door the spillover of volatility from one capital market to the other, hence constant monitoring and timely actions are required in order to prevent emergence of speculative activities.
As per Keynesian Theory, the objective of holding of money & forex reserve is as follows:
1. Transaction motives: International trade leads to capital/ currency flows which are mostly handled by private banks.
2. Speculative motives: Individuals or corporates transact in forex market for short term gains.
3. Precautionary motives: Central banks of the countries which are considered as a banker of the last resort hold foreign currency usually for precautionary motive. They act as war chest which can be used for the following reasons:
As collateral/security for international borrowings which will provide confidence esp. to the credit rating agencies that external obligations like borrowings from IMF, World Bank & other financial institutions etc can always be met, thus reducing the overall borrowing costs at which loans are available to all the market participants,
Uphold confidence in country's monetary & exchange rate policies, i.e. ensuring that the rupee vis-a-vis other major currencies do not fluctuate widely. Hence keeping the exports competitive which may foster economic growth,
Limits the economy's vulnerability to external shocks & hence shields from national disasters
Incidentally boost international confidence on domestic economy & its stature
Hence, the objective of reserve management can be found in the RBI Act, which reads as 'to use the currency system to the country's advantage and with a view to securing monetary stability'. The whole approach to Reserve Management got changed post 1991
Balance of Payment crisis. Until then, we had a traditional mindset of maintaining forex as an import cover defined in terms of number of weeks of imports. This underwent a paradigm shift with the adoption of the recommendations of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). The Committee recommended that while determining the target level of reserve, due attention should be paid to the payment obligations in addition to the level of imports. It should accommodate at least three months of imports.
2. Movement in Forex Reserves over the last decade:
It had steadily increased post 1991 crisis from US$ 5.8 billion as at end-March 1991 to US$ 199.2 billion by end-March 2007 and further rose to US$ 309.7 billion by end-March 2008. Later, the reserves declined to US $ 286.3 billion by end September 2008 because of subprime crisis. During the half year under review, it came down to US$ 294.4 billion at the end of March 2012 after reaching a record level of US$ 310.2 billion at the end of October, 2011. The main reasons for decline in foreign exchange reserves were intervention in the domestic foreign exchange market due to purchases and sales of foreign exchange done by the RBI and effect of assets revaluation. As on January 2013, our forex reserves were at $295.74 billion with FCA (the biggest component of the forex reserves) at $261.70 billion, Gold reserves at $27.21 billion, SDRs at $4.43 billion and reserves with the International Monetary Fund (IMF) at $2.38 billion. Although India is holding $289.7 billion of reserves as on June 7, 2013, it has a very low level of reserves in comparison to other BRIC members such as Brazil, Russia and China.
Table 1: Composition of India's Forex Reserves (in %) from 1990-91 to 2011-12
This is not enough to fund seven months' imports,
while Brazil and Russia enjoy an import cover of 17 months and China of 21 months.
The table shows the composition of India's foreign exchange reserves in the percentage form of each constituent. We can see that from 2002 onwards India is keeping a small percentage of its reserves in the form of RTP.
The figure clearly shows that percentage of gold in the foreign exchange reserves has declined over the years & it has been replaced by FCA.
India's continuous efforts & policies have resulted in huge build up of Foreign Exchange Reserves of US$ 290bn, providing the economy with an import cover comfortably of about 7 months as on March '12.
India is in a healthy state of affairs as is depicted from its short term debt to FCA ratio which was 146 in the year 1990-91 and has improved to 27. This indicates that India has a strong cushion to pay its short term debts on time. In addition, India's kitty of Forex Reserves is 14 times the size of total debt.
1. Are Forex Reserves a Double Edged Sword?
After the historic economic liberalization in India, which started on 24th July 1991, India witnessed a drastic transformation from a regulated environment to the more liberalized market driven economy. Interestingly over the last two decades, India also accumulated ample forex reserves of US $290 bn which is enough to fund comfortably almost 7 months of imports. The growth in stock piling of international reserves has been so sharp, despite the fact that India has entered into managed float exchange rate system since March 1993. There is a theoretical belief that under managed float exchange rate regime, central banks are not obliged to defend their exchange rate parity through frequent interventions, hence less need for forex reserves.
Nations hold international reserves for several reasons mentioned above. But, generally it is assumed that too much of anything is also bad as too little is also not good. The pace of growth in international reserves will impact the monetary base and consequently lead to an increase in the money supply. This will kick up inflation as “too much money chasing too few goods”, kills exports and boosts imports. To neutralize this inflow, RBI needs to issue bonds to suck the excess money out of the system. However, this sterilization may prevent inflation from gripping the economy, but it is a fairly expensive process since RBI gets a smaller return on the foreign money vis-a-vis what they end up paying on the bonds.
India is dependent at stubborn 80% imports on its oil requirements. The huge reserves give a cushion that India would be able to effectively handle any oil shock. Rainy day funds can be used by RBI to sustain massive fund outflows period.
On the other hand, low foreign exchange reserves are also not good because India needs more reserves to pay for imports and to pay for its short-term debt.
As the Rupee hit an all-time low of Rs 59.25 per USD on19 th June' 13, some economists suggested that there is a need to issue bonds that will target Indians who live abroad. Such bonds have been issued just thrice in the past, namely; “India Development Bonds”, “Resurgent India Bonds” and “India Millennium Deposits” and had been a huge success. Such bonds are 5 year bonds, issued in foreign currencies like dollar, pound and repaid in the foreign currency thus removing the exchange rate risk for investors. The proceeds from such bonds are primarily meant to boost foreign exchange reserves and ultimately help India's BoP. But at current times of India's weakening economic growth, it might not be the right time to issue new lot as it can scale up the costs of issuing these bonds.
Rating Agency Fitch has upped the outlook for the Indian economy to 'Stable' from the earlier 'negative'. Indian Finance Minister Mr. P Chidambaram has asked people to avoid buying gold as it is deteriorating the current account deficit of the country. Global Rating agency Moody's opined, “the Government's decision to issue Rs 15,000 crore inflation indexed bonds to curb demand for gold , is unlikely to have any positive impact on the country's rating as the size of the issue is too small to have a material impact on the credit profile of India. These bonds offer an inflationhedged financial asset that promotes savings as well as diversification away from gold. This would result in reduction in gold import growth, in turn, would alleviate balance of payments and exchange rate pressures”.
2. CONCLUSION & SUGGESTIONS
Forex reserves play a vital role in developing country like India with twin deficits. But thoughts need to take round with respect to remunerative usage of excess reserves which have been piled up over the years. The various suggestions are as follows: 1. The government should use its excess reserves in paying its high cost foreign debt as a large amount of money is getting spent in servicing these loans. 2. Efforts should be made to promote exports and bring our current account back to surplus position. In that scenario, central banks need not intervene in the forex market using their reserves to make the exports competitive. 3. As India is now in a more comfortable position going by various measures of reserves adequacy, hence it should think of channeling them more lucratively such as: (a) Recapitalizing public sector banks (b) Funding infrastructure projects such as
ports, power etc. (c) Setting up corporation with a prime objective of investing forex reserves more lucratively. Liquidity & safety continue to be the primary objectives. 4. Our foreign reserves majorly consist of volatile hot money in the form of Portfolio investments. They can exit the country any time after making quick bucks from Indian equities. Hence, government should ensure a proper mix of capital inflows, where it should majorly be non-debt inflows. This can happen by liberalizing investments in some of the sectors like Retail, Airline, Insurance etc. It should accompany by smoothing the process of getting clearances, helping the foreign entities in land acquisition without hassles and in lesser time, project financing for such development activities should be encouraged by Indian banks and there should be transparency in the functioning of the approval bodies. 5. Deficit financing is managed by using our forex reserves. In order to reduce fiscal deficit, efficient controls need to be put in granting subsidies. Hence, the need for maintaining international reserves will go down. 6. Components of foreign currency assets should be more diversified so that the depreciation of one particular currency available in our foreign currency basket has not much impact on the total value of forex reserves. 7. The international reserves have many pleasures but government should keep a check that it should not lead to inflationary pressure in the economy and hence become a source of pain.
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