- Ms. Deepti Pi­plani

Economic Challenger - - NEWS - * Ms. Deepti Pi­plani * As­so­ciate Pro­fes­sor, Amity Univer­sity, Dubai, Mo­bile: +971554193358 email: deep­tip­i­plani@gmail.com


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”.


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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