The importance of managing forex reserves: The Indian experience news

No levels of foreign exchange reserves are enough to protect an economy from speculative capital attack. The RBI needs to spend as much time in finding suitable uses for the huge reserves it has accumulated as it does in accumulating them. By Adarsh Ananthakrishna, associate, Capco.

In recent years there has been a lot of attention focused on the management of foreign exchange reserves. There are various reasons for this, such as the emergence of the Euro as an alternate currency to dollar, changes in the exchange rate regimes, the changing perception on adequacy of reserves and their role in managing crisis, and the operational use of reserve targets while calculating financing gaps by the IMF. In addition, there are various other reasons like increase in transparency and accountability at various levels. Moreover, the IMF guidelines have increased focus on foreign exchange reserves management.

Foreign exchange reserves are required to meet a defined set of objectives of a country. The central bank of a country acts as the reserve management entity. As the chief monetary authority of the country, it is the central bank's responsibility to ensure that there is general macroeconomic financial stability. Since the central bank also happens to be the custodian of the foreign exchange reserves, it needs to maintain adequate liquidity, safety, and yield on

One of IMF's surveys reveals distinct characteristics in the foreign exchange reserves management of various countries. It suggests that many countries maintain reserves to support monetary policy. The primary objective of these countries is to use the large reserves to cope with short-term fluctuations in exchange markets. Many countries use foreign exchange reserves for stability and integrity of the monetary and financial system as well.

The Indian context

In the Indian context, the RBI Act and the Foreign Exchange Management Act, 1999, set the legal provisions for governing the foreign exchange reserves. RBI acts as the chief monetary authority and the custodian of foreign exchange assets. RBI accumulates foreign currency reserves by purchasing from authorised dealers in the open market operations. Another source of foreign exchange for RBI is deployment of foreign exchange reserves in appropriate instruments of select currencies. The type of instruments in which RBI can invest is stipulated in the RBI Act. The aid received by the government also becomes part of the reserves.

The surge in the forex reserves
The Asian crisis taught us just how countries could suffer due to bad management of foreign exchange reserves. Many countries have responded and in order to reduce their vulnerability to the external shocks have accumulated heavy foreign exchange reserves. Countries want to keep their exports competitive; hence, they prefer to depreciate their currencies against the major currencies. In recent days, there has been a continuous appreciation of rupee vis-à-vis the dollar. To avoid the appreciation of the rupee, RBI has been continuously interfering in the money markets, by buying dollars, which are added to the reserves.

Unlike, in the past, the NRI (non-resident Indian) community is more dispersed now and not just confined to the Gulf region. Due to the software boom, Indians are heading towards new destinations. NRIs are doing well there and sending back their savings to India. In addition, foreign institutional investors are making huge investments in Indian stocks. The emergence of India as an offshore outsourcing hub has also created new opportunities. There are huge dollar earnings for India. Further, India is also proving to be a worthy manufacturing hub for many companies. All these factors played a positive role in building up of huge foreign exchange reserves.

Costs and benefits
The costs and benefits of holding huge reserves are assessed constantly. Holding sufficient reserves protects a country from external shocks. Of course, this kind of insurance is not free. The cost of holding such high reserves is the opportunity cost of not using these resources to help increase domestic productivity. Thus, the marginal productivity of domestic capital is the opportunity cost of holding reserves. Reserves management intends to minimise the opportunity costs against the benefits that are generated from holding the reserves. Putting a stop to accumulation of reserves can result in sharp appreciation of the rupee.

The foreign exchange reserves can be used to acquire new technologies. This would scale up the productivity of the industry. The government can even consider raising the ceiling on the amount that can be used by Indian companies to take over or acquire companies across the world. This would help in the creation and expansion of Indian multinational companies.

The appropriate level
It is difficult to quantify the appropriate level of foreign exchange reserves for a country. Economists have suggested some models or methods by which the reserve adequacy can be assessed. The usual parameters are adequacy of foreign exchange reserves to take care of the future imports and whether reserves are enough to meet sudden withdrawals.

Many economists and analysts feel that the foreign exchange reserves of India are in surplus. Though RBI keeps justifying the accumulation of reserves by saying that this can be used as a shield to protect the economy from capital flight and currency crises, some economists do not buy this theory. Experience has taught us that countries, which are sitting comfortably on large amounts of foreign exchange reserves, faced more severe economic crises. Thus one can say that no levels of foreign exchange reserves are enough to protect an economy from speculative capital attack.

The high reserves can be used to smooth the destabilising movements. This can also be used as a shield to counter the currency fluctuations. Though, it is difficult for RBI to control the foreign exchange reserves accumulations, it can use these reserves for some productive purposes. It can help corporates to aggressively restructure their expensive foreign debt or allow the government to use them for repaying the high cost of debts that are outstanding. Consequently, the RBI needs to spend as much time in finding suitable uses for the huge reserves it has accumulated as it does in accumulating them.