A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 5 - External Sector - Capital Account, External Debt and
Exchange Rate: Approach, Development & Issues

Foreign Exchange Reserves: Approach, Developments and Issues

Approach

The subject of foreign exchange reserves has received renewed interest in recent times in the context of increasing globalisation, acceleration of capital flows and integration of financial markets. The debt-banking-financial crises in several countries have also necessitated the need for an international financial architecture in which the management of foreign exchange reserves has emerged as one of the critical issues.

Contextually, the subject of foreign exchange reserves may be broadly classified into two inter-linked areas, viz., the theory of reserves and the management of reserves. The theory of reserves encompasses issues relating to institutional and legal arrangements for holding reserve assets, conceptual and definitional aspects, objectives for holding reserve assets, exchange rate regimes and conceptualisation of the appropriate level of foreign reserves. In essence, a theoretical framework for reserves provides the rationale for holding foreign exchange reserves. Reserve management is mainly guided by the portfolio management consideration, i.e., how best to deploy foreign reserve assets subject to statutory stipulations? The portfolio considerations take into account inter alia, safety, liquidity and yield on reserves as the principal objectives of reserve management. The institutional and legal arrangements are largely country specific and these differences should be recognised in approaching the critical issues relating to both reserve management practices and policy-making (Reddy, 2002).

The motives for holding reserves may be broadly classified under three categories, viz., transaction, speculative and precautionary. International trade gives rise to currency flows, which are assumed to be handled by banks driven by the transaction motive. Similarly, speculative motive is left to individuals or corporates. Central bank reserves, however, are characterised primarily as a last resort stock of foreign currency for unpredictable flows, which is consistent with precautionary motive for holding foreign assets. Precautionary motive for holding foreign currency, like the demand for money, can be positively related to wealth and the cost of covering unplanned deficit, and negatively related to the return from alternative assets. Furthermore, foreign exchange reserves are instruments to maintain or manage the exchange rate, while enabling orderly absorption of international capital flows. Official reserves are mainly held for precautionary and transaction motives keeping in view the aggregate of national interests, to achieve balance between demand for and supply of foreign currencies, for intervention, and to preserve confidence in the country’s ability to carry out external transactions.

The objectives for maintaining reserves are:

1. maintaining confidence in monetary and exchange rate policies;

2. enhancing capacity to intervene in foreign exchange markets

3. limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis including national disasters or emergencies;

4. providing confidence to the markets, including credit rating agencies, that external obligations can always be met (thus reducing the overall costs at which foreign exchange resources are available to all the market participants); and

5. adding to the comfort of the market participants, by demonstrating the backing of domestic currency by external assets.

India’s approach to reserve management, until the balance of payments crisis of 1991 was essentially based on the traditional approach, i.e., to maintain an appropriate level of import cover defined in terms of number of months of imports equivalent to reserves. For example, the import cover of reserves shrank to three weeks of imports by the end of December 1990, and the emphasis on import cover constituted the primary concern say, till 1993-94. The approach to reserve management, as part of exchange rate management, and indeed the overall external sector policy underwent a paradigm shift with the adoption of the recommendations of the High Level Committee on Balance of Payments, 1993 (Chairman: C. Rangarajan). The Committee had recommended that the foreign exchange reserve targets be fixed in such a way that they are generally in a position to accommodate imports of three months. In the view of the Committee, the factors that are to be taken into consideration in determining the desirable level of reserves are:

1. the need to ensure a reasonable level of confidence in the international financial and trading communities about the capacity of the country to honour its obligations and maintain trade and financial flows;

2. the need to take care of the seasonal factors in any balance of payments transaction with reference to the possible uncertainties in the monsoon conditions of India;

3. the amount of foreign currency reserves required to counter speculative tendencies or anticipatory actions amongst players in the foreign exchange market; and,

4. the capacity to maintain the reserves so that the cost of carrying liquidity is minimal.

With the introduction of market determined exchange rate, a change in the approach to reserve management was warranted and the emphasis on import cover had to be supplemented with the objective of smoothening out the volatility in the exchange rate, which has been reflective of the underlying market condition (RBI, 1996). Against the backdrop of currency crises in East-Asian countries and in the light of country experiences of volatile cross-border capital flows, there emerged a need to take into consideration a host of factors. The shift in the pattern of leads and lags in payments/receipts during exchange market uncertainties brought to the fore the fact that besides the size of reserves, the quality of reserves also assumes importance. Unencumbered reserve assets (defined as reserve assets net of encumbrances such as forward commitments, lines of credit to domestic entities, guarantees and other contingent liabilities) must be available at any point of time to the authorities for fulfilling various objectives assigned to reserves (RBI, 1998). As a part of prudent management of external liabilities, the policy is to keep forward liabilities at a relatively low level as a proportion of gross reserves (RBI, 1999).

The overall approach to management of foreign exchange reserves reflected the changing composition of balance of payments and liquidity risks associated with different types of flows and other requirements. The policy for reserve management is built upon a host of identifiable factors and other contingencies, including, inter alia, the size of the current account deficit and short-term liabilities (including current repayment obligations on long-term loans), the possible variability in FPI and other types of capital flows, the unanticipated pressures on the balance of payments arising out of external shocks and movements in repatriable foreign currency NRI deposits (RBI, 2000).

An important issue which has figured prominently in the current debate on foreign exchange management is the question of appropriate policy for management of foreign exchange reserves. In a regime of free float, it can be argued that there is no need for reserves. In the light of volatility induced by capital flows and self-fulfilling expectations that this can generate, there is now a growing consensus among emerging market economies to maintain ‘adequate’ reserves (Jalan, 2002). Therefore, while focusing on prudent management of foreign exchange reserves in recent years, the ‘liquidity at risk’ associated with different types of flows has come to the fore (RBI, 2001). With the changing profile of capital flows, the traditional approach to assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition, and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. A sufficiently high level of reserves is necessary to ensure that even if there is prolonged uncertainty, reserves can cover the liquidity at risk on all accounts over a fairly long period. Taking these considerations into account, India’s foreign exchange reserves have reached a very comfortable level. The current thinking in this regard has been clearly articulated: "The prevalent national security environment further underscores the need for strong reserves. We must continue to ensure that, leaving aside short-term variations in reserves level, the quantum of reserves in the long-run is in line with the growth of the economy, the size of risk-adjusted capital flows and national security requirements. This will provide us with greater security against unfavourable or unanticipated developments, which can occur quite suddenly" (RBI, 2002c). In the context of the uncertain ramifications of the current developments in Iraq, the relevance of a comfortable reserve level appears particularly important. Unlike 1990-91, implications of such developments in the Gulf region for the external sector appears modest and manageable, mainly due to the comfortable reserve level.

The foregoing discussion points to the evolving considerations and a paradigm shift in India’s approach to reserve management. The shift has occurred from a single indicator to a menu or multiple indicators approach. Furthermore, the policy of reserve management is built upon a host of factors, some of which are not quantifiable, and in any case, weights attached to each of them do change from time to time.

In India, reserves have been steadily built up by encouraging non-debt creating flows and de-emphasising debt creating flows, particularly short-term debt. This strategy, coupled with the maintenance of an acceptable level of current account deficit and market determined exchange rate regime was the cornerstone of the policy of external sector management. In the context of the changing interface with the external sector and the importance of the capital account, reserve adequacy is now evaluated by the Reserve Bank in terms of several indicators and not merely through conventional norms, such as, the import cover. As a matter of policy, as far as possible, foreign exchange reserves are kept at a level which is adequate to withstand both cyclical and unanticipated shocks (RBI, 1999).

In the context of increasing cross-border linkages and the growing importance of the capital account, it became necessary to evaluate reserve adequacy in terms of both conventional indicators and non-conventional norms (Reddy, 1997). The Report of the Committee on Capital Account Convertibility, 1997 (Chairman: S. S. Tarapore) suggested four alternative measures to assess reserve adequacy:

1. import cover of six months;

2. import cover of three months plus 50 per cent of annual debt service payments plus one month’s imports and exports to take into account the possibility of leads and lags;

3. ratio of short-term debt and stock of portfolio investment related non-debt liabilities to reserves at not more than 60 per cent; and

4. the net foreign exchange assets to currency ratio (NFA/currency ratio) at around 70 per cent with a minimum of 40 per cent for this ratio to be stipulated by the RBI Act.

In recent times, Pablo Guidotti has suggested that emerging market economies must maintain usable forex reserves exceeding scheduled amortisation of foreign currency debts falling due (assuming no roll-overs) during the following year. The concept of ‘usable reserves’ merits particular attention in view of the developments experienced by Korea and Thailand during the 1997 crisis. A large part of the gross reserves was not available to the authorities to defend the falling exchange rates. Greenspan (1999) suggested a ‘liquidity-at-risk’ rule and observed that "countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 per cent of the time".

India is amongst the top ten reserve holding emerging market nations. Reserve adequacy indicators also place India at a comfortable position vis-à-vis emerging market economies.

India’s foreign exchange reserves increased from US $ 4.7 billion in June 1991 to US $ 73.9 billion as on March 13, 2003. The predominant component of foreign exchange reserves is in the form of foreign currency assets that increased from US $ 1.1 billion to US $ 71.7 billion during the same period. The gold holdings of the Reserve Bank remained broadly stable at around US $ 3-4 billion during the same period. SDR holdings of the Government came down from US $ 63 million in June 1991 to US $ 4 million as on March 13, 2003. The movement in India’s foreign exchange reserves since 1993-94 can be divided into three phases:

1. the period March 1993 to March 1995, when reserves increased sharply from US $ 9.8 billion to US $ 25.2 billion,

2. the period March 1995 to March 1999, when reserves increased moderately to US $ 32.5 billion, and

3. finally since 1999-2000, when there was a phenomenal increase in reserves - as much as US $ 41.3 billion cumulatively (by US $ 5.5 billion in 1999-2000, US $ 4.2 billion in 2000-01, US $ 11.8 billion in 2001-02, and US $ 19.8 billion during 2002-03 (up to March 13, 2003).

The traditional trade-based indicator of reserve adequacy, i.e., the import cover of reserves (foreign currency assets), which fell to a low of two weeks of imports in June 1991 improved to 11.3 months of imports as at end-March 2002. Import cover of reserves further increased to nearly 14 months of imports by March 2003. In terms of the money-based indicators, the ratio of net foreign exchange assets of the Reserve Bank to currency in circulation sharply increased from 14.4 per cent at end-March 1991 to 105.2 per cent at end-March 2002 while that of net foreign exchange assets to broad money increased from 3.0 per cent to 17.6 per cent over the same period. The debt-based indicators of reserve adequacy also steadily improved in the 1990s. The ratio of volatile capital flows (defined as cumulative portfolio flows and short-term debt to reserves), which was 71.1 per cent as at end-March 1996 fell to 48.1 per cent as at end-March 2002. The ratio of short-term debt to reserves declined from 146.5 per cent in 1990-91 to 5.1 per cent in 2001-02. Taking these factors into account, India’s foreign exchange reserves are at present comfortable and consistent with the rate of growth, the share of external sector in the economy and the size of the risk adjusted capital flows (RBI, 2002c).

As a part of prudent reserve management policy, the net forward liabilities have been kept at relatively low levels. The proportion of forward liabilities declined from 6.1 per cent of gross reserves at end-March 1998 to 0.3 per cent at end-August 2002. In the subsequent months, these have been fully retired and the Reserve Bank held net forward assets of US $ 2.6 billion in February 2003.

While the significant accretion to foreign exchange reserves has provided comfort on external sector management, two contentious issues have come to the fore. These are the trade-off between costs and benefits accruing from the reserves accretion and the associated monetary impact that emanates from it.