Reserving currency to go shopping abroad

Indian Express, 29 November 2004

What are foreign exchange reserves?

Foreign exchange reserves are assets held by the central bank of a country which can be converted into internationally acceptable currency at a short notice. India’s forex reserves consist mainly of US government treasury bills, that are assets denominated in US dollars. Treasury bills of other developed countries denominated in Euros, in Yen, gold and Special Drawing Rights with the IMF also form part of India’s foreign exchange reserves.

How are reserves accumulated?

For the major part, reserves are accumulated when RBI buys dollars. Also, since the RBI holds a portfolio of various currencies, movements in exchange rates lead to fluctuations in reserves. For example, if the Euro gains value vs the USD, our reserves number, reported in USD, goes up.

Why do countries hold foreign exchange reserves?

Countries hold foreign exchange reserves so that the central bank can manipulate the exchange rate by trading in the currency market. Countries with flexible exchange rate regimes do not hold need to hold reserves.

Why does India hold among the highest levels of foreign exchange reserves in the world?

When India had a fixed exchange rate, was a relatively closed economy and when the international political climate was considered to be hostile enough to stop all credit to India, foreign exchange reserves were held so as to be used in times of crises. In the days of a fixed exchange rate it was thought that forex reserves would be used in keeping the rupee from depreciating. Today they are the undesirable side effect of the RBI’s currency manipulation. The same is true for countries such as China, Taiwan, Singapore and Korea who have piled up huge reserves after the East Asian crisis.

What are the costs of accumulating foreign exchange reserves?

The cost of currency intervention and the consequent reserve accumulation is loss of autonomy over domestic monetary policy. India can either choose to set her domestic interest rates according to the needs and preferences of domestic consumers and producers, or India can choose to have a stable exchange rate. In an open economy, to have both choices is impossible. This theorem is known as the ‘‘impossible trinity’’. You can only have two of the three: an open economy, a pegged exchange rate or an independent monetary policy.

Why do we have to make a choice between interest rate stability and exchange rate stability?

This is how it works. If you try to keep the exchange rate from appreciating, you buy dollars. Your monetary base will go up. To control demand and prevent inflation you will raise interest rate. Focusing on exchange rates thus reduces the central bank’s control over money supply. We have seen some of this happen in recent months in India.

If instead, you were focused on the domestic economy and you decide to reduce interest rates to meet investment needs, this will induce an outflow of capital and put pressure on the currency to depreciate. In this situation you have a choice. You can either lower domestic interest rates, and not worry about the impact on the currency, or you can worry about the impact on the currency and, therefore, not reduce domestic interest rates.

All advanced countries, other than Japan, have pondered over this choice and consciously decided to stop trading on the currency market. The US Fed has not traded in the last 10 years. The UK suffered major losses in 1992 and learned its lesson ever since.

Interest rates in India are among the most volatile in the world, they fluctuate more than interest rates in almost all countries. This is because the RBI focuses on stablilising the exchange rate, at the cost of stability of interest rates. Day-to-day movements of the rupee-dollar exchange rate are consequently very small.

Is there something automatic—that when capital comes into the country, reserves go up?

No. It is only if RBI chooses to buy on the market that reserves go up. There is nothing automatic about it. RBI can choose not to buy. If it were not so focused on day-to-day movements of the exchange rate, it would not intervene in the foreign exchange market.

How does the RBI minimise the cost of reserves accumulation?

RBI buys dollars by paying out rupees. This means that as RBI buys more and more dollars, the amount of rupees circulating in the economy increases. To counter this impact on money supply, the RBI, which holds Government of India bonds as well, sells these bonds. This is known as open market operations. Banks buy bonds by paying the RBI rupees. In this manner the RBI can reduce the impact of its dollar purchases on money supply in the economy. This is known as sterilisation. In the last two years the RBI sold off almost all the government bonds it held in its attempt to control money supply. When it ran out of bonds, it asked the Ministry of Finance for more bonds, known as the Monetary Stabilisation Bonds, worth Rs 60,000 crore.

What is wrong with a central bank trading on the currency market?

One set of concerns is about accountability. The bank might believe it benefits India when it manipulates the currency market. But it is not always clear that trading is done in the interests of the majority of the population. For example, trading to induce depreciation makes the currency weaker and helps one group of people, the exporters, but hurts consumers across the country who pay more for imported inputs.

Ila Patnaik