• Why are foreign exchange reserves needed?
Foreign exchange reserves are needed for a central bank to determine the exchange rate, in a regime in which exchange rates are market determined.• How are foreign exchange reserves used?
Think of the central bank as a trader who buys and sells on the foreign exchange market to influence demand and supply of domestic vs foreign currency. When the RBI believes that the rupee should be made weaker it can increase its supply by selling rupees and buying dollars in the forex market.
If the country adopts a flexible exchange rate policy, where manipulating the currency market is not required, then reserves are not needed. Advanced countries have set up currency regimes whereby negligible reserves are required.• When are forex reserves considered adequate?
Earlier the way to say whether reserves are adequate was to look at how many months of import cover they provided. Three or four months would be considered adequate. Some people then worried that while there may be enough to cover for a few months of imports, this may not be enough at a moment of crisis because then the ‘‘hot money’’, which is money that can be taken out easily, will leave the country. So reserves should be adequate even after that money has left. Such money includes foreign portfolio investment and NRI deposits. Still others worried that India should hold enough reserves to be able to repay all her debt if no one was willing to lend money to India. This measure required holding additional dollars.• Why are India’s foreign exchange reserves today much larger than ever before?
The story began in 1991 when India used to operate a fixed exchange rate - which innately requires a lot of reserves. India found herself with barely two weeks worth of foreign exchange reserves. Imports had to be sharply cut and the economy faced a recession. The first half of the Nineties was spent in learning to have an flexible exchange rate, and also in piling up dollars, so that India never has to be in the humiliating position of having a begging bowl in her hand. By 2000 India had over US$ 40 billion of reserves.• Are India’s reserves adequate?
According to the RBI, India met even the broadest criterion described above known as the liquidity-at-risk measure of reserve adequacy, by April 2002 when reserves were half of what they are today, i.e. US$ 60 billion.• Then, why were more forex reserves accumulated?
After April 2002 there was a strong pressure on the rupee to appreciate. This rose from India exporting more goods and services in dollar terms than we imported. The supply of dollars to India was consequently greater than the country could absorb. Since reserve adequacy requirements had already been met there was no reason for RBI to buy any more dollars. If the RBI had let this surplus be absorbed in the currency market through a change in the price of the rupee, this would have led to some appreciation of the exchange rate. Some adjustment of prices would have happened and in all probability the story would have ended.• If so, why did RBI buy dollars?
One of the objectives of RBI’s policies is to keep fluctuations in the rupee low. When it saw a large pressure on the rupee, it chose to prevent sharp movements in the rupee dollar rate by buying up dollars. This slowed down the movement, but the pressure remained. The result was that the rupee was getting stronger, but very, very slowly. For a whole year the RBI kept on buying dollars in such a way that the free market price of the dollar in the foreign exchange market never moved by more than 10 paisa per day. Over US $ 30 billion were added in one year to reserves.This strategy proved to be counter-productive. If you converted your dollars to rupees, held the rupees for a month, converted them back into dollars, you would take back more dollars than you had brought in. The inflow of hot money increased sharply. RBI bought up the additonal dollars that came in, pushing up reserves to their present level of US $ 122 billion.• Can the problem of excess reserves be solved?
The problem of excess forex reserves is similar to the problem of excess food stocks faced by India in the past. If you sell the product whose large stocks you happen to hold, the market price of the product would decline. Food stocks are not sold in the open market even though they are way beyond the country’s needs, because their off-loading will bring down the price of food grains. Dollars are not sold in the rupee-dollar market because off-loading dollars would bring down the price of dollars and make the rupee stronger. In both cases since we try to choose how prices would move, we are in a quagmire. We are stuck with the consequences of past mistakes. In both cases the government is trying to think of ways out of the mess.• How can forex reserves be used?
Recently Montek Singh Ahluwalia, Deputy Chairman, Planning Commission, proposed that the reserves be used for infrastructure projects, for social sector lending, for non-bankable projects.
The basic message behind this proposal is that India’s foreign exchange reserves need to be reduced. Today they are over US $ 120 billion. They need to be brought down.
However, there are difficulties in implementing this well-meaning proposal. First, the infrastructure sector does not suffer from a shortage of funds, so increasing the availability of lending to it be pointless if borrowers do not come forth. Second, suppose ways are found to lend the money, when RBI lends out these reserves, the dollars will be converted into rupees. This means that the supply of rupees in the economy will increase, which creates the danger of higher inflation. If the RBI lends for public sector investment projects, it will lend to the government of India, something it is prevented from doing under current legislation. It means increasing the deficit, which also it is prevented from doing under the current legislation. To change the legislation is dangerous because while today the ceiling may be removed for a good cause, but future governments may misuse their borrowing and spending powers.• What is the best way to reduce the level of reserves?
First, the RBI should stop buying any more dollars. Next, it should sell the massive holding of dollars it possesses. The rupee would appreciate. By making imports cheaper it would encourage people to import more into the country. The Finance Minister should reject all proposals to increase the government’s borrowing from the RBI. He should cut custom duties on imports and hope that as a result imports will increase, pulling down the level of reserves. Faster growth of the Indian economy will mean higher imports and using foreign exchange for the things people wish to use them for.