Y V Reddy: India's foreign exchange reserves - policy, status and issues
Special Lecture by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the National
Council of Applied Economic Research, New Delhi, 10 May 2002. Dr Reddy is thankful to
Dr R K Pattnaik for his assistance
* * *
Mr. Chairman and friends,
I am thankful to the National Council of Applied Economic Research, (NCAER) and in particular, to
Dr. Suman Bery, for giving me this opportunity to make a presentation on the foreign exchange
reserves. There are several reasons for speaking on this subject before this august gathering in the
capital.
First, the subject is receiving renewed global interest among policy makers and academicians against
the backdrop of increasing globalization of emerging economies, acceleration of capital flows, and
integration of financial markets domestically as well as globally. The debt crisis in some of the
developing countries in the early nineties, the East Asian crisis in 1997 and more recently the currency
crisis of Argentina have posed several dilemmas to policy makers on forex reserves.
Second, multilateral bodies, especially, the Bank for International Settlements (BIS) and International
Monetary Fund (IMF) are attempting several initiatives in regard to international financial architecture
in the context of the debt-banking-financial crisis in several countries, and matters relating to forex
reserves have become an important component of this initiative, encompassing issues on policy,
management and transparency.
Third, there is some interest within India on our level of forex reserves, as evidenced by several
articles in financial dailies, economic journals and research papers. There are also some differences
among academics on the direct as well as indirect costs and benefits of the level of forex reserves,
from the point of view of macro-economic policy, financial stability and fiscal or quasi-fiscal impact.
Fourth, Reserve Bank of India (RBI) has been adopting a proactive communication policy, particularly
under the leadership of Governor Bimal Jalan, and accordingly it is appropriate that the relevant issues
are also presented from the perspective of RBI.
Finally, there is some personal involvement and excitement for me in this subject. The period
1990-2002 has been a journey from agony to comfort in matters relating to forex reserves; for in
1990-91, sitting in North Block in Ministry of Finance in Delhi, I was one of those who had to ensure
that given the very low level of forex reserves and the manner in which they happened to be deployed,
there was enough cash balance to permit day-to-day forex payments of even a million U.S. dollars. In
such a predicament, the threat of national humiliation as well as discomforting relations with foreign
agencies obviously touched on personal pride. Furthermore, in crafting a liberalized forex regime in
the last decade, those of us involved in the process of reform have been acutely aware of the
judgements and risks involved at every step in forex reserves policy and management. Over the
period, without adding much to the stock of external debt, there has been a quantum jump in forex
reserves. This position needs to be contrasted with the 1980s, when external debt, especially short
term debt, mounted while the forex reserves got depleted. In fact, it is often held that, between 1956
and 1992, India faced balance of payments constraints in all but six years, while during the last ten
years, there has never been a feeling of constraint on this account, eventhough the period coincided
with liberalization of external account, global currency crisis and domestic political uncertainties.
This presentation attempts to capture the basic concepts, theory and practice with orientation on
issues relevant to India. The questions addressed are; What are forex reserves? Why hold forex
reserves and how did the policy evolve? What is the appropriate level of reserves? How does the
current status appear in terms of indicators of adequacy of reserves? The presentation proceeds
further to focus on several aspects of forex management, such as the implications for quasi fiscal
deficit and communication policy of the RBI. The issues in regard to policy and management of forex
reserves in India are posed in some detail while the concluding part contains my random thoughts
from a futuristic perspective. Given the broad canvass and well recognized complexity, the
presentation, for most part, touches on the broad contours without going into abstruse technical and
academic details.
The subject of forex reserves may be broadly classified into two inter-linked areas, namely, 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 conceptualization of the appropriate
level of foreign reserves. In essence, a theoretical framework for reserves provides the rationale for
holding forex reserves. Reserve management is mainly guided by the portfolio management
consideration i.e., how best to deploy foreign reserve assets? The portfolio considerations take into
inter
account 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
difference should be recognised in approaching the critical issues relating to both reserve
management practices and policy making.
What are Forex Reserves?
Conceptually, a unique definition of forex reserves is not available as there have been divergence of
views in terms of coverage of items, ownership of assets, liquidity aspects and need for a distinction
between owned and non-owned reserves Nevertheless, for policy and operational purposes, most
countries have adopted the definition suggested by the International Monetary Fund (Balance of
Payments Manual, and Guidelines on Foreign Exchange Reserve Management, 2001); which defines
reserves as external assets that are readily available to and controlled by monetary authorities for
direct financing of external payments imbalances, for indirectly regulating the magnitudes of such
imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for
other purposes.
The standard approach for measuring international reserves takes into account the unencumbered
international reserve assets of the monetary authority; however, the foreign currency and the
securities held by the public including the banks and corporate bodies are not accounted for in the
definition of official holdings of international reserves.
In India, the Reserve Bank of India Act 1934 contains the enabling provisions for the RBI to act as the
custodian of foreign reserves, and manage reserves with defined objectives. The powers of being the
custodian of foreign reserves is enshrined, in the first instance, in the preamble of the Act. The
'reserves' refer to both foreign reserves in the form of gold assets in the Banking Department and
foreign securities held by the Issue Department, and domestic reserves in the form of 'bank reserves'.
The composition of foreign reserves is indicated, a minimum reserve system is set out, and the
instruments and securities in which the country's reserves could be deployed are spelt out in the
relevant Sections of the RBI Act.
In brief, in India, what constitutes forex reserves; who is the custodian and how it should be deployed
are laid out clearly in the Statute, and in an extremely conservative fashion as far as management of
reserves is concerned. In substantive terms, RBI functions as the custodian and manager of forex
reserves, and operates within the overall policy framework agreed upon with Government of India.
Why Hold Forex Reserves?
Technically, it is possible to consider three motives i.e., transaction, speculative and precautionary
motives for holding reserves. International trade gives rise to currency flows, which are assumed to be
handled by private banks driven by the transaction motive. Similarly, speculative motive is left to
individual or corporates. Central bank reserves, however, are characterized 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.
From a policy perspective, it is clear that the country benefits through economies of scale by pooling
the transaction reserves, while subserving the precautionary motive of keeping official reserves as a
'war chest'. Furthermore, forex reserves are instruments to maintain or manage the exchange rate,
while enabling orderly absorption of international money and capital flows. In brief, official reserves are
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.
Reserve assets could be defined with respect to assets of monetary authority as the custodian, or of
sovereign government as the principal. For the monetary authority, the motives for holding reserves
may not deviate from the monetary policy objectives, while for government, the objectives of holding
reserves may go beyond that of the monetary authorities. In other words, the final expression of the
objective of holding reserve assets would be influenced by the reconciliation of objectives of the
monetary authority as the custodian and the government as principal. There are cases, however,
when reserves are used as a convenient mechanism for government purchases of goods and
services, servicing foreign currency debt of government, insurance against emergencies, and in
respect of a few, as a source of income.
What are the dominant policy objectives in regard to forex reserves in India? It is difficult to lay down
objectives in very precise terms, nor is it possible to order all relevant objectives by order of
precedence in view of emerging situations which are described later. For the present, a list of
objectives in broader terms may be encapsulated viz., (a) maintaining confidence in monetary and
exchange rate policies, (b) enhancing capacity to intervene in forex markets, (c) limiting external
vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis including
national disasters or emergencies; (d) providing confidence to the markets especially credit rating
agencies that external obligations can always be met, thus reducing the overall costs at which forex
resources are available to all the market participants, and (e) incidentally adding to the comfort of the
market participants, by demonstrating the backing of domestic currency by external assets.
At a formal level, the objective of reserve management in India could be found in the RBI Act, where
the relevant part of the preamble reads as 'to use the currency system to the country's advantage and
with a view to securing monetary stability'. This statement may be interpreted to hold that monetary
stability means internal as well as external stability; implying stable exchange rate as the overall
objective of the reserve management policy. While internal stability implies that reserve management
cannot be isolated from domestic macroeconomic stability and economic growth, the phrase 'to use
the currency system to the country's advantage' implies that maximum gains for the country as a
whole or economy in general could be derived in the process of reserve management, which not only
provides for considerable flexibility to reserve management practice, but also warrants a very dynamic
view of what the country needs and how best to meet the requirements. In other words, the financial
return or trade off between financial costs and benefits of holding and maintaining reserves is not the
only or the predominant objective in management of reserves.
Evolution of Reserve Management Policy in India
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 RBI's Annual Report
1990-91 stated that the import cover of reserves shrank to 3 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 external sector
policy underwent a paradigm shift with the adoption of the recommendations of the High Level
Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). The Report, of which I had the
privilege of being Member-Secretary, articulated an integrated view of the issues and made specific
recommendations on foreign currency reserves. The relevant extracts are:
"It has traditionally been the practice to view the level of desirable reserves as a percentage of the
annual imports-say reserves to meet three months imports or four months imports. However, this
approach would be inadequate when a large number of transactions and payment liabilities arise in
areas other than import of commodities. Thus, liabilities may arise either for discharging short-term
debt obligations or servicing of medium-term debt, both interest and principal. The Committee
recommends that while determining the target level of reserve, due attention should be paid to the
payment obligations in addition to the level of imports. The Committee, recommends that the foreign
exchange reserves targets be fixed in such a way that they are generally in a position to accommodate
imports of three months. (Paragraph 6.3)
In the view of the Committee, the factors that are to be taken into consideration in determining the
desirable level of reserves are: 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; 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;
the amount of foreign currency reserves required to counter speculative tendencies or anticipatory
actions amongst players in the foreign exchange market; and the capacity to maintain the reserves so
that the cost of carrying liquidity is minimal." (Paragraph 6.4)
With the introduction of market determined exchange rate as mentioned in the RBI's Annual Report,
1995-96 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.
Against the backdrop of currency crises in East-Asian countries, and in the light of country
experiences of volatile cross-border capital flows, the Reserve Bank's Annual Report 1997-98
reiterated the need to take into consideration a host of factors, but is noteworthy for bringing to the
fore the shift in the pattern of leads and lags in payments/receipts during exchange market
uncertainties and emphasized that besides the size of reserves, the quality of reserves also assume
importance. Highlighting this, the Report stated that 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.
As a part of prudent management of external liabilities, the RBI policy is to keep forward liabilities at a
relatively low level as a proportion of gross reserves and the emphasis on prudent reserve
management i.e., keeping forward liabilities within manageable limits, was highlighted in the RBI's
Annual Report, 1998-99.
The RBI Annual Report, 1999-2000 stated that the overall approach to management of India's foreign
exchange reserves reflects the changing composition of balance of payments and liquidity risks
associated with different types of flows and other requirements and the introduction of the concept of
liquidity risks is noteworthy.
"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 portfolio investment, 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 deposits of non-resident Indians." (Paragraph
6.30)
While focusing on prudent management of foreign exchange reserves in recent years, RBI's Annual
Report 2000-01 elaborated on 'liquidity risk' associated with different types of flows. The Report stated
that with the changing profile of capital flows, the traditional approach of 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.
Governor Jalan's latest statement on Monetary and Credit Policy (April 29, 2002) provides, an
up-todate and comprehensive view on the approach to reserve management and of special significance is
the statement :
"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 are now very comfortable." (Paragraph
23)...."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." (Paragraph 24).
The above discussion points to evolving considerations and indeed 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 them are not quantifiable, and in any case, weights attached to each of them do change from
time to time.
What is the Appropriate Level of Forex Reserves?
Basic motives for holding reserves do result in alternative frameworks for determining appropriate level
of foreign reserves. Efforts have been made by economists to present an optimising framework for
maintaining appropriate level of foreign reserves and one viewpoint suggests that optimal reserves
pertain to the level at which marginal social cost equals marginal social benefit. Optimal level of
reserves has also been indicated as the level where marginal productivity of reserves plus interest
earned on reserve assets equals the marginal productivity of real resources and this framework
encompasses exchange rate stability as the predominant objective of reserve management. Since the
underlying costs and benefits of reserves can be measured in several ways, these approaches to
optimal level provide ample scope for developing a host of indicators of appropriate level of reserves.
It is possible to identify four sets of indicators to assess adequacy of reserves, and each of them do
provide an insight into adequacy though none of them may by itself fully explain adequacy. First, the
money based indicators including reserve to broad money or reserves to base money which provide a
measure of potential for resident based capital flight from currency. An unstable demand for money or
the presence of a weak banking system may indicate greater probability of such capital flights. Money
based indicators, however, suffer from several drawbacks. In countries, where money demand is
stable and confidence in domestic currency high, domestic money demand tends to be larger and
reserves over money ratios, relatively small. Therefore, while a sizable money stock in relation to
reserves, prima facie, suggests a large potential for capital flight out of money, it is not necessarily a
good predictor of actual capital flight. Money based indicators also do not capture comprehensively the
potential for domestic capital flight. Moreover, empirical studies find a weak relationship between
money based indicator and occurrence and depth of international crises.
Secondly, trade based indicators, usually the import-based indicators defined in terms of reserves in
months of imports provide a simple way of scaling the level of reserves by the size and openness of
the economy. It has a straightforward interpretation- a number of months a country can continue to
support its current level of imports if all other inflows and outflows cease. As the measure focuses on
current account, it is relevant for small economies, which have limited access and vulnerabilities to
capital markets. For substantially open economies with a sizable capital account, the import cover
measure may not be appropriate.
Thirdly, debt based indicators are of recent origin; they appeared with episodes of international crises,
as several studies confirmed that reserves to short term debt by remaining maturity is a better
indicator of identifying financial crises. Debt-based indicators are useful for gauging risks associated
with adverse developments in international capital markets. Since short-term debt by remaining
maturity provides a measure of all debt repayments to nonresidents over the coming year, it
constitutes a useful measure of how quickly a country would be forced to adjust in the face of capital
market distortion. Studies have shown that it could be the single most important indicator of reserve
adequacy in countries with significant but uncertain access to capital markets.
Fourthly, more recent approaches to reserve adequacy have suggested a combination of
currentcapital accounts as the meaningful measure of liquidity risks. Of particular interest, is the Guidotti
Rule, which has received wide appreciation form many central bankers including Alan Greenspan,
postulates that the ratio of short term debt augmented with a projected current account deficit (or
another measure of expected borrowing) could serve useful an indicator of how long a country can
sustain external imbalance without resorting to foreign borrowing. As a matter of practice, the Guidotti
Rule suggests that the countries should hold external assets sufficient to ensure that they could live
without access to new foreign borrowings for up to twelve months. This implies that the usable foreign
exchange reserves should exceed scheduled amortisation of foreign currency debts (assuming no
rollover during the following year).
Alan Greenspan suggests a 'Liquidity at Risk' Rule that takes into account the foreseeable risks that a
country could face in the event of (a) near absence of a purely non-interventionist exchange rate
policies and (b) cost-benefit trade-off in the quantity of reserve accumulation. Accordingly, a country's
liquidity position could be calculated under a range of possible outcomes for relevant financial
variables such as exchange rate, commodity prices, credit spreads, etc. While the concept of 'Liquidity
at Risks' has been broadly discussed at different fora, it appears that no specific methodology has
been outlined. It has been left to institutions and countries to develop their own approaches.
Level of Forex Reserves in India
The Indian approach to determining adequacy of forex reserves has been evolving over the past few
years, especially since the pioneering Report of the High Level Committee on Balance of Payments,
culminating in Governor Jalan's exposition of the combination of global uncertainties, domestic
economy and national security considerations in determining liquidity at risk and thus assessing
reserve adequacy. It is appropriate to submit stylized facts in relation to some of the indicators of
reserve-adequacy described here without making any particular judgment about adequacy.
The foreign exchange reserves include three items; gold, SDRs and foreign currency assets. As on
May 3, 2002, out of the US $ 55.6 billion of total reserves, foreign currency assets account the major
share at US $ 52.5 billion. Gold accounts for about US $ 3 billion. In July 1991, as a part of reserve
management policy, and as a means of raising resources, the RBI temporarily pledged gold to raise
loans. The gold holdings, thus have played a crucial role of reserve management at a time of external
crisis. Since then, Gold has played passive role in reserve management.
The level of foreign exchange reserves has steadily increased from US$ 5.8 billion as at end-March,
1991 to US$ 54.1 billion as at end-March 2002 and further to US$ 55.6 billion as at May 3, 2002. The
traditional measure of trade based indicator of reserve adequacy, i.e., the import cover (defined as the
twelve times the ratio of reserves to merchandise imports ) which shrank to 3 weeks of imports by the
end of December 1990, has improved to about 11.5 months as at end-March 2002.
In terms of money-based indicators, the proportion of net foreign exchange assets of RBI (NFA) to
currency with the public has sharply increased from 15 per cent in 1991 to 109 per cent as at
end-March 2002. The proportion of NFA to broad money(M3) has increased by more than six fold;
from 3 per cent to 18 per cent.
The debt-based indicators of reserve adequacy show remarkable improvement in the 1990s. The
proportion of short term debt (i.e., debt obligations with an original maturity up to one year) to foreign
exchange reserves has substantially declined form 147 per cent as at end-March 1991 to 8 per cent
as at end-March 2001. The proportion of volatile capital flows defined to include cumulative portfolio
inflows and short term debt to reserves has lowered from 147 per cent in 1991 to 58.5 per cent as at
end-March 2001. As part of sustainable external debt position, the short term debt component has
decreased from 10 per cent as at end-March 1991 to 3 per cent as at end-March 2001. Similarly, the
size of debt service payments relative to current receipts has decreased from 35 per cent in 1991 to
16 per cent in 2001.
Management of International Reserves
In the recent years, for several reasons, increasing attention is being paid to management of
international reserves. First, advent of the Euro as an alternate currency to US dollar; second,
movement of many central banks out of gold; third, changes in exchange rate regimes; fourth,
changing views on reserve adequacy and its role in crisis prevention; and fifth, operational use of
"reserve targets" in calculating financing gaps by IMF. The attention to the subject is evidenced by
increasing emphasis on transparency, accountability in various fora, and more recently, the issue of
IMF guidelines on the subject.
Operationally, reserve management is a process that ensures that adequate official public sector
foreign assets are readily available to and controlled by the authorities for meeting a defined range of
objectives for a country. A reserve management entity is normally made responsible for the
management of reserves and associated risks. Invariably, the reserve management entity is the
central bank and hence the objectives of reserve management tend to be critical as they would
encompass the objectives of the monetary authority and the objectives of a portfolio manager or the
custodian of reserves. As a monetary authority, a central bank's primary objective is to ensure
macroeconomic financial stability in general and external stability in particular. As a custodian, the
central bank's main objectives are to ensure liquidity, safety and yield on deployment of reserves.
In considering management of reserves, the benefits and costs of holding reserves are constantly
assessed. On the benefits, recent international financial crises have shown that holding and managing
sufficient reserves and disclosing adequate information to markets helps a country to prevent external
crises, especially those stemming from the capital account. The growing appreciation of the role of
reserves in crises prevention and as a buffer to manage exchange market pressures has given
reserve management a more central role, now than before, in national economic policies. Maintaining
high level of reserves to tide over external shocks, however, involves opportunity cost. The opportunity
cost of holding reserves is the foregone investment because resources have been used to purchase
reserves instead of increasing domestic capital. The marginal productivity of domestic capital is the
opportunity cost of holding reserves and reserves management seeks to minimize the opportunity
costs against the benefits that accrue from holding reserves.
The objectives of reserve management vary across countries, and a recent survey of reserve
management practices of select countries (IMF guidelines, 2001) provide good insights on the subject.
First, most countries hold reserves to support monetary policy. While ensuring liquidity in foreign
exchange market to smooth out undue short-term fluctuations in exchange markets constitutes the
primary objective, some countries take a cautious approach to intervention. Smaller countries, hold
reserves mainly for consideration of transaction motives to meet external payment imbalances as well
as a store of wealth. Precautionary motive of holding reserves to mitigate adverse external shocks is
implicit in most countries' objectives though among a few, it finds explicit mention. Few countries
explicitly use international reserves as the backing for monetary base and to maintain the stability and
integrity of the monetary and financial system.
From a policy perspective, the objective of holding reserves to support monetary policy is common to
most countries and the objective of holding reserves in regard to many emerging economies is
primarily to maintain international confidence about its short-term payment obligations as well as
confidence in monetary and financial polices.
Secondly, most countries have informal coordination between debt management and reserve
management policies. As part of informal coordination, most countries take into account external debt
indicators, particularly the maturity composition of short-term and long-term debt, as part of reserve
management.
Thirdly, in regard to transparency and disclosure standards, many countries adhere to the IMF's
Special Data Dissemination Standards (SDDS) requirement. Most countries publish data on external
debt and reserves on an annual basis in either their central bank annual reports or other reports of
Government.
Fourthly, liquidity and safety (low risks) prevail upon reserve management entities in most countries as
part of objective of reserve management. The yield objective is secondary to most countries in reserve
management.
Fifthly, most countries use benchmarks for managing currency composition of reserves though
information to the public about the benchmarks for the underlying currency composition of reserves is
generally not made available. Information about the underlying norms for adopting the benchmarks
are, however available in a number of countries.
Management of Forex Reserves in India
In India, legal provisions governing management of forex reserves are set out in the RBI Act and
Foreign Exchange Management Act, 1999 and they also govern the open market operations for
ensuring orderly conditions in the forex markets, the exercise of powers as a monetary authority and
the custodian in regard to management of foreign exchange assets.
In practice,