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Foreign Exchange Reserves Management in India: Accumulation and Utilisation
Foreign Exchange Reserves Management in India: Accumulation and Utilisation
Foreign Exchange Reserves Management in India: Accumulation and Utilisation
Abstract
This study aims to examine the adequacy and utilization aspects of the foreign
exchange reserves in India and in addition aims to identify the factors that
determine international reserves hoarding in India on the basis of quarterly
data for the period 1996 to 2009. The recent rapid reserve accumulation by
India has brought the attention of the world on to it. During this period the
foreign exchange reserves have swelled and are now well ahead of the reserve
adequacy parameters. The total reserves which now stand at about US $ 275
billion are far in excess of the generally accepted benchmark levels. The
disadvantages of hoarding surplus reserves are: appreciation of the currency,
opportunity cost, sterilization costs, inflationary impact and so on. Thus there
is a case for better management of these excess reserves in India. Our
emphasis is on overall movements, rather than on volatility, caused by
fundamentals such as GDP, exchange rates, exports, and openness (proxied
using marginal propensity to import). Applied econometric methodology of
modern time series is utilized to ensure rigorous analysis. The most significant
determinants turn out to be openness followed by exports and GDP with
exchange rate being the least significant.
Acknowledgement
We are grateful to Prof. Vishwanath Pandit, Vice-Chancellor, Sri Sathya Sai
University, Prasanthi Nilayam and Prof. K Krishnamurthy, Administrative Staff
College, Hyderabad, for their help and valuable comments.
296 Rama Krishna Prasad M. and G. Raghavender Raju
Introduction
The subject of exchange rate management, in particular foreign exchange reserves
management has of late been the topic of discussion at various domestic and
international forums among the policymakers and academicians. This renewed
interest in the subject may be attributed to various reasons but one reason that stands
out is the precautionary purpose to hold onto reserves. In the aftermath of the
currency crises that paralysed the economies in different parts of the world, be it the
East Asian crisis (1997) or the Argentinean crisis (1999-2002), the study of foreign
exchange reserves management assumes great importance. There is a belief among
the policy makers and academicians that, after these crises the tendency to hold
surplus reserves on the part of developing countries has increased. At this stage we
must be mindful of the repercussions of piling up reserves. It is generally not
advisable to pile up reserves beyond the adequacy levels because of the inflationary
impact they have on the economy and also the costs that the country pays. There is
also the issue of opportunity cost involved when one is dealing with surplus reserves.
Hence it is necessary to address the adequacy and utilisation aspects of the reserves.
India’s reserves position has seen a huge change from the early nineties when we
did not have reserves to meet even three weeks of imports. Now we have reserves
sufficient to meet 12.4 months of imports that is roughly more than a year, clearly
exceeding the traditional adequacy measure of import cover 3-4 months. Thus it is in
necessary to study the adequacy, utilisation and determinants aspects of these ‘excess
reserves’ so that the cost of holding excess reserves is minimised and are used
optimally.
FER= FCA+GOLD+SDR+RTP.
Where,
FER: Foreign Exchange Reserves; FCA: Foreign Currency Assets; SDR: Special
Drawing Rights; RTP: Reserve Tranche Position.
of import cover) and the RBI had to intervene in the foreign exchange market to mop
up the excess liquidity in-order to prevent the currency from appreciating. The
reserves which stood at US $ 5.8 billion at the end of March 1991 increased to US $
25.2 billion by the end of March 1995. The growth continued in the second half of the
1990’s, with the reserves touching the level of 38.0 billion US $. The quantum of
reserves rose impressively to US $ 113.0 billion by the end of March 2004. In March
2005 the reserves touched US $ 141.5 billion, US $ 151.6 billion in 2006 March and
rose further to US $199.9 billion by the end of March 2007. The reserves have further
increased and shot up to US $ 309.7 billion, end March 2008. Thereafter the reserves
declined to US $ 251 billion by end March 2009. The reserve accumulation picked up
since then and stands at US $ 278 billion as on 5 March 2010. The growth of reserves
from 1991 has brought the attention of world on India. This phenomenal rise in
reserves testifies the fact that the fundamentals of the economy are well reflected in
the external value of the rupee.
Reserves to imports
This is one of the conventional and traditional measures. This can be useful for low
income countries with limited access to international capital markets and are
vulnerable to current account shocks. It is considered that a reserve level sufficient to
meet the imports of about three to four months to be an adequate measure. At the end
of September 2009 the ratio stood at 12.4 months while the benchmark is 3 months
clearly showing the surplus reserve level.
the end of March 2007. The ratio of short term external debt to reserves declined from
146.5% at the end of March 1991 to 6% end March 2007. The ratio of volatile flows
to reserves declined from 146.6% end March 1991 to 38.2% end March 2007.
Source: Half Yearly Report on Foreign Exchange Reserves, Reserve Bank of India
2008-2009.
The forex reserves are invested in multi currency and multi asset portfolios as per
the existing norms which are similar to the international practises. At the end of
March 2009 out of total foreign currency assets of US $ 251.9 billion, around US $
134.0 billion was invested in securities, US $ 101.9 billion was deposited with other
central banks, BIS, IMF and US $ 4.7 billion in the form of deposits with foreign
commercial banks. During the year 2005-06 the return on foreign currency assets and
gold, after accounting for depreciation increased to 3.9% from 3.1% during 2004-05
owing to hardening of global short term interest rates.
Majority of the studies point out that the major reasons for holding reserves are
1. To prevent the crises i.e. insurance cover.
2. The mercantilist motive – to prevent the appreciation of the home currency.
With regard to adequacy of reserves there are notable contributions from Alan
Greenspan (1999), Reddy (1998), Singh (2006), Sachs, Torrnell and Velasco (1996),
Beaufort and Kapteyn (2001), Rajan (2002), Rodrik (2006), Green and Torgerson
(2007).
It would be an interesting exercise to identify the variables that determine the
international reserves hoarding by countries. Gab-Je Jo in 2007 identified the
variables that influence the reserves hoarding in Korea. The same exercise was carried
out for China by Huang in 1995. Ana María Romero identified the factors that affect
302 Rama Krishna Prasad M. and G. Raghavender Raju
foreign currency reserves in India and China. Li and Rajan in 2005 explored the issue
of optimal precautionary demand for reserves by a central bank within a context of a
simple analytical model.
In this exercise of ours we have tried to identify the determinants of international
reserves hoarding for India using a quarterly series ranging from 1996 1st quarter to
the 1st quarter 2007. We posit that the variables determining the foreign exchange
reserves hoarding for India are: Gross Domestic Product, a ratio of imports to
GDP.Though the ratio of imports to GDP may not be a perfect measure for openness
but it captures the marginal propensity to import. Thus we use this ratio to proxy for
the openness. Exports, measured as the growth rate of the exports, this variable gives
a measure of the contribution of export receipts to the reserve accumulation.
Exchange rate, this variable is measured as the growth rate of exchange rates and
describes the effect of a fluctuating exchange rate on the reserve accumulation
process. Thus we have
FER = f (GDP, OPEN, EXP, EXC)
Where,
FER: Foreign Exchange Reserves
GDP: Gross Domestic Product
OPEN: ratio of Imports to GDP, a measure of openness
EXP: Exports
EXC: Exchange Rate
Empirical Results
Unit Root Tests
Table 1: Unit Root Tests with Trend and Intercept: (1996:1 to 2009:1).
*Implies MacKinnon critical value for rejection of hypothesis of a unit root at 10%
level. 1% critical value = -3.50, 5% critical value = -2.89, 10% critical value = -2.58
Foreign Exchange Reserves Management in India 303
From the table we observe that all the other variables GDP, Exports, Exchange
Rates and Openness are stationary at levels and thus there is no necessity to go for
differences. The only non stationary variable forex reserves has become stationary on
application of first difference.
*The figures in parenthesis in OLS and ARCH-GARCH models are t-statistic and z-
statistic respectively.
The following conclusions are drawn from the above estimation results:
R2 = 0.60 or 60%, implying that 60% of the variation in forex reserves is
explained by the explanatory variables.
The GDP has a positive relationship with reserve hoarding. This can be explained
by the fact that GDP is a measure of the economic activity in a country and gives the
size of the economy. Therefore higher the GDP higher would be the quantum of
reserves held. When the output (GDP) of the country increases, the forex reserves
level increases. GDP has a two period lag thus any increase in the GDP would result
in the increase in forex hoarding only after 2 time periods.
The openness (OPEN) measure is given by imports/GDP. Though imports to GDP
may not be a perfect proxy for openness we use it as a proxy for calculating the
Marginal Propensity to Import. The long run relationship between openness and
reserves must be negative according to the Keynesian Open economy model. Our
304 Rama Krishna Prasad M. and G. Raghavender Raju
results are in conformity with this principle1. This is because higher the marginal
propensity to import, more powerful the income reducing policy to restore the
Balance of Payments equilibrium and lesser the holding of reserves and this inference
is quite debatable as the sign of openness is ambiguous, Gab-Je Jo (2007). The
openness has a lag of 2 periods implying that any increase in the ratio would result in
a fall in the reserve levels only after 2 periods.
The exchange rate (EXC) is inversely related to the forex reserves. Any change in
exchange rate would lead to a movement of forex reserve levels in the opposite
direction. Implying that, with a weakening exchange rate or depreciating currency, the
forex reserve levels diminish. This phenomenon is observed because, with a
depreciating exchange rate the intervention in the forex market by the central bank
increases and thus the quantum of reserves decreases and thus the inverse
relationship between exchange rates and reserves.
When the exports (EXP) are highly fluctuating that is, in a situation of high
volatility in exports the need to hoard forex reserves increases. This is because, when
the export receipts are highly fluctuating, the earnings from them become unreliable
and the reserves needed for meeting the import bill increases and thus the need to
hoard more reserves increases. Thus, higher the volatility in export receipts, higher
the reserves to be held indicating the positive relation between exports volatility and
reserves.
The Durbin-Watson statistic, an indicator of the presence or absence of the
problem of autocorrelation i.e. correlation among the error terms is found to be a
healthy 2.11. Any value around 2 indicates the absence of the problem of correlation
among the error terms.
Conclusions
Our present endeavour in this exercise was to identify the determinants of
international reserves hoarding for India. This work assumes importance a scenario of
increasing forex reserve levels in India; our Forex reserve are nearly around US $ 280
million. It aids in throwing more light on the reasons for increased reserve
accumulation by India and also in a situation where there has been a lot debate among
the academicians, policymakers and media on the logic behind this exercise.
In our model all the variables are statistically significant, with t statistic above the
value 2 and are according to the theory. Economic theory identifies that the exchange
rates’ coefficient must be negative. Another variable that is having a negative
coefficient is the openness. Studies so far have remained inconclusive about the sign
of this variable. Thus the sign of openness is debatable and ambiguous. The use of
dummy variable is justified as evident from the significant t statistic. When we
perform in sample forecasting, we observe that the Root Mean Square Percentage
Error (RMSPE) is 0.057 which is very good. The Thiel Inequality coefficient is 0.002,
1
The sign of the variable OPEN (openness) is ambiguous as earlier studies have shown that openness
can have both positive and negative relationships with reserves. Studies by Frenkel (1980) Karfakis
(1997) have shown a positive relationship, while studies by Huang (1995), Landel-Mills (1989) have
shown the existence of negative relationship between the two variables.
Foreign Exchange Reserves Management in India 305
which is very low and suggests that the predictive performance of the model is highly
satisfactory. It implies that the forecasted series in model is very close to the actual
series and there are no systemic tendencies to over or under estimate the actual data as
shown in the diagram below.
15.0
14.5
14.0
13.5
13.0
12.5
12.0
96 97 98 99 00 01 02 03 04 05 06 07
LNFER LNFERF
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306 Rama Krishna Prasad M. and G. Raghavender Raju
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