Foreign exchange reserves
Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, such as the dollar, euro and yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.
History
Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, all major currencies have not been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can [and do] function as official international reserves.
Purpose [key point]
In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank. This action can stabilize the value of the domestic currency. [foreign reserves main purpose is to defend the value of the domestic currency]
Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates.
Changes in reserves
The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a fixed exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations (sterilized or unsterilized) to maintain the targeted exchange rate within the prescribed limits.
Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.
To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency [this is what China is doing], which will increase the sum of foreign reserves [this explains China's massive foreign reserves]. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand [ie: Chinese yuan], foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls) [in other words, currency pegs. In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves.
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.
Costs, benefits, and criticisms
Large reserves of foreign currency allow a government to manipulate exchange rates - usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides, but in practice this has not been the case.
There are costs in maintaining large currency reserves.Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves [every nation with dollar reserves is soon going to experience such a loss]. Even in the absence of a currency crisis, fluctuations can result in huge losses. For example, China holds huge U.S. dollar-denominated assets, but the U.S. dollar has been weakening on the exchange markets, resulting in a relative loss of wealth. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates.Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.
Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, such as the dollar, euro and yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.
History
Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, all major currencies have not been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can [and do] function as official international reserves.
Purpose [key point]
In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank. This action can stabilize the value of the domestic currency. [foreign reserves main purpose is to defend the value of the domestic currency]
Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates.
Changes in reserves
The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a fixed exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations (sterilized or unsterilized) to maintain the targeted exchange rate within the prescribed limits.
Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.
To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency [this is what China is doing], which will increase the sum of foreign reserves [this explains China's massive foreign reserves]. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand [ie: Chinese yuan], foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls) [in other words, currency pegs. In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves.
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.
Costs, benefits, and criticisms
Large reserves of foreign currency allow a government to manipulate exchange rates - usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides, but in practice this has not been the case.
There are costs in maintaining large currency reserves.Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves [every nation with dollar reserves is soon going to experience such a loss]. Even in the absence of a currency crisis, fluctuations can result in huge losses. For example, China holds huge U.S. dollar-denominated assets, but the U.S. dollar has been weakening on the exchange markets, resulting in a relative loss of wealth. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates.Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.
The RBI should consider alternative uses of the excess reserves, such as investment in infrastructure.
In the last two decades, the Indian economy has witnessed a dramatic transformation from a regulated environment to the one which is more market-oriented. Over this period, a crisis-hit economy with limited resources to finance even three months of imports in 1991, accumulated a huge stock ($ 321 billion on September 2, 2011) of international reserves that is enough to fund almost a year of import.
Interestingly over the last decade, the pace of accretion in the stock of international reserve has been so striking that it has registered more than 1000 per cent growth, despite the fact that India has entered into flexible exchange rate system since March 1993. Now it seems reasonable to argue that India has surpassed many standard measures of reserve adequacy to rest in a somewhat protected zone.
REASONS FOR RESERVES
Theoretically, it was believed that under flexible exchange rate system countries will need to keep less stock of international reserves, since central banks were not obligated to defend their parities through frequent interventions.
While a regime shift from fixed exchange rate to floating system theoretically reduces the need for holding international reserves, on empirical and practical grounds this may not hold good as precautionary motives play a predominant role in reserve accumulation. Nations hold international reserves for several reasons: to smooth out temporary fluctuations in external payment imbalances, to neutralise speculative attacks on currencies, for boosting international confidence on domestic economy, for prestige and as collateral for international borrowing. Alternatively, reserve accumulation can also be used to keep the exchange rate favourable for export growth which maylead to higher economic growth and more employment in the domestic economy.
But, on the other hand, massive outward movement of capital may expose the country to a greater risk of liquidity squeeze, which occasionally leads to a full-fledged financial crisis. Therefore, holding international reserves may be a quick-fix solution for this possible threat. The precautionary benefits of keeping huge stockpiles of international reserves are numerous. However, reserve accumulation also involves incurring some opportunity costs beyond a certain limit. In the words of Prof. Dani Rodrik, “central banks hold their foreign exchange reserves mostly in the form of low-yielding short-term US treasury (and other) securities. Each dollar of reserves that a country invests in these assets comes at an opportunity cost that equals the cost of external borrowing for that economy.”
In the case of a developing country like India, where the demand for financial resources to support developmental projects is always greater than the available supply, it is not completely justified to keep these precious funds unemployed for a longer period.
The broad conclusion (reflected even in RBI's reports) suggests that India has accumulated more excess reserves than necessary to avoid any unforeseen financial calamity in the near future. The opportunity cost of reserves holding is high for the Indian central bank, as returns from the foreign currency asset (FCA) deposits are too low, whereas the domestic interest rate is comparatively very high. This poses a couple of relevant questions: what is the adequate level of international reserves for India, and what is the opportunity cost of excess reserves?
RIGHT LEVEL OF RESERVES
In our recent research we have attempted to answer these questions. First, the level of adequacy and excess reserves holding is measured. This is performed using the rule of thumb of holding international reserves equal to three months' import coverage plus short term external debt in addition to 30 per cent of foreign stock market holding. Furthermore, the issue of ‘internal drain' is also included; this is mainly because of the fact that the quality of the financial system is an important consideration in capital flight from the country.
Money supply is used as proxy for this purpose. Another important factor that can be included in the analysis is the country's risk. This factor is considered on the argument that any increase in the country's risk increases the risk of capital flight. This measurement has broadened the adequacy measure of reserves. This analysis suggests that in 2001-02, reserves adequacy was $24,062 million and excess reserves was $26,987 million. Over the analysis period, reserves adequacy has been increasing; however, excess holding of reserves too has been growing. This suggests the opportunity cost of reserves holding and excess reserves were US$ 3502 million and US$ 1851 million, respectively in 2001–02, which is 0.41 per cent of India's GDP. The trend of growth in adequacy, excess reserves and cost has been increasing over the period till 2007-08. The excess reserves holding rose to 1.13 per cent of GDP in 2007–08, while it observed a marginal decrease of 0.87 per cent in 2008–09. Therefore, it is evident that excess holding of reserves and its cost of holding is too high to bear on the argument of safety.
USE IN INFRASTRUCTURE
Therefore, RBI needs to act and consider alternative uses of the excess reserves such as investment in infrastructure, re-capitalisation of public sector banks, investment in overseas financial markets or repayment of costly external debt. To start with it would be reasonable to argue for a safe option of employing a smaller portion of reserves, excess or otherwise, towards productive investments such as infrastructure. This way, one would be clear about the pros and cons of such usage of excess reserves.
