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.

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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, no major currencies have 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
function as official international reserves.

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Purposes of holding foreign currency reserves

Reserve assets may serve a variety of purposes, ranging from exchange rate
management to external debt management. In general, central banks hold reserves for a
variety of reasons, such as to:

 Fund foreign exchange market operations that arise as part of Central Banks’
monetary policy function
 Support monetary policy
 Guarantee payments of foreign currency debt
 Control excessive volatility of the national currency against other currencies
 Other reasons:
 Support trade in an open economy for transaction purposes
 Take precautionary measures, associated with potential balance of payment’s
crisis
 Improve a country’s access to international capital markets via maintaining
sound foreign exchange liquidity policies
 Help governments in lowering future tax rates
 Save surpluses for future generation
 Compensate for any reduction in natural resources

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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. BIS Review
30/2002 3 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

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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.

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Legal Framework and Policies

The Reserve Bank of India Act, 1934 provides the overarching legal framework for
deployment of the foreign currency assets (FCA) and gold defining the broad parameters in
respect of currencies, instruments, issuers and counterparties. The essential legal framework
for reserves management is provided in sub-sections 17 (6A), 17(12), 17(12A), 17(13) and
33(1) of the above Act. In brief, the law broadly permits the following investment categories:

(i) deposits with other central banks and the Bank for International Settlements (BIS);

(ii) deposits with foreign commercial banks;

(iii) debt instruments representing sovereign/sovereign-guaranteed liability with residual

maturity for the debt papers not exceeding 10 years;

(iv) other instruments / institutions as approved by the Central Board of the Reserve Bank in
accordance with the provisions of the Act; and

(v) dealing in certain types of derivatives. RBI has framed appropriate guidelines stipulating
stringent criteria for issuers/counterparties/investments with a view to enhancing the safety
and liquidity aspects of the reserves.

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Movement of Reserves

India’s foreign exchange reserves have grown significantly since 1991. The
reserves, which stood at US$ 5.8 billion at end-March 1991 increased gradually to US$ 25.2
billion by end-March 1995. The growth continued in the second half of the 1990s with the
reserves touching the level of US$ 38.0 billion by end-March 2000. Subsequently, the
reserves rose to US$ 113.0 billion by end-March 2004, US$ 199.2 billion by end-March 2007
and further to US$ 309.7 billion by end-March 2008. Thereafter the reserves declined to US$
252.0 billion by end March 2009

Although both US dollar and Euro are intervention currencies and the Foreign
Currency Assets are maintained in major currencies like US Dollar, Euro, Pound Sterling,
Australian Dollar, Japanese Yen etc., the foreign exchange reserves are denominated and
expressed in US Dollar only. The foreign exchange reserve data prior to 2002-03 do not
include the Reserve Tranche Position (RTP) in the International Monetary Fund (IMF).
Movements in the FCA occur mainly on account of purchases and sales of foreign exchange
by RBI in the foreign exchange market in India. In addition, income arising out of the
deployment of foreign exchange reserves is also held in the portfolio of the reserves. External
aid receipts of the Central Government also flow into the reserves. The movement of the US
dollar against other currencies in which FCA are held also impact the level of reserves in US
dollar terms.

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Objectives of Foreign Exchange Reserves Management

The main objectives in managing a stock of reserves for any developing country,
including India, are preserving their long-term value in terms of purchasing power over goods
and services, and minimizing risk and volatility in returns. After the East Asian crises of
1997, India has followed a policy to build higher levels of FER that take into account not only
anticipated current account deficits but also liquidity at risk arising from unanticipated capital
movements. Accordingly, the primary objectives of maintaining FER in India are safety and
liquidity; maximizing returns is considered secondary. In India, reserves are held for
precautionary and transaction motives to provide confidence to the markets, both domestic
and external, that foreign obligations can always be met.

Why Is India Accumulating Foreign Exchange Reserves?

There are multiple reasons why India has accumulated large reserves. India was
virtually a closed economy until 1991 and has gradually been opening its economic frontiers
since then. The current account was opened in August 1994, and the capital account is
cautiously, though gradually, being liberalized. In any emerging economy, the desirable size
of reserves can be explained mainly by four factors: the size of the economy, its vulnerability
to the current and capital accounts, exchange rate flexibility, and opportunity cost. In recent
years, some additional factors have emerged for developing economies like India. First, with
increasing financial integration in global markets, movement of capital is swift and FER are
considered as a first defense in a crisis — a selfinsurance — reflecting a lack of confidence in
the current international financial architecture. To illustrate, the Government of India had to
ship 47 tonnes of gold to the Bank of England in June 1991, amidst national humiliation, to
secure a loan of about US$415 million before funds could be arranged from the International
Monetary Fund to ride out the financial crisis. Second, the reserve accumulation in India
could be a reflection of abundant international liquidity in the global economy resulting from
easing of monetary policy in developed countries, especially the United States. Therefore,

8
this could be a short-term phenomenon, which might reverse swiftly with a rise in interest
rates in the developed countries.

Sources of Rising Foreign Exchange Reserves

The main sources of rising FER in India are inflows of foreign investment
(more portfolio than direct) and banking capital, including deposits by non-resident Indians.
In 2004-05, of the total investment of US$12 billion, foreign direct investment amounted to
about US$5 billion. In the current account, a major contribution has been made by computer
services and software exports, mainly banking, financial, and insurance, which increased
from less than US$1 billion in 1995-96 to US$17 billion in 2004-05. In addition, inward
remittances from workers abroad, mainly from Western Europe and the United States, more
than doubled from US$8 billion to US$21billion over a similar period.

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Sources of Accretion to the Reserves
The major sources of accretion to foreign exchange reserves during the period from March
1991 to March 2009. -
Table 2: Sources of Accretion to Foreign Exchange Reserves since 1991
1991-92 to 2008-09
(US$ billion) Items
(up to end March 2009)
A 5.8
Reserve Outstanding as on end-
March 1991
B.I. -81.6
Current Account Balance
B.II. Capital Account (net) 331.7
(a to e)
a. Foreign Investment 155.2
of which: 75.8
(i) FDI 51.6
(ii) FII
b. NRI Deposits 34.1
c. External Assistance 18.6
d. External Commercial Borrowings 68.2
e. Other items in Capital Account* 55.6
B.III. Valuation Change -4.0
Total (A+BI+BII+BIII) 252.0
*: also include errors and omissions.

The foreign exchange reserves (including the valuation effects) declined by US$ 57,738
million during 2008-09 as against an increase of US$ 110,544 million during 2007-08. On
balance of payments basis (i.e., excluding valuation effects), the foreign exchange reserves
declined by US$ 20,080 million during 2008- 09 as against an increase of US$ 92,164 million
during 2007-08. The valuation loss explained 65.2 per cent of decline in reserves during
2008-09. Apart from current account deficits, outflows under FIIs, short-term trade credit to
India and banking capital were the other major sources contributing to decline in foreign
exchange reserves during the financial year 2008-09.

How Are the Foreign Exchange Reserves Managed in India?

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 The Reserve Bank of India (RBI), in consultation with the Government of India,
currently manages FER. As the objectives of reserve management are liquidity and safety,
attention is paid to the currency composition and duration of investment, so that a significant
proportion can be converted into cash at short notice. The essential framework for investment
is conservative and is provided by the RBI Act, 1934, which requires that investments be
made in foreign government securities (with maturity not exceeding 10 years), and that
deposits be placed with other central banks, international commercial banks, and the Bank for
International Settlement following a multicurrency and multi-market approach

The conservative strategy adopted in the management of FER has implications

for the rate of return on investment. The direct financial return on holdings of foreign
currency assets is low, given the low interest rates prevailing in the international markets.
However, the low returns on foreign investment have to be compared with the costs involved
in reviving international confidence once eroded, and with the benefits of retaining
confidence of the domestic and international markets, including that of the credit rating
agencies.

Level of Forex Reserves in India

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 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 thetwelve times the ratio of reserves to
merchandise imports ) which shrank to 3 weeks of imports by theend 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

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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 to16 per cent in
2001.

External Liabilities vis-à-vis Foreign Exchange Reserves

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 The accretion of foreign exchange reserves needs to be seen in the light of total
external liabilities of the country. India’s International Investment Position (IIP), which is a
summary record of the stock of country’s external financial assets and liabilities, is available
as of end December 2008

Management of Gold Reserves

The Reserve Bank holds about 357 tonnes of gold forming about 3.8 per cent of the
total foreign exchange reserves in value terms as on March 31, 2009. Of these, 65 tonnes are
being held abroad since 1991 in deposits / safe custody with the Bank of England and the
BIS.

Risk Management

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 Sound risk management is an integral part of efficient foreign exchange reserves
management. The strategy for reserves management places emphasis on managing and
controlling the exposure to financial and operational risks associated with deployment of
reserves. The broad strategy for reserve management including currency composition and
investment policy is decided in consultation with the Government of India. The risk
management functions are aimed at ensuring development of sound governance structure in
line with the best international practices, improved accountability, a culture of risk awareness
across all operations and efficient allocation of resources for development of in-house skills
and expertise. The risks attendant on deployment of reserves, viz., credit risk, market risk,
liquidity risk and operational risk and the systems employed to manage these are detailed in
the following paragraphs

 Credit Risk
Credit risk is defined as the potential that a borrower or counterparty will fail to
meet its obligation in accordance with agreed terms. The Reserve Bank has been extremely
sensitive to the credit risk it faces on the investment of foreign exchange reserves in the
international markets. Investments in bonds/treasury bills, which represent debt obligations of
highly rated sovereigns and supranational entities, do not give rise to any substantial credit
risk. Placement of deposit with BIS and other central banks is also considered credit risk-free.
However, placement of deposits with commercial banks as also transactions in foreign
exchange and bonds/treasury bills with commercial banks/investment banks and other
securities firms give rise to credit risk. Stringent credit criteria are, therefore, applied for
selection of counterparties. Credit exposure vis-a-vis sanctioned limit in respect of approved
counterparties is monitored continuously. The basic objective of an on-going tracking
exercise is to assess if any approved institution's quality is under potential threat and
accordingly prune down the credit limits or de-list it altogether, if considered necessary. A
quarterly review exercise is also carried out in respect of counterparties for possible
inclusion/ deletion.

⇒ Market Risk

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 Market risk arises on account of exchange rate and interest rate movements. These
are addressed as under:

⇒ Currency Risk

Currency risk arises due to uncertainty in exchange rates. Foreign exchange

reserves are invested in multi-currency, multi-market portfolios. Decisions are taken
regarding the long-term exposure on different currencies depending on the likely movements
in its exchange rate and other considerations in the medium- and long-term (eg., maintenance
of major portion of reserves in the intervention currency, the approximate currency profile of
the reserves in line with the changing external trade profile of the country, benefit of
diversification, etc.). The decision making procedure is supported by reviews of the strategy
on a regular basis.

⇒ Interest Rate Risk

The crucial aspect of the management of interest rate risk is to protect the value of
the investments as much as possible from the adverse impact of the interest rate movements.
The interest rate sensitivity of the reserves portfolio is identified in terms of benchmark
duration and the permitted deviation from the benchmark. The concept of duration is used to
measure and manage interest rate risk. The focus of the investment strategy revolves around
the overwhelming need to keep the interest rate risk of the portfolio reasonably low with a
view to minimising losses arising out of adverse interest rate movements, if any. This
approach is warranted as reserves are viewed as a market stabilising force in an uncertain
environment.

⇒ Liquidity Risk
Liquidity risk involves the risk of not being able to sell an instrument or close a
position when required without facing significant costs. The reserves need to maintain a high
level of liquidity at all times in order to be able to meet any unforeseen and emergency needs.
Any adverse development has to be met with reserves and, hence, the need for a highly liquid
portfolio is a necessary constraint in the investment strategy. The choice of instruments

16
determines the liquidity of the portfolio. For example, Treasury securities can be liquidated in
large volumes without much distortion to the price in the market and, thus, can be considered
as liquid. In fact, excepting fixed deposits held with the foreign commercial banks and the
central banks, almost all other types of investments are in highly liquid instruments which
could be converted into cash at short notice. The Reserve Bank closely monitors the portion
of the reserves which could be converted into cash at a very short notice to meet any
unforeseen/emergent needs.

Issues

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 It is proposed to consider issues covering policy matters; adequacy; and costs and
benefits;

⇒ Policy Matters

First, a critical issue is whether all the external assets are readily available for use.
The management of foreign currency assets in India ensures such availability though in
respect of a large part of gold which is a small part of official reserves, the quality is not in a
form that is readily accepted in international financial markets. There is no likelihood of use
of gold in reserves in the foreseeable future. Nevertheless, India has devised mechanisms by
which a part of the gold holdings of RBI could be converted into usable foreign currency. An
incidental issue relates to the policy on enhancement or otherwise of gold component in the
foreign exchange reserves and the way it is managed. The proportion of gold in our reserves
is coming down in view of accretion to foreign currency reserves and the policy in regard to
both holdings and management has been passive.

Secondly, an issue common to many central banks is the advantage in clearly spelling
out policy objectives in regard to Forex reserves. The mandate as well as the practice in India
clearly indicates that maintaining stability is an overriding objective but the detailing of
objectives has to reckon the changing circumstances. As explained in the presentation on
evolution of policy in India, a very dynamic view, based on multiple indicator approach has
been adopted. In this background, the practice of detailing of the context and objectives as is
being done in the recent Monetary and Credit Policy Statements of Governor Jalan appears to
be very appropriate; since such statements indicate the objectives ex ante, supplementing the
earlier practice of reporting the policy and management, expost in the Annual Report. The
major objective as articulated in recent Policy Statements appears to be to infuse and sustain
confidence in the financial markets on our liquidity position and operate therein as
appropriate, with a view to containing volatility in Forex markets and contributing to
financial stability

⇒ Adequacy or Appropriate Level

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 First, the dominant concern of policy is maintaining confidence in our ability to
provide liquidity and, there is no precise way of defining at what level the confidence factor
would be undermined. In practice, policy makers should make judgements on
(a) the difficulties in reviving confidence once it starts getting eroded;
(b) the focus of market participants on incremental changes more than total size; and
(c) demonstration of willingness to use the reserves when warranted without committing to
do so and getting locked into a straight jacket situation. The issue of managing the level of
reserves thus becomes, in many ways, as important as the level itself.

Secondly, there are judgements involved in assessing whether the level of forex
reserves provides comfort in the face of some weakness in domestic fundamentals. Such a
comfort will perhaps not be forthcoming if the current account deficit is not sustainable or
exchange rate is highly overvalued. For example, it has been argued that high level of
reserves could, under some circumstances, give comfort against weaknesses in the financial
sector or high public debt or encourage laxity in financial and fiscal policies.

Thirdly, many indicators of adequacy of reserves do, to a significant extent, capture

the potential for drawdown by non-residents while the factors governing drawdown by
residents through capital flight are not easily assessed. Hence, the domestic perceptions of
level of reserves add to the comfort in withstanding drawdown through capital flight, and
experience indicates that crisis of confidence in currency often originates among residents.

Fourthly, the leads and lags in trade and even invisibles can significantly influence
supply and demand in markets, particularly when markets are not fully developed. How
should reserve adequacy be assessed with reference to prevalence of such leads and lags? If
the leads and lags can be demonstrably impacted by discretionary administrative measures,
the amount of reserves needed to moderate such leads and lags may be reduced.

Fifthly, where there is lumpiness in demand and supply as is the case in India, the
forex reserves have to be used for meeting the temporary mismatches in forex markets. In
such a situation, the incremental changes in the level of forex reserves may also be
correspondingly large. There is a tendency among the analysts and media to react negatively
to erosion in a more intensive way and positively to addition to reserves in a less intensive

19
way. A higher level of reserves may possibly give greater scope for changes by making them
appear marginal.

Sixthly, it was widely felt that contingent credit lines from private sector could be
negotiated and thus actual level of forex reserves to be maintained may be correspondingly
brought down. The Contingency Credit Line (CCL) from the International Monetary Fund
could also have similar effect. India had not accessed this facility, and in any case, experience
of other countries has not been very satisfactory on this.

Seventhly, bilateral or multilateral relations at government level do provide some

indications, though on a judgemental basis, of the forex resources that may be readily
accessed in case of difficulties. In other words, geopolitical factors do give different levels of
comfort of ready availability of forex resources from official sector through bilateral or
multilateral channels. India has to constantly make and review its assessment of such access,
noting that adequacy of forex reserves needs to be assessed with reference to changing
perceptions of the economy in the market place as well as among governments or the official
sector. In brief, a practical issue is, how much of judgemental, non-economic, and non-market
considerations are relevant in assessing adequacy of Forex reserves?

⇒ Cost and Benefits

First, a major question on the level of reserves relates to the scope for
measuring overall economic costs and benefits of holding reserves. While concepts of
marginal social costs, or opportunity costs are useful for analytical purposes, computation is
difficult though assessments are not impossible.

Second, if it is assumed that the direct financial cost of holding reserves is the
difference between interest paid on external debt and returns on external assets in reserves,
such costs have to be treated as insurance premium to assure and maintain confidence in the
availability of liquidity. The benefits of such a premium are not merely in terms of warding
off risks but also in terms of better credit rating and finer spreads that many private
participants may get while contracting debt. The costs of comfort level in reserves are often
met by some benefits, but both are difficult to measure, in financial or economic, and in
quantitative terms. BIS Review 30/2002 11

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 Third, if the level of reserves is considered to be significantly in the high comfort
zone, it may be possible to add greater weight to return on forex assets than on liquidity thus
reducing net costs if any, of holding reserves.

Fourth, such calculations of costs of holding reserves by comparing return on forex

reserve with costs of external debt may imply that addition to reserves has been made by
contracting additional external debt. In India, almost the whole of addition to reserves in the
last few years has been made while keeping the overall level of external debt almost constant.

Fifth, the costs and benefits of adding or not adding to reserves should be assessed
with a medium-term view. For example, in case there is uncertainty about capacity to acquire
needed reserves at a later date, a country may prefer to acquire them sooner than later.
Indeed, an inter-temporal view of the adequacy as well as costs and benefits of forex reserves
may be in order.

Finally, it is necessary to assess the costs of not adding to reserves through open
market operation at a time when the capital flows are strong. In other words, the costs and
benefits of forex reserves may have something to do with the open market operations, both in
money and forex markets than merely the level itself. In brief, the costs and benefits arise as
much out of open market operations of the central bank as out of management of levels of
reserve

Use of Foreign Exchange Reserves – International Experience

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 International experience in the deployment of FER is scant, but the experience
of Singapore, spanning nearly a quarter of a century, is most interesting. In Singapore, the
Monetary Authority of Singapore (MAS) and the Government of Singapore Investment
Corporation (GIC) basically manage FER. GIC, incorporated in May 1981 as a private
company and wholly owned by the government, manages more than US$100 billion of FER
owned by the government and the MAS as of 2005. GIC, with investments in more than 30
countries, is among the largest fund management companies in the world and has overseas
offices in key financial centers including New York, London, Tokyo and Hong Kong. The
GIC Group comprises four main areas — public markets, real estate, special investments and
corporate services — and a diversified portfolio of equities, bonds, real estate and money
market instruments. GIC’s portfolio returns in US dollars exceeded 5 percent annually during
1981 – 2001. On the pattern of GIC, given its performance, South Korea has established the
Korean Investment Corporation (KIC) in June 2005, with a capital of US $20 billion. Another
interesting case is China, where FER have been utilized to strengthen the financial
institutions. China has transferred funds from its international reserves, held with the People’s
Bank of China (PBC), to a new company, Central Huijin Investment Company (CHIC), set
up in December 2003 and jointly managed by the government and PBC. CHIC has used the
reserves to recapitalize three large banks so far, by injecting equity amounting to US$57.5
billion.

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What Should Concern India in Managing Foreign
Exchange Reserves?

There is considerable consensus that improvements in India’s infrastructure

would have a strong impact on GDP growth, but also that a prudent policy to finance it would
be necessary. At present, significant fiscal problems have been noted in the infrastructure
sector-persistent underperformance of revenue effort with unsustainable tariff structures and
non-transparent subsidy schemes. In terms of financial aspects, many organizations providing
infrastructure services lack creditworthiness, with opaque financial and accounting systems
and limited treasury management systems. The prevailing labour laws are restrictive, dispute
resolution is slow, and transparency and public disclosure are lacking in the absence of
focused rules, orders, and regulations. Therefore, there are concerns and issues that need to be
considered before utilizing FER to finance infrastructure.

Consequently, the most important question for India is: How sustainable are
current account surpluses and capital inflows over the longer term?

First, in a developing country, the current account is generally expected to be

in deficit, but India recorded a surplus during 2001-04, mainly due to high exports of
software and IT-related services.The surplus on the current account could not be expected to
last long, and in 2004-05, with the revival of growth in domestic industry and higher oil
prices in international markets, the current account recorded a deficit of US$6.4 billion, or 1
percent of GDP.

Second, India was a financially repressed economy for many decades until
1991, which generally implies that residents might have held a part of their wealth in
international markets. In recent years, with continued emphasis on liberalization in the reform
process, there is a strong possibility that such off-shore capital might be returning to India as
a part of a one-time portfolio realignment. This reverse flow, however, cannot be assumed to
last. Finally, a significant component of reserves could be sensitive to economic and political
developments in India, especially deposits of non-resident Indians and foreign portfolio
investments that constitute more than half of annual inflows.

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 Another related concern is the quantity and quality of inflows. India, in seeking
to accumulate reserves as well as to globalize, has been encouraging foreign participation by
liberalizing investment regulations in various economic activities, including banking and
insurance. As a result, India has been able to attract more foreign portfolio investment
(outstanding amount at US$44 billion as on as at end March – 2004) than foreign direct
investment (outstanding amount at US$39 billion as on as at end – March 31, 2004). As
foreign portfolio investment is considered less stable than foreign direct investment, with
increasing level of FER, it may become necessary to adopt a cautious approach toward capital
inflows, especially inflows from tax havens, to ensure financial sector stability.

Third, if the primary objective for accumulating FER is the precautionary

motive with liquidity as the key feature of investment, then it may be inappropriate to use
reserves for financing infrastructure. Infrastructure projects in India characteristically yield
low returns on account of low user charges, inefficient technology, and archaic labor laws. In
fact, many infrastructure projects operating in India yield negative returns. For example, the
performance of the electricity boards continues to be dismal despite power sector reforms
initiated since 1991. The State Electricity Boards have continued to record percent during
1991 to 2005, and the difficulties in raising user charges on electricity have continued to deter
private participation in power sector projects despite concerted efforts. In most of the states,
transmission and distribution losses, mainly because of low quality equipment and theft,
range between 30 to 50 percent and in some cases reach 62 percent.

Fourth, some important concerns relate to the political economy aspect of a

federal structure. The provincial governments also may seek such extra-budgetary resources
for urgent public work projects under their administration. In that eventuality, prudent
management of the overall government finances, both federal and provincial, could then
become difficult, as was the recent experience of some countries in Latin America, especially
Argentina. Even in India, with the onset of reforms in 1991 and tightening of the budget
constraints, state government guarantees sharply rose from 4 percent of GDP in 1996 to 8
percent in 2001, when urgent measures were initiated to stem the rise. Also, in a multi-party
coalition democracy, a soft-budget scheme, though imaginative, is susceptible to exploitation.
In India, the scheme of ad hoc Treasury bills initiated innocuously in 1955 and repeatedly
abused until 1997 is an interesting illustration. Further, the confidence of the markets could

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be adversely affected if FER-financed projects are delayed or abandoned for economic or
political reasons.

Finally, ad hoc use of FER to finance infrastructure, as proposed in the Union

Budget, could hinder the operations of the monetary policy and result in higher public debt.
As stressed in the literature, financial engineering that ignores fiscal fundamentals cannot
lead to healthy economic growth. The use of FER for infrastructure would expand the money
supply (foreign currency assets would be sold for Indian rupees) normally requiring
sterilization by the Reserve Bank of India to stabilize the price level. Sterilization is
expensive, as the government rupee bonds issued to mop up excess funds have to be serviced
at the prevailing market interest rates. The supply of the “mop-up” bonds increases domestic
debt — the issuance of which could be used to finance infrastructure in the first place. The
sequential cycle of using FER, sterilization, and issuance of bonds makes domestic monetary
management more difficult.

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List of countries by foreign exchange reserves

At the end of 2007, 63.90% of the identified official foreign exchange reserves in the world
were held in United States dollars and 26.5% in euros [1].

Monetary Authorities with the largest foreign reserves in 2009.

Rank Country/Monetary Authority billion USD (end of month)

1 People's Republic of China $ 2273 (Sep 2009) 1[1]
2 Japan $ 1019 (Jun 2009)[2]
- Eurozone $ 531 (Feb 2009)
3 Russia $ 423 (Oct 2009) 2 [3]
4 Taiwan $ 321.09 (Apr 2009) [4]
5 India $ 281 (Sep 2009) 2 [5]
6 South Korea $ 254 (Sep 2009)[6]
7 Hong Kong $ 233 (Aug 2009)
8 Brazil $ 233 (Oct 2009) 3[7]
9 Germany $ 184 (Sep 2009)
10 Singapore $ 182 (Sep 2009)

These few holders account for more than 60% of total world foreign currency
reserves. The adequacy of the foreign exchange reserves is more often expressed not as an
absolute level, but as a percentage of short-term foreign debt, money supply, or average
monthly imports.

On July 15, 2009, the People's Bank of China announced China's foreign
exchange reserve had reached $2.132 trillion by far the largest holders of foreign exchange
reserves and the first time a country had surpassed the $2 trillion benchmark

Conclusion

The rising levels of FER have succeeded in infusing necessary confidence, both to
the markets and policy makers. However, neither the capital inflow to India nor the size of

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FER is disproportionately large when compared to some other countries in the region. The
main sources of accretion to FER are exports of IT-related services and foreign portfolio
investment-not foreign direct investment (which is more stable), as in the cases of China and
Singapore. Therefore, India, which is accumulating FER for precautionary and safety
motives, especially after the embarrassing experience of June 1991, should avoid utilizing
reserves to finance infrastructure. Infrastructure projects in India yield low or negative returns
due to difficulties — political and economic — especially in adjusting the tariff structure,
introducing labor reforms, and upgrading technology. The use of FER to finance
infrastructure may lead to more economic difficulties, including problems in monetary
management. However, if India continues to accumulate reserves and seeks to enhance the
returns on FER in the future, it may consider establishing a separate investment institution on
the pattern of the GIC.

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