Ref. No.

: MEBE0029

As per the lease agreement dated 15th May, 1991 entered into between Government of India (GOI) and State Bank of India (SBI), GOl leased to SBl, 20 metric tonnes of gold to raise foreign exchange reserves expected to be of the order of $200 million.1 Mr. Rameshwar Thakur, Minister of State for Finance, India

The introduction of Foreign Exchange Regulation Act in 1973 helped India to build up its foreign reserves. In the late 1970s, the prices of oil increased again. In 1980, the deficit in Indias trade account had to be financed by taking loan from the IMF. In 1990, the Gulf war led to increase in oil prices, which resulted in a balance of payment crisis in India. India did not have enough foreign reserves to fund this gap and it had to approach IMF for financial aid. In 1991, India devalued its rupee, followed by changes in its exchange rate regime. The exchange rate regime is the way a

Murali D., When pauper turns prince, there are new worries, http://www.blonnet.com/2003/01/18/stories/ 2003011800040800.htm, January 18 th 2003

This case study was written by Bhavika N under the direction of G Srikanth. Revised (in september 2009) by Hepsi Swarna, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources. 2004, IBSCDC. No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without the permission of the copyright owner.

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After its independence from the British in 1947, India formulated all its economic policies on the objective of attaining self-reliance. The Indian government economic reforms helped India to accumulate foreign reserves to as high as $100 billion by the end of 2003. To attain productivity and self-efficiency, the government realised the need to attract foreign capital to India. To encourage foreign investment, the government introduced many reforms and policies, starting with the Industrial Policy Statement of 1948 and the Five Year Plans in 1951. The First Five-Year Plan aimed at industrialisation of the country, which required importing a lot of machinery. In 1957, increasing imports led to balance of payment crisis, which was financed by using the foreign reserves. In the 1960s, the Indian foreign reserves declined after the war between India and Pakistan. In the mid1960s, the food prices increased due to severe droughts in the country. Further there was increase in the prices of oil imports in the early 1970s and the foreign reserves were used to maintain stability in the economy.

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Indias Forex Reserves

Indias Forex Reserves

Foreign Exchange Reserves through the Years

Immediately after Indias independence, the Economic Programmes Committee of the Congress Party presented the Industrial Policy Statement of 1948 (IPS 48). The IPS 48 stated that foreign capital was an important resource for India, which would help bring industrialisation in the country. Later, on April 6th 1949, Jawaharlal Nehru, the first Prime Minister of India, submitted a policy statement on foreign capital to the Indian Parliament. This document stated the role and place of foreign capital in explicit terms. The Planning Commission was established in 1950, to develop the nations economic conditions. The Planning Commission introduced the Five-Year Plans. The First Five-year Plan (19511956) aimed at raising domestic savings and bringing industrialisation in the country. During the First Plan the balance of payment deteriorated as the country imported machinery and other producer goods to encourage industrialisation. The gap in the balance of payment was financed by using the sterling balances.5

In the foreign exchange market one currency is traded for another. In Forex market banks, speculators, multinational corporations and other financial institutions easily buy and sell currencies. The Forex market like any other market is governed by the law of demand and supply. Demand and supply of a currency in the Forex market determines the exchange rates.

Agarwal N.R, Exchange Rate Determination in India Endogenising Foreign Capital Flows and Some Entities of the Monetary Sector, http://www.iegindia.org/dispap/dis13.pdf, page 2 and page 4 Exchange Rate Management: An Emerging Consensus?- Part I", http://www.banknetindia.com/banking/jalan2.htm India had accumulated sterling balances from Britain during the pre-independence period.

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In 1957, as India entered the Second Five-Year Plan, it had a shortage of foreign exchange. The country did not have enough foreign exchange balance to fill in the trade deficits. Recognising the need for foreign exchange, the government entered into an agreement with the IMF in February

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country manages its currency in respect to foreign currencies and the foreign exchange (Forex) market2. Floating exchange rate system is the most common exchange rate regimes in todays world. In floating exchange rate system, a countrys currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Floating exchange rates change freely and are determined by trading in the Forex market. US dollar, Euro, Pound and Yen all float. Whereas under fixed or pegged exchange rate regime, the exchange rate is fixed by the central government, and the currency is tied to another currency or gold, and the currency moves in tandem with the currency to which it is tied. The exchange rate in India had not been fully floating until the financial year 1992-1993. Even after this the exchange rate market has required intervention on many occasions by the Reserve Bank of India that sold US dollars in the spot and forward markets... The exchange rate regime in India can best be characterised as intermediate, i.e. between fully managed and freely floating regimes.3 This holds true for other countries also, as Most common exchange rate regime adopted by countries, including industrial countries, is not a free float. Most of the countries have adopted intermediate regimes of various types, such as, managed floats with no pre-announced path, and independent floats with foreign exchange intervention moderating the rate of change and preventing undue fluctuations. By and large, barring a few, countries have managed floats and Central Banks intervene periodically. This has also been true of industrial countries. In the past, the U.S., the EU and the U.K. have also intervened at one time or another. 4

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Indias Forex Reserves

Finally in June 1966, India devalued the rupee by 57.5%, from 4.7 rupees to 7.5 rupees per dollar8 (One British Pound = 2.754 US dollars in 1966). The devaluation was accompanied by liberalising the import policy. The import tariffs were reduced and the export subsidies were lowered. The devaluation was unable to increase the exports of the country because of the abolition of subsidies. In five months after the devaluation, India received an aid of only $465 million from the World Bank. The aid of the World Bank was made on the condition that India would devalue the rupee. If we had waited another six months, we would have had absence of imports in India9 said the then Finance Minister Sachindra Chowdhury, when he was asked as to why the government did not wait for another six months before going for devaluation. But again by 1968, the liberalisation policy was changed and the import controls were re-imposed. Further, in order to promote exports of non-traditional goods like, engineering goods, chemicals, plastics, paper goods, sports goods and processed foods, many schemes were started. These schemes included the duty drawback scheme10, import replenishment scheme11 and cash assistance schemes. These schemes diversified the structure of the exports. The exports of engineering goods increased during the mid-1960s. But many of the engineering firms were started with foreign collaborations and their

6 7 8

The Bank and 1957 Forex Crisis, http://www.ieo.org/world-c2-p2.html Ibid. Panagariya Arvind, India in the 1980s and 1990s: A Triumph of Reforms, http://www.imf.org/external/np/apd/seminars/ 2003/newdelhi/pana.pdf, November 6 th 2003, page 14 The Bank and 1966 Forex Crisis, http://www.ieo.org/world-c2-p3.html A duty drawback scheme is a form of Border Tax Adjustment whereby the duties or taxes levied on imported goods are refunded, in whole or in part, when the goods are re-exported. Import replenishment scheme enabled registered exporters to obtain raw materials, components and spares against export of specified products.

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To promote foreign investment in India, the Indian Investment Centre was set up in 1961. It had offices in major investing countries. In the early 1960s, India had accumulated trade deficits. The Government of India also had a budget deficit problem. In 1962, the government subsidised the exports, as a step to reduce the current account deficit. Import tariffs were imposed to increase the governments revenue. The government also tried to increase the money supply, by issuing bonds to the Reserve Bank of India (RBI). By taking these measures the government tried to maintain the exchange rate, though the inflation was increasing. In 1964, the World Bank submitted a report on Indian economic policy. The report stated that India should devalue the rupee and abolish the foreign trade controls. In 1965, a financial aid from America was suspended, due to the war between India and Pakistan. India also suffered due to two years of drought in 1965 and 1966.

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1957 for financial aid, which was soon exhausted by June 1957. In the same year the Indian government approached the US and the World Bank for loans. To receive these loans, the government had to take measures to facilitate foreign investment. In 1958, India received a credit of more than $600 million from the US, Germany, Britain, Japan, the World Bank and the IMF.6 Thereafter Indian collaboration with the western companies increased. Around 150, 380 and 403 foreign collaborations took place in 1959, 1960 and 1961 respectively. The total outstanding foreign investment which was $1.007 billion in December 1956, increased to $2.014 billion by March 1965.7

Indias Forex Reserves

Exhibit I Foreign Exchange Regulation Act 1973

Finally on September 19th 1973, the FERA was amended. Under FERA 1973, foreign companies operating in India were asked to reduce their share in equity capital of their Indian companies to below 40%, unless they were engaged in specified coreactivities, or used sophisticated technology, or met certain export commitments.
Compiled by the author

For the Fourth Five-year Plan (19691974), India took a gross external assistance of Rs. 3,830 crores. During 19731975, there was a shortage of food, which gave rise to inflation. The inflation increased from 5.6% in 19711972 to 25.2% in 19741975.15 The consumer price index rose by 31.8%16 between March 1974 and September 1974. Following the Indo-Pakistan war of 1972, the prices of oil rose from $2.7 per barrel in September 1973 to $11.2 per barrel in September 1974.17 The steep rise in the price of imported oil and other material led to a gap in the balance of payment. But after 1975, there was an increase in the exports and a rise in the remittances also. The exports increased as a result of the hidden devaluation of the
12

Tarlok Singh, Balance of Trade, Exchange Rate And Trade Policy Regimes In India: Some Issues And Policy Perspective, The Indian Economic Journal 48(1), 2000 Ibid.

13 14

Under the MRTP Act 1969, all applications for a license from companies belonging to a list of big business houses and subsidiaries of foreign companies were to be referred to an MRTP Commission, which invited objections and held public hearings before granting a license. Bhalla G. S., Political Economy of Indian Development in the 20th Century Indias Road to Freedom and Growth, The Indian Economic Journal 48(3), JanuaryMarch 2001 A Review Of The Economic Situation, http://www.education.nic.in/cd50years/15/8P/83/8P830101.htm Political Economy of Indian Development in the 20th Century Indias Road to Freedom and Growth, op.cit.

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In 1947, the Foreign Exchange Regulation Act (FERA) was enacted as a temporary measure, which was later made permanent in 1957. It was enacted to regulate the entry of foreign capital in the form of branches and to control the non-resident interest, employment of foreigners, etc. In June 1971, the Parliament of India studied the question of the leakage of foreign exchange through invoice manipulation.

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agreements contained clauses, which restricted their exports for five to ten years. Along with the exports, the imports of the country also increased. The successive droughts had increased the requirement of importing food products. During the Three Annual Plan period (19661969), there was a trade deficit of Rs.710.6 crore12. The current account deficits during the three annual plans were entirely financed in the form of loans. The loans increased from Rs.448.1 crore during the Third Five-Year Plan to Rs.897.3 crores per annum during three annual plans. 13 The government controlled the trade by introducing the Monopolies and Restrictive Trade Practices (MRTP) Act in 1969.14 Further in 1973, the government introduced the Foreign Exchange Regulation Act, which restricted the foreign investment in India. (Exhibit I).

Indias Forex Reserves

During the late 1980s, India had forex reserves of nearly $5.5 billion.22 The RBI had deposited part of these reserves with Indian banks situated abroad. In August 1990, the Iraq-Kuwait war led to increase in the prices of oil. At the same time the exports and remittances from abroad also fell. By September 1990, $660 million were withdrawn from the IMF to add to Indias reserves. By 19901991, the external debt was $83.8 billion. During the same period, the foreign reserves were $5.8 billion. In January 1991, India had forex reserves equal to only two weeks of imports. At such a time when RBI required these reserves in the midst of the balance of payment crisis, the Indian banks were unable to give back the reserves to RBI on time. India took a loan of $1.8 billion from IMF in January 1991 and another loan of $2.3 billion in October 1991. In March 1991, the currency reserves reduced to $2.1 billion, which was less than six weeks of imports.23 Between March 1991 and June 1991, the non-residents withdrew their deposits worth $952 million, which further reduced the forex reserves.24 In May 1991, the Indian government pledged 20 tonnes of its gold reserves with the State
18 19 20

Balance of Trade, Exchange Rate and Trade Policy Regimes in India: Some Issues and Policy Perspective, op.cit. Political Economy of Indian Development in the 20th Century Indias Road to Freedom and Growth, op.cit. Kamath J Shyam, Foreign Aid and India: pub_display.php?pub_id=1030&full=1, May 6 th 1992 Ibid. Financing the Leviathan State, http://www.cato.org/

21 22

Vikraman Shaji, Forex reserves: Use and misuse, http://www.blonnet.com/2002/09/16/stories/2002091600140900.htm, September 16th 2002 Foreign Aid and India: Financing the Leviathan State, op.cit Rangarajan C, BoP crisis of 1990-91: Overcoming the forex constraint, http://www.financialexpress.com/old/fe20010702/ an1.html, July 2 nd 2001

23 24

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Again in 1979-1980 the prices of oil increased. The trade deficit of India also widened from $1.5 billion in 1979 to $7.7 billion in 1980. In 1980, the government of India took a loan of $5.8 billion under the IMFs Extended Fund Facility.20 In 1980-1981, India had accumulated an external debt of $23.5 billion, whereas its foreign exchange reserves amounted to $7.4 billion. In the 1980s, India had a growth rate of 5.46%, when compared to 3.45% during the 1970s. The exports had also recorded a growth of 10% per annum. During the mid and late 1980s, India borrowed huge amounts from the IMF and the World Bank to fill in Indias budget deficits. Indias fiscal deficit was widening as the government increased its expenditure on subsidies, public sector employment and interest payments for government debt. The annual borrowing of the government increased 55 fold from 1981-1982 to 1989-1990.21 Between 1980-1981 and 1990-1991, the revenue receipts increased at 16.6% per annum, whereas the revenue expenses rose at 17.1%.

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rupee that took place. Before 1975, the rupee was pegged to the pound, and as the value of pound depreciated against the dollar, the rupee value also depreciated, which increased Indias exports. However in 1975, the rupee was pegged to an undisclosed currency basket. At the end of the Fourth Five Year Plan the trade deficit had reduced to Rs.346.3 crore. The net invisible surplus (including transfer payments) also increased from Rs.23.4 crores during the three annual plans to Rs.275.5 crores during the Fourth Five-Year Plan.18 In the later 1970s, oil deposits were found in the Gulf and other west Asian countries. Remittances increased as large number of Indian workers were attracted towards the gulf countries. In 1978, India had foreign exchange reserves of $7 billion, and the reserves covered nine months of import.19

Indias Forex Reserves

Exhibit II Indias External Debt (in millions of dollar)

I. Multilateral A. Government borrowing B. Non-government borrowing a. Public sector b. Financial institutions c. Private sector II. Bilateral A. Government borrowing B. Non-government borrowing III. IMF IV. Export credit V. Commercial borrowing 1991-92 23,090 21,651 1992-93 25,008 23,247 1993-94 26,263 24,158 1994-95 28,542 26,127 1995-96 28,616 26,059 2,557 1,353 721 483 19,213 15,535 3,678 2,374 5,376 13,873 1996-97 29,218 26,369 2,849 1,318 665 866 17,494 13,652 3,842 1,313 5,861 14,335 1997-98 29,553 26,344 3,209 2,216 550 443 16,969 12,998 3,971 664 6,526 16,986

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Source: http://exim.indiamart.com
25 26

BoP crisis of 1990-91: Overcoming the forex constraint, op.cit. Chauvin Sophie and Lemoine Francoise, India in the World Economy: Traditional Specialisations and Technology Niches http://www.cepii.fr/anglaisgraph/workpap/summaries/2003/wp03-09.htm, August 9 th 2003

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1,439 458 754 227 15,466 13,099 2,367 3,451 3,990 11,715 1,761 572 928 261 16,154 13,578 2,576 4,799 4,322 11,643 2,105 891 869 345 17,450 14,519 2,931 5,040 5,203 12,363 2,415 1,033 813 569 20,270 16,841 3,429 4,300 6,629 12,991

In December 1991, a High Level Committee was set up to examine and recommend a strategy for maintaining the balance of payments. The committee made recommendations on the size of the current account deficit, the level of foreign exchange reserves and the structure of external debt. After devaluation of the rupee, the government introduced the EXIM scrip scheme, which allowed the exporters to import 30% of the value of their exports. But in March 1992, the scheme was abolished and a dual exchange rate regime, known as the Liberalised Exchange Rate Management System (LERMS) was established. According to this system, 40% of the current receipts had to be surrendered to the RBI at the official exchange rate and the balance 60% were converted at the market rate. In March 1993, when the rupee was set to float, the foreign currency assets had increased to $3.4 billion. But at the same time, the external debt payable to the IMF alone was around $4.8 billion (Exhibit II). In August 1994, the RBI established full convertibility for the current account transactions.26

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Bank of India, which in turn sold the gold to an international bank with a repurchase option. RBI also pledged 46.9 tonnes of gold with the Bank of England to raise a temporary loan of $405 million. The Bank of England and the Bank of Japan provided the loan jointly.25 In June 1991, the foreign currency assets of RBI were $1.12 billion. During the first week of July 1991, India devalued the rupee by between 18% and 19% against major international currencies. By July 12th 1991, the currency reserves had decreased to $975 million, which was hardly equal to a weeks imports.

Indias Forex Reserves

Exhibit III Key Components of India's Balance of Payments - INR

Item I 2001-2002

Merchandise A) Exports B) Imports

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By the end of 1996-1997, the foreign exchange reserves rose to $26.4 billion (Annexure I). At the same time, the current account deficit was only 1% of the GDP. From 1994 to 1997, Indias GDP grew at an average of 7%. Following the Asian crisis in 1997-1998, Indias exports decreased by 5% for the year 1998. But the FDI increased to $2.4 billion for the same year.27 From 1997, India started removing the quantitative restrictions on its foreign trade. On June 1st 2000, the RBI replaced the FERA 1973, with the Foreign Exchange Management Act (FEMA), 1999. The objective of FEMA was to facilitate external trade and payments and to promote orderly maintenance of the foreign exchange markets in India.28 By April 2001, India removed all the restrictions on its trade, but it still retained some non-tariff barriers on certain sensitive products. In May 2001, the government allowed foreign investment of 100% in several industrial sectors, as well as in the pharmaceutical industry, tourism and hotel industry. Later the limits on the investment made by the Foreign Institutional Investors in Indian companies were increased from 30% to 40%.29 At the end of the financial year 2001-2002, India's forex assets were $54.106 billion.30 Of this, $51.049 billion was in form of foreign currency reserves, $3.047 billion was in gold reserves and the remaining in Special Drawing Rights (SDR). The amount of gold reserves has more or less remained the same since 1990-1991. The amount of foreign currency assets has increased significantly in this decade. The BoP statement (Exhibit III), gives a clear indication of the source of forex reserves in the country.

Trade Balance (A B) II III IV Invisibles, net

Current Account (I + II) Capital Account (A to F) A) Foreign investment B) External assistance, net

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C) Commercial borrowings, net

27 28

India: Background http://sg.bis.yahoo.com FEMA relaxes forex limits, promises transparency, http://www.thehindubusinessline.com/2000/06/03/stories/14030867.htm, June 3rd 2000 India in the World Economy: Traditional Specialisations and Technology Niches, op.cit. Table 165: Foreign exchange reserves, http://www.rbi.org.in/scripts/PublicationsView.aspx?id=8715

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213345 268300 -54955 71381 16426 40167 38861 5819 -7543 Contd...

Indias Forex Reserves

D) Rupee debt service E) NRI deposits, net F) Other capital V VI VII VIII IX Overall balance (III + IV) Monetary movements (VII + VIII + IX) Reserves (increase / decrease +) IMF, net SDR allocation

-2457 13127 -7640

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56593 -56593 -56593 0 0

Source: Key components of Indias balance of payments rupees, http://www.rbi.org.in/scripts/ PublicationsView.aspx?id=8700, September 18 th 2006

Increase in foreign investment inflows, trade flows and currency gains due to the weakness of the dollar against the global currencies, led to the foreign exchange reserves reaching $100 billion 31 on December 19th 2003. In 2003, the rupee value had increased by around 5.4% against the dollar. For the same year, the net foreign investments in Indian assets were $7.1 billion. India had prepaid around Rs.14,015 crore of offshore debt, which it owed to foreign financial institutions. 32 India's forex reserve position by the end of 2002-2003 was comfortable (Exhibits IV and V). We are clear that it is a beginning and a good beginning,33 said Jaswant Singh, Union Finance Minister. On April 16th, 2004, India's forex reserves were $117.6 billion and it probably exceeded its external debt, which was $112 billion at the end of 2003.34

31

Dash Ranjan Priya, Forex reserves cross $100-bn mark, http://timesofindia.indiatimes.com/Business/India-Business/Forexreserves-cross-100-bn-mark/articleshow/372452.cms, December 21 st 2003 Forex kitty to help pay back foreign debt, http://www.telegraphindia.com/1040328/asp/business/story_3056709.asp, March 28 th 2004 Fine-tune administrative reforms: Jaswant", http://www.blonnet.com/2004/03/01/stories/2004030101740500.htm, March 1st 2004 DJ India Forex Reserves $117.592B; +$1.532B In Wk End Apr 16, www.isteelasia.com, April 24 th 2004

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In 2001-2002, India had a trade deficit, as imports were greater than exports. The income from the Invisibles account was greater than the trade deficit, and resulted in a surplus in the current account. Foreign investments, external assistance and NRI deposits contributed to the surplus in the capital account. Overall there was a surplus in the BoP, implying net income inflow into the country. Corresponding to the surplus in the BoP is the increase in forex reserves by an equal amount. The reserve position is strengthened by the Invisibles account and foreign investments. The Invisibles account includes income from services like travel, transportation, insurance and miscellaneous items. Income from software services mostly to overseas clients, which forms a major part of miscellaneous services, is an important source of foreign exchange.

Indias Forex Reserves

Exhibit IV Forex Reserves of India and Some Other Asian Countries

($ billion, at end of the period) Country Japan China Taiwan South Korea Hong Kong India
Compiled by the author

2001 401.5 212.2 122.2 102.8 111.2 48.1

2002

460.5 286.4 159.1 121.4

Exhibit V Reserve Adequacy Indicators of India (in Percentage)

Net Foreign Import cover Reserves to Reserves to Reserves to Reserves to Exchange of Reserves Reserve Broad External Short-term Assets to (months) Money Money Debt debt Currency 2.5 5.3 4.9 8.6 8.4 13 24 4.3 7.5 8.4 7 68.3 130.4 155.1 530.9 590 430.8 392.8 582 760.2 966.4 1,165.40 1,971.10 1,650.90 14.4 29.6 31.8 60.2 71.4 60.4 69.1 76.7 78.5 84.2 90.4 105.2 126.8

Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03

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6.9 8.2 8.2 8.6 11.3 13.8

Source: Foreign Exchange Reserves 2002-03 www.rbi.org.in

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10.8 10.9 20.8 25.4 23.1 28.3 31.4 33.5 38.7 41.8 54.8 72 27.8 43.6 47.1 38.3 47.5 51.2 53.2 59.1 65 78.1 97.1 14 15.1 12.4 13.6 14.1 14.1 14.8 15 17.6 20.8 6 6.5

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2003 673.5 403.3 206.6 155.4 111 118.4 70.3 100.6

Indias Forex Reserves

Management of Forex Reserves

The sterilisation process is through the sale of rupee-denominated securities to domestic financial institutions and commercial banks. When commercial banks increase their stock of government securities, they effectively increase their reserve ratios reducing the stock of money available for lending operations of banks. This invariably leads to a rise in interest rates in the economy. High interest rates on one hand attracts fresh deposits into banks, but on the other hand reduces lending. Thus, by intervening in the currency market the central bank influences other monetary variables like money supply and interest rates. The legal provisions governing the management of forex reserves are set out in the RBI Act, 1934 (Exhibit VI) and the FEMA, 1999.

35 36

Forex reserves touch $200 bn in FY06-07, http://www.financialexpress.com/fe_full_story.php?content_id=160363 Key components of India's balance of payments - rupees, http://www.rbi.org.in/scripts/PublicationsView.aspx?id=8700, September 18th 2006

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When foreign exchange inflows are greater than the demand for foreign exchange, the central bank to keep the value of the currency stable, intervenes in the currency market and mops up the excess foreign currency. The Reserve Bank of India (RBI), in consultation with the Government of India together manage the foreign exchange reserves. RBI has been intervening in the currency market by buying dollars to prevent the rupee from appreciating. The RBI has been absorbing dollars generated as a result of exports, remittances from non-resident Indians, portfolio investments, foreign direct investments and corporate borrowing or External Commercial Borrowings (ECB). The direct effect of the RBI's intervention is the increase in the monetary base or increase in money supply; that is, the RBI has to print rupees to buy dollars. Currency stabilisation is not the only objective of the RBI; analysts opine it must also maintain domestic price stability. Increase in money supply causes inflation because too much money chases too few goods. The RBI must sterilise the increase in money supply to control inflation.

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Indias foreign exchange reserves rose to $199.179 billion on March 30th 2007.35 This is a record increase of almost $50 billion over the previous year. Between 2000 and 2006, the domestic forex reserves increased at 15.66% compound annual growth rate.36 This is a complete turnaround from the crisis situation that India experienced in 1991, when it did not have enough forex reserves to cover the Balance of Payments (BoP) deficit.

Indias Forex Reserves

Exhibit VII Framework of Foreign Reserves Management in India

Deposits with Bank for International Settlements (BIS) and other Central Banks Deposits with foreign commercial banks

Debt instruments representing sovereign/sovereign-guaranteed liability. Residual maturity for debt papers should not exceed 10 years Other instruments or institutions as approved by the Central Board of RBI.

Compiled by the author from www.tradelawonline.com and www.thehindubusinessline.com

37 38

Import cover is the trade-based indicator for the appropriate level of forex reserves. Foreign Exchange Reserves 200203 www.rbi.org.in

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Before the crisis of 1991, Indias approach to manage the forex reserves was based on the trade related indicators. It maintained its reserves in relation to its imports (Exhibit VII). But in 1992, as RBI changed the exchange rate regime, it also changed its emphasis from the import cover 37 to the exchange rate. The main objective of managing the forex reserve from 1992 has been to smoothen the volatility in the exchange rate of the country. After the Asian crisis of 19971998, RBI identified that, to hold reserve assets, factors such as, the stock of short-term and volatile external liabilities, shift in the pattern of leads and lags in payments/receipts during exchange market uncertainties along with the conventional norm of cover for sufficient months of imports should be considered. 38 The RBI also takes into account the foreseeable risks such as the credit risk, market risk and operational risk.

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At the end of September 2003, the total foreign currency reserve was $87.2 billion. Foreign currency worth $31.7 billion was invested in securities, $39.6 billion was deposited with other central banks & BIS and $15.8 billion was deposited with foreign commercial banks. In December 2003, India had invested $15.5 billion worth of its foreign currency in U.S government securities. But by February 2004, it reduced the investment to $12 billion after RBI sold part of the securities. Bankers said that the cash reserves were switched from dollar to other currencies, like the pound sterling. This was done to improve the interest earnings. The interest rates on pound sterling were 0.5% to 1% high than the dollar rates. There was also the advantage of the sterling appreciating against the dollar.

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The forex reserves are invested in multi-currency, multi-market portfolios as per the norms provided in the RBI Act, 1934. The investment categories permitted by the RBI Act are:

Indias Forex Reserves

Exhibit VII Appropriate Level of Forex Reserve in a Developing Economy

Money based indicators, include reserves to broad money or reserves to base money, which provide a measure of potential for resident based capital flight from currency. Trade based indicators define the reserves in months of imports. Also called import-based indicators. Debt based indicators are defined as reserves to short-term debt.

By the end of 2003, many developing countries had built up huge levels of forex reserves (Exhibit IV). Global foreign exchange reserves had almost doubled from 4.1% to 7.8% of world GDP between 1990 and 2002. The strengthening of the forex reserves by the developing countries reflects the lack of confidence in the international financial structure. It also reflects the efforts that are taken to contain the risks from various external shocks. The developing countries are trying to control the volatility in the foreign exchange markets. The easing of the monetary policies by the industrialised countries has allowed excess liquidity to flow into the emerging markets. This has made the developing nations accumulate high reserves.
Compiled by the author from www.bis.org and www.rbi.org.in

Between April 2006 and February 2007, the RBI purchased $24.517 billion, when the exchange rate was between INR 44.78 and INR 44.12 per dollar. At the exchange rate of INR 42 per dollar in April 2007, the foreign exchange it purchased was worth less by INR 5,916 crore. Thus the RBI has incurred a loss of almost INR 6,000 crore through currency conversion, in accumulating foreign exchange.40 Some economists feel RBI's frequent intervention in the exchange market is the cause
39 40

Foreign Exchange Reserves 200203 www.rbi.org.in FII party isnt about to stop any day soon, http://www.thehindubusinessline.com/2007/04/17/stories/2007041704830600.htm, April 17th 2007

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From the late 1990s to 2004, the approach to management of Indias forex reserves has been based on the size of the current account deficit; the size of short-term liabilities (including current repayment obligations on long-term loans); the possible variability in portfolio investments and other types of capital flows; unanticipated pressures on the balance of payments arising out of external shocks; and movements in the repatriable foreign currency deposits of non-resident Indians. 39 The RBI ensures that the reserves would be able to cover the liquidity at risk, which is associated with the different types of flows and other requirements.

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Liquidity Risks give the ratio of short-term debt augmented with a projected current account deficit. It indicates, how long a country can sustain external imbalance without resorting to foreign borrowing.

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The level at which marginal social cost equals marginal social benefit can be termed as the optimum level of reserves. Four sets of indicators can be assessed to judge the optimum level of reserves.

Indias Forex Reserves

of the loss. At the end of 2006, the RBI had absorbed $9 billion worth of ECB, the preferred route through which Indian companies borrow from foreign financial markets. The excess inflow of foreign exchange through this route, led to liquidity and exchange rate management problems.

Exchange Rate Management and Capital Account Convertibility (CAC)41

In August 1994, Indian economy adopted Current Account Convertibility42, under Article VIII of the IMF's Articles of Agreement. In 1997, the first Tarapore Committee set up by RBI, recommended the liberalisation of India's capital account in a phased manner over 3 years, with objective of making available credit at cheap rates to Indian businesses in the international financial markets. The Committee laid out three conditions before full convertibility on the capital account could be implemented: fiscal discipline, reducing inflation and reforming the financial system. Prime Minister Manmohan Singh on 18th March 2006 said there was merit in India moving towards fuller capital account convertibility.43 India's move towards greater capital account convertibility leads to a conflict between monetary policy autonomy and exchange rate stability. This is related to the problem of the 'impossible trinity', which implies that a country cannot simultaneously achieve the three macroeconomic objectives: fixed exchange rate, freedom to formulate the monetary policy and capital account convertibility. However, of the three preconditions for full capital account convertibility, only reduction of inflation has been achieved. Fiscal consolidation is yet to take place - the share of public sector deficit to GDP is 7.7% in 2005-2006, and total public debt is 83% of GDP.44 And reform of financial sector is also yet to be achieved. In a bid to attract foreign investment, many developing countries went in for CAC in the 80s not realising that free mobility of capital leaves countries open to both sudden and huge inflows as well as outflows, both of which can be potentially destabilising Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank and the IMF realised that the dangers of going in for CAC without adequate preparation could be catastrophic. Since then the received wisdom has been to move slowly but cautiously towards CAC with priority being accorded to fiscal consolidation and financial sector reform above all else.45 Moreover, the move towards capital account convertibility presupposes a flexible exchange rate policy, by which change in capital flows is reflected by change in the exchange rate rather than build up of foreign exchange reserves. However, with domestic economic objectives in place, such a policy stance would be difficult for an emerging economy like India.

41

CAC for Indian Economy refers to the abolition of all limitations with respect to the movement of capital from India to different countries across the globe. In other words, CAC is the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.

42

Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. Capital Account Convertibility in India Special Feature, http://www.banknetindia.com/banking/jalan1.htm Williamson John, Why Capital Account Convertibility in India Is Premature, Economic and Political Weekly, May 13 th 2006, pages 1848-1850 http://www.welcome-nri.com/cac.htm

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Indias Forex Reserves

Annexure I Reserves of India ($ million)

Gold 1950-51 1960-61 1961-62 1962-63 1963-64 1964-65 1965-66 1966-67 1967-68 1968-69 1969-70 1970-71 1971-72 1972-73 1973-74 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980-81 1981-82 1982-83 1983-84 1984-85 247 247 247 247 247 247 243 243 243 243 243 243 264 293 293 304 281 290 319 377 375 370 335 324 320 325 SDRs Foreign currency 1914 Total 2161 637 624 619 642 490 626 638 718 769 1094 975 1194 1219 1325 1379 2172 3747 5824 7268 6761 6823 4390 4896 5649 5952 Contd... 14

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123 148 269 297 296 293 234 217 200 470 62 603 473 291 230 145

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390 377 372 395 243 383 395 475 526 728 584 661 629 736 782 1657 3240 5305 6421 6324 5850 3582 4281 5099 5482

Indias Forex Reserves

1985-86 1986-87 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03

417 471 508 473 487 3496 3499 3380 4078 4370 4561 4054 3391 2960 2974 2725 3047 3534

131 179 197 103 107 102 90 18 108 7 82

5972 5924 5618 4226 3368 2236 5631 6434

6520 6574 6323 4802 3962 5834 9220 9832

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2 1 8 4 2 10 4

Source: http://exim.indiamart.com

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15068 20809 17044 22367 25975 29522 35058 39554 51049 71890

19254 25186 21687 26423 29367 32490 38036 42281 54106 75428