Since the Asian financial crisis in 1997, the world has seen foreign currency reserves holdings in Asian countries skyrocket. China and India rank as second and fifth in foreign currency reserve holdings in the world, respectively. Together, the Asian emerging countries comprise approximately 40% of all world foreign currency holdings. The amount of reserves being held is one of the highest in history. Because of this, it is interesting to examine the factors that are driving this increase in reserves. It is important to examine why countries would hold large amounts of reserves. To that extent, there is an ongoing debate on whether having large holding of international reserves is beneficial or not. The critics’ main argument is that those resources could and should be used in a more productive manner to develop the economy, such as investing in building roads, bridges and schools.
In particular, the Indian Planning Commission Chairman announced on October 12th, 2004 the viability of using foreign reserves to finance local infrastructure projects. In his opinion, since the reserves are enough to finance 17 months of imports, excess reserves should be used to finance projects that would help India eradicate poverty. On the other hand, those who support large holdings of reserves argue that the opportunity cost of holding the foreign reserves is small compared to the economic consequences of sharp devaluation of the currency.
Reserves are held to influence the exchange rate of a currency and prevent devaluations. This is done by purchasing and selling the country’s own currency to affect its demand and supply; thus, helping maintain a stable value in the international markets. This argument is valid mostly for emerging economies, whose debt is mostly denominated in foreign currencies and would be greatly affect by devaluation. Devaluation would also affect the cost of inflated goods and raise inflation. This was the counter argument of the Indian Central Bank to the plan to use foreign exchange reserves domestically. They argue that doing so would fuel inflationary pressures in the economy and lead to instability. This argument describes the precautionary theory for reserves, that is, to hold reserves as a means of self-insurance in case of a financial crisis.
Clearly, there are pros and cons to holding large amounts of foreign reserves. However, regardless of whether reserves are being held as self insurance or as ways to manage the exchange rate system, there have to be variables that help determine the optimum level. What this paper seeks to examine is the effect that different exchange rate regimes have on reserve holdings. This has been mentioned before, central banks are generally thought to hold stocks of foreign reserves so their economies can avoid incurring the cost of adjusting to every international imbalance that would be transmitted to the domestic economy through changes in exchange rates.
Under a fixed exchange rate system, reserve holdings are expected to be larger, since they are necessary to maintain the exchange rate stable. China and India hold approximately 40% of the world foreign currency holdings. The reason for this is that although the nominal exchange rate is fixed, the market can still affect the real exchange rate and the central bank might find it necessary to use reserves or other monetary tools to maintain the peg. A fixed currency might also be subject to speculative attacks, and large reserve holdings are necessary to counteract these attacks as well. Therefore, under a fixed exchange rate system holdings of reserves are expected to be larger, since they are needed to maintain the fixed exchange rate stable.
Countries with a flexible exchange rate are expected to absorb these changes through changes in their exchange rate, requiring fewer amounts of foreign currency reserves. These countries will still hold reserves, since they are important monetary tool and a means to self insure against major financial crisis. However, reserves would be capped at some benchmark amount computed using import coverage. What this paper seeks to analyze is how the exchange rate system impacts the level of reserves in a country. The focus is on China as fixed exchange rate system and India as a flexible exchange rate system. It explores the results obtained from the estimating equations and analyzes the variables that seem to differ more for each country.
Since the data for reserves and the current account is given in billions of dollars, scientific notation is used to facilitate interpretation and comparison of the numbers. It can be seen that both countries have relatively large standard deviations for their reserves, suggesting that reserves from this sample have been growing over time. Although the large standard deviation is consistent with the trend has been observed since the collapse of the Breton Woods Agreement. It was thought that high capital mobility and exchange rate flexibility would reduce the amount of reserves over time. The mean reflects the magnitude of the holdings. In China’s case, the mean for reserves is roughly eighty-four billion dollars. For India it is a modest (in comparison with China) eleven billion dollars. As mentioned in the introduction, these high levels of reserves have placed China and India as second and fifth largest reserve holders in the world, respectively. The nominal reserve levels from 1980 to 2003 of both countries show an upward trend in reserve levels, particularly in the mid and late nineties. This is due to the financial crises in the world during this time period.
The unprecedented rise in Foreign Exchange Reserves (FCR) in some of the Asian countries raises a concern about their optimal size and appropriate utilization. In India too, in recent months, different ways to utilize FCR, in particular, to social infrastructure, have been debated. The Government of India intends to use a part of its FCR for infrastructure financing and has announced a scheme — yet to be implemented — in its annual Budget in February 2005.There is no evidence that any other country has used FCR to finance infrastructure. The amount of FCR in India is modest when compared to some of the other countries in the region, and it can be argued that the proposed plan may lead to more economic difficulties than anticipated benefits.
The Government of India neglected development of social infrastructure in comparison of physical infrastructure in the 1990s. There has been mounting pressure on the UPA government from state governments and left front as coalition partner of the UPA for use of FCR in the development of social infrastructure since 2004. India have place in the global standard of human development index on bottom particularly social index like health, pension, education, potable water and sanitation. Higher education laying on moribund situation lack of sufficient educational infrastructure. More than 60% child under age of 5 year born underweight, malnutrition problems in both child and mother. There is need of about $150b for adequate development of social infrastructure in 5 years. India has adequate FCR for this purpose.
Now the time has come for meeting to our social development goals for these we committed in UNMC 2000, in the governments’ budgets, political parties’ agendas as well as our private businessmen and corporate companies for their social responsibilities. There should be social responsibility of the MNCs and FDIs for investment in the development of social infrastructure in their destination places. There have been increasing money inflation and liquidity in the market along with increase of FCR and change in currency exchange rate since 2005. The FCR increased to money liquidity; money liquidity increased to money inflation and money inflation put negative effects over social development. There is no utilization of physical infrastructure in the lack of the social infrastructure as same way what profit of the FCR when economy suffering from illnesses of inflation, extra-liquidity of currency and abundant black money in the market.
Use of Foreign Exchange Reserves: – International Experience
International experience in the deployment of FCR 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 FCR. GIC, incorporated in May 1981 as a private company and wholly owned by the government, manages more than US$100 billion of FCR 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 FCR have been utilized to strengthen the social institutions for development of social infrastructure. 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.
Emerging Trends of Foreign Currency Reserves in India
India followed a restrictive external sector policy until 1991, mainly designed to conserve limited FCR for essential imports (petroleum goods and food grains), restrict capital mobility, and discourage entry of multinationals. The external sector strategy since 1991, though gradualist in approach has shifted from import substitution to export promotion, with sufficiency of FCR as an important element. As a result of measures initiated to liberalize capital inflows, India’s FCR (mainly foreign currency assets) have increased from US$6 billion at end-March 1991 to US$140 billion at end-March 2005. The acceleration in the trend first emerged in 1993, as recorded by the rise in foreign currency assets, when India adopted the market-based system of exchange rates and then in 2001, when the current account recorded a surplus after a persistent deficit since 1978.
In March 2005, FCR exceeded 15 months of imports, in contrast to two weeks in June 1991.The substantial growth in FCR has led to a sharp decline in the ratio of short-term debt to reserves from 147 percent in 1991 to 5 percent in 2005. India ranks fifth in the world in holdings of FCR in 2004. India’s Foreign Currency Reserve up to 131$ Billion, Balance of Payment worsens to deficit $3.2 Billion, trade deficit worsens to $17.4 Billion in first week of November 2007. In March 2005, the foreign currency reserve stood at about $150b. By the end of March 2006 they were almost $200 billion, an increase of one-third in a year, and as of October19, 2007 they amounted to $261b.
Objectives of Foreign Currency or 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 FCR 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 FCR 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, those foreign obligations can always be met.
India is 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 FCR are considered as a first defense in a crisis — a self-insurance — reflecting a lack of confidence in the current international financial architecture. To illustrate, the Government of India had to ship 47 tones 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, this could be a short-term phenomenon, which might reverse swiftly with a rise in interest rates in the developed countries.
The Sources of Rising Foreign Currency Reserves
The main sources of rising FCR 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$21 billion over a similar period.
The Foreign Currency Reserves Management in India
The Reserve Bank of India (RBI), in consultation with the Government of India, currently manages FCR. 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.
Deployment of Foreign Currency Assets –
The conservative strategy adopted in the management of FCR 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.
Adequate Foreign Currency Reserves in India
Traditionally, the adequacy of reserves is determined by months of import cover (stock of reserves to volume of imports), with three or four months regarded as adequate. This measure implicitly assumes a time frame to successfully overcome a short-term shock in external payments. But in the case of South East Asian countries, the crises of 1997 lasted for a lengthy period and import cover of a few months was inadequate to absorb the shock. In addition to the experience of 1997, many changes in international financial markets since then have led to new measures of adequate reserves. The most prominent of these is the Guidotti rule, which, though modified over the years, continues to stress that liquid reserves be maintained sufficient to meet external obligations for about a year without any external assistance. A cross country comparison of some major adequacy indicators is presented in Graph 4. In terms of the adequacy ratios, except for import cover, India’s reserves are modest when compared with those of other countries.
India’s Concern in Managing of Foreign Currency 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 nontransparent 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 labor 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 FCR 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 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. 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 negative rates of return ranging between 13 to 38 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 be adversely affected if FCR-financed projects are delayed or abandoned for economic or political reasons. Finally, ad hoc use of FCR 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 FCR 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 FCR, sterilization, and issuance of bonds makes domestic monetary management more difficult.
Conclusions
The rising levels of FCR have succeeded in infusing necessary confidence, both to the markets and policy makers. However, neither the capital inflow to India nor the size of FCR is disproportionately large when compared to some other countries in the region. The main sources of accretion to FCR 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 FCR 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 FCR 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 FCR in the future, it may consider establishing a separate investment institution on the pattern of the GIC.
------------------------------------------------------------------Suwa Lal Jangu, Research Scholar Department of Political Science, Banaras Hindu University, Varanasi
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