India's surging Forex Reserves
Boon or Bane
 

 Article by -  Abdul Khader , Faculty Associate and
Sanjib Dutta , Faculty Member ,
ICMR Case Studies and Management Resources.

Is the foreign exchange reserves growth of India, a factor to worry about?
 

India's Foreign exchange reserves touched $106 billion in February 2004. Millions more are pouring in every day. The continuous surge in foreign exchange reserves is very encouraging keeping in mind the state of affairs in the early 1990s when the country was on the verge of defaulting on its foreign debt.

The Committee recommended various factors that need to be addressed while determining the desirable level of reserves. The committee was of the opinion that a positive image regarding the country's capacity to honor its obligations needs to be built up in the international financial community. The Committee also recommended that a foreign currency reserve should be maintained to address any speculative tendencies by the players in the foreign exchange market. At the same time, the cost of carrying the liquidity should be minimal.

The importance of managing Forex Reserves

In the recent past the focus on management of foreign exchange reserves has increased. There are various reasons for this. Emergence of Euro as an alternate currency to dollar; change in the exchange rate regimes; change in perception on adequacy of reserves and its role in managing crisis; and operational use of "reserve targets" while calculating financing gaps by IMF. Apart from these there are various other reasons like increase in transparency and accountability at various levels. Moreover, the IMF guidelines have increased focus on foreign exchange reserves management.

Foreign exchange reserves are required to meet a defined set of objectives of a country. Central bank of a country acts as the reserve management entity. As the chief monetary authority of the country, it is central bank's responsibility to ensure a general macroeconomic financial stability. Since, the central bank also happens to be the custodian of the foreign exchange reserves, it needs to maintain adequate liquidity, safety and yield on deployment of reserves.

A survey done by IMF in 2000 reveals distinct characteristics in the foreign exchange reserves management of various countries. It says that many countries maintain reserves to support monetary policy. The primary objective of the countries, while maintaining the reserves is to cope up with the short-term fluctuations in exchange markets. Many countries use foreign exchange reserves for stability and integrity of the monetary and financial system as well.

The Indian Context

In the Indian context, the RBI Act and the Foreign Exchange Management Act, 1999 set the legal provisions for governing the foreign exchange reserves. RBI acts as the chief monetary authority and the custodian of foreign exchange assets. RBI accumulates foreign currency reserves by purchasing from authorized dealers in the open market operations. Another source of Foreign exchange for RBI is deployment of foreign exchange reserves in appropriate instruments of select currencies. The type of instruments in which RBI can invest is stipulated in the RBI Act. The aid received by the government also becomes a part of the reserves.

The outflow of funds results from the sale of foreign currency to the authorized dealers through open market operations. The resultant effect of the sale and purchase of foreign currency determines the level of foreign exchange reserves in a country.

The Surge in the Forex Reserves

The Asian crisis tells us how countries suffer due to ill management of the foreign exchange reserves. Many countries foresaw the vulnerability to the external shocks and accumulated heavy foreign exchange reserves. Countries want to keep their exports competitive. Hence, they prefer to depreciate their currencies against dollars. In recent days, there has been a continuous appreciation of rupee vis-a-vis dollar. To avoid the appreciation of rupee, RBI has been continuously interfering in the money market. RBI is buying dollars from the market. The dollars that are being bought add to the foreign exchange kitty.

Unlike, in the past, the NRI community is more dispersed now, not just confining to the Gulf. Due to software boom, Indians are heading towards new destinations. NRIs are doing well there and ploughing back their savings to India. Moreover, foreign institutional investors are also making huge investments into Indian stocks.

The emergence of India as an offshore outsourcing hub has created new opportunities. There are huge dollar earnings for India. Further, India is also proving to be a worthy manufacturing hub for many companies. All these factors played a positive role in building up of huge foreign exchange reserves.

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