INDIA’S FX RESERVES – THE DARK LINING ON THE SILVER CLOUD

India's Fx Reserves – The Dark Lining On The Silver Cloud -By Ramesh Ramanathan

Last week, I wrote of Sovereign Wealth Funds (SWFs) becoming a dominant force in global markets, a consequence of burgeoning global currency reserves. This week, I want to focus on India’s own reserves: with $200 billion, rising at $1billion a week, we have found our place in the global spotlight, but the glare is getting uncomfortable. Effective response to this trend is a key policy issue for our public finance experts.

The Reserve Bank of India – RBI - is generally seen as a regulator, managing the nation’s money supply and overseeing the banking system. But the RBI is also a bank, working to make a profit – surplus as it calls it. While RBI had always engaged in trading activities, the explosion of foreign exchange reserves is forcing the bank to use new and complex market instruments. To understand the magnitude of this shift, witness how the composition of its finances has changed just over the past decade.



Source: RBI Annual Report, 2006

In 1993-94, just 10% of the RBI’s gross income came from foreign sources; in 2005-06, over 90%. The domestic-foreign income ratio has inverted in a decade. Of RBI’s Rs 800,000 crore in assets, almost 90% is foreign. This will increase as India’s becomes more and more entwined with the global economy, earning foreign income and attracting overseas capital. Managing such a dramatic transformation requires new systems, differently-trained resources, and modern financial instruments.


Global guidelines for reserve management have reflected the changing dynamics in the reserves themselves. The early thinking was substantially trade-driven: three to four months of import cover. However, the Asian financial crisis of 1998 caused a dramatic re-think, as countries found themselves buffeted by fast capital movements. Martin Feldstein advocated larger reserves to give countries flexibility, protection and trust. The Greenspan-Guidoti rule suggested that a country should have sufficient reserves to survive a year without loans.

The RBI’s own approach has mirrored global thinking, with incremental policy modifications every few years. The central bank has been a conservative player, preferring to allow innovations to emerge elsewhere, before changing course. This has resulted in a reputation for steadiness among the global financial community, a tough accolade to win.

However, where the RBI is weak is in the traditional instruments it uses to manage its risk. This creates challenges. For example, foreign income changes are jumping around quite dramatically – they are up 200% in two years. But what goes up must come down. Similarly, foreign asset valuation changes are captured in a reserve fund called the Currency and Gold Revaluation Account (CGRA). CGRA has grown eight-fold in the past decade alone, to Rs 87,000 crore, at last year’s exchange rates. These buffers will erode with rupee appreciation.

Against this, the bank’s continuing use of conservative instruments could use some re-thinking, since more options will only allow greater flexibility. For example, the UK’s reserve management document states, “Benchmarks for active management are adjusted for positions…such that the returns to active risk taking are properly identified for each portfolio. Such management positions count against the overall Value-at-Risk limits.”

Compare this to the RBI’s approach: “While investments in securities are restricted to sovereign and sovereign-guaranteed instruments, the residual maturity of these instruments cannot exceed 10 years. A good percentage of reserves is invested in the money market.”

The absence of terms like “active risk-taking”, “Value-at-Risk”, and “performance benchmarks” is revealing.

The RBI’s challenges are not unique. Effective reserve management is a global quandary. Krzysztof Rybinski and Urszula Sowa1 of the Polish Central Bank coined a term OCHAR – Opportunity Cost of Holding Ample Reserves. The authors concede that this is a volatile arena, with rapid changes in policy prescriptions: “It was only eight years ago when economists recommended building up of sizeable foreign exchange reserves.”


India therefore stands on the double-edged sword of choosing what it does with its reserves. One highly-debated idea is to use them for infrastructure creation. Another suggestion from Raghuram Rajan is to create domestic mutual funds that can buy foreign exchange from the RBI and invest overseas. Alternatively, India could have its own SWF like China. Each of these choices has consequences, and needs to be imbedded in solid institutional arrangements. As the debates take place, the Reserve Bank’s approach of cautious flexibility should – as it has over the past decade - serve us well.

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The author is Co-Founder of Janaagraha.