The importance of managing forex reserves: The Indian experience

08 September 2006

No levels of foreign exchange reserves are enough to protect an economy from speculative capital attack. The RBI needs to spend as much time in finding suitable uses for the huge reserves it has accumulated as it does in accumulating them. By Adarsh Ananthakrishna, associate, Capco.

In recent years there has been a lot of attention focused on the management of foreign exchange reserves. There are various reasons for this, such as the emergence of the Euro as an alternate currency to dollar, changes in the exchange rate regimes, the changing perception on adequacy of reserves and their role in managing crisis, and the operational use of reserve targets while calculating financing gaps by the IMF. In addition, 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. The central bank of a country acts as the reserve management entity. As the chief monetary authority of the country, it is the central bank's responsibility to ensure that there is 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.

One of IMF's surveys reveals distinct characteristics in the foreign exchange reserves management of various countries. It suggests that many countries maintain reserves to support monetary policy. The primary objective of these countries is to use the large reserves to cope with 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 authorised 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 part of the reserves.

The surge in the forex reserves
The Asian crisis taught us just how countries could suffer due to bad management of foreign exchange reserves. Many countries have responded and in order to reduce their vulnerability to the external shocks have accumulated heavy foreign exchange reserves. Countries want to keep their exports competitive; hence, they prefer to depreciate their currencies against the major currencies. In recent days, there has been a continuous appreciation of rupee vis-à-vis the dollar. To avoid the appreciation of the rupee, RBI has been continuously interfering in the money markets, by buying dollars, which are added to the reserves.