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.