2011

FOREIGN EXCHANGE RESERVE

By: KUMAR SHREYAS

1. Background of the project 1.1 Introduction: Foreign Exchange Reserves are the reserves that a government
maintains in the form of foreign currency deposits and bonds, gold, SDRs, IMF reserve etc, to back their liabilities. History: Looking at the history, the operations in the foreign exchange market began in a big way only after the breakdown of the Bretton Woods system in 1971. In Bretton Woods system, every country was obliged to maintain the exchange rate of its currency with a fix amount of gold, plus or minus one percent. IMF had the authority to maintain any imbalance of payment Indian context: To begin with, we all realized the importance of Foreign Exchange Reserve in 1991 when the crisis of Balance of Payment hit India. India had to transfer 47 ton Gold to Bank of England and 20 ton Gold to the Union Bank of Switzerland as a security. The very fact that the country was about to default on its payment was a major embarrassment for the country. The major problem with Indias progress was the lack of capital. India was not able to capitalize on the large amount of natural resources. Considering these facts government gave permission to the Indian banks for intra day trade in foreign exchange market in 1978. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. After the opening of the markets in 1992, India has witnessed a large amount of foreign exchange inflow and outflows. The exchange rate of the rupee that was pegged earlier was floated partially in March 1992 and fully in March 1993. This resulted in market determined exchange rate of the rupee. India adopted Current Account Convertibility of the Rupee on August 20, 1994. Present: Looking at the last decade we can say that there has been tremendous increase in the mobility of international capital. Indian companies are going abroad to raise capital by using instruments such as ADR and GDR. On the other hand foreign companies and investors are putting their money in India by FDIs and FIIs.

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2. Objective
In our project we try to ascertain the various trends of Foreign Exchange Reserve. We will also see the change in the proportion in which the component of the foreign reserve. We will also discuss about the changes in world foreign exchange market.

3. Rationale
Due to globalization trade between the countries has increased. So to do the trade with different countries, we need the foreign exchange reserve. This makes understanding and management of foreign exchange reserves very essential.

4. Analysis: 4.1 Global Trend:

Exhibit1

Source: IMF

This figure clearly shows that from 1995 the amount of foreign exchange reserve in the hand of developing countries is increasing. And after 2004 the amount of foreign exchange reserve with the developing world ahs become more than that of the developed once.
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4.2

Indian Reserve:

Reserves In Million $
350000 300000 250000 200000 150000 100000 50000 0 Reserves In Million $

Exhibit 2

Source: Handbook on Indian Statistics, RBI

Form this we can clearly see that Indias Foreign Reserve has raised from 3627 million US dollars in 1991 to 279057 million US dollars in 2010, reaching a peak of 309723 million US dollars in 2008. The main source of raising FER in India is foreign portfolio investments and bank capital, which includes deposit from Non Residential Indians. FER is managed by RBI in consultation with the government. The main objective of its management is to maintain the liquidity in the market. The policy to build an adequate level of foreign exchange reserves has been based on a number of considerations such as size of the current account deficit and short term liabilities, and the composition and risk profile of capital flows

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Movement of Reserves

Foreign Exchange Reserves in India (1950-1951 to 2009-2010)

Year (As at endMarch) SDRs##
Rs. in Crore 200 233 55 339 23 280 7 4 34 16 11 50 19 10 20 12 8 74 6 22596 USD Milli on 102 90 18 108 7 82 2 1 8 4 2 10 4 2 5 3 2 18 1 5006

Gold*
Rs. in Crore 6828 9039 10549 12794 13752 15658 14557 13394 12559 12973 12711 14868 16785 18216 19686 25674 29573 40124 48793 81188 USD Millio n 3496 3499 3380 4078 4370 4561 4054 3391 2960 2974 2725 3047 3534 4198 4500 5755 6784 10039 9577 17986

Foreign Currency Assets*

Rs. in Crore USD Millio n 2236 5631 6434 15068 20809 17044 22367 25975 29522 35058 39554 51049 71890 107448 135571 145108 191924 299230 241426 254685

Reserve Tranche Position

Rs. in Cror e 3190 5688 6289 3374 2044 1744 5000 6231 USD Milli on 672 1311 1438 756 469 436 981 1380

Total
Rs. in Crore USD Millio n 5834 9220 9832 19254 25186 21687 26423 29367 32490 38036 42281 54106 76100 112959 141514 151622 199179 309723 251985 279057

199091 199192 199293 199394 199495 199596 199697 199798 199899 199900 200001 200102 200203 200304 200405 200506 200607 200708 200809 200910

4388 14578 20140 47287 66005 58446 80368 102507 125412 152924 184482 249118 341476 466215 593121 647327 836597 1196023 1230066 1149650

11416 23850 30744 60420 79780 74384 94932 115905 138005 165913 197204 264036 361470 490129 619116 676387 868222 1237965 1283865 1259665

Exhibit 3

Source: Reserve Bank of India

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SDR- Special drawing rights are international foreign exchange reserve asset. It represents a claim to foreign currencies for which it may be exchanged. The influence of US Dollar has ebbed the value of SDRs. Dollar has become the main foreign exchange reserve asset. But, still countries like Russia, China and United Nations prefer SDRs. SDRs came into picture in 1969 to support the Bretton Woods fixed exchange rate system. It was created by IMF. Initially the value of SDR was defined by .888617 grams of Gold (which was equivalent to $1 at that time). The nominal value of SDRs is based on the basket of goods especially a fixed amount of Japanese Yen, US Dollar, British Pound and, Euro. SDRs are The International Monetary Funds unit of account. It is denoted by ISO 4217 currency code XDR. Every 5 years, the value of SDR is revised by IMF. IMF members often need to buy SDRs to discharge obligations to the IMF, or they may wish to sell SDRs in order to adjust the composition of their reserves. The IMF acts as an intermediary between members and prescribed holders to ensure that SDRs can be exchanged for freely usable currencies. Reserve Tranche Position- Member countries of the International Monetary Fund (IMF) have a reserve tranche position to the extent that their quotas exceed the IMF's holdings of its currency in the General Resources Account, excluding holdings arising out of purchases made by the member under all policies on the use of the IMF's general resources. A member may purchase up to the full amount of its reserve tranche at any time, subject only to the requirement of balance of payments need. A reserve tranche position does not constitute a use of IMF credit and is not subject to charges or to an expectation or obligation to repurchase.

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year
1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

%SDR
1.748371615 0.976138829 0.183075671 0.560922406 0.027793218 0.3781067 0.007569163 0.003405183 0.024622961 0.010516353 0.004730257 0.018482239 0.005256242 0.001770554 0.003533219 0.001978605 0.001004122 0.005811645 0.000396849 1.793898738

%GOLD
59.92458005 37.95010846 34.37754272 21.18001454 17.35090924 21.03103242 15.34269387 11.5469745 9.110495537 7.818908403 6.444975284 5.631538092 4.643889619 3.716392673 3.179897395 3.795623326 3.405981554 3.24128334 3.800623053 6.445278205

%FCA
38.32704834 61.07375271 65.43938161 78.25906305 82.62129755 78.59086088 84.64973697 88.44962032 90.8648815 92.17057524 93.55029446 94.34997967 94.46780552 95.12123868 95.80041551 95.70378969 96.35754773 96.61213407 95.80967121 91.26630043

%RTP
0 0 0 0 0 0 0 0 0 0 0 0 0.88304862 1.160598093 1.016153879 0.498608381 0.23546659 0.140770947 0.389308887 0.494522624

TOTAL
5834 9220 9832 19254 25186 21687 26423 29367 32490 38036 42281 54106 76100 112959 141514 151622 199179 309723 251985 279057

Exhibit 4 This table shows the composition of Indias foreign exchange reserve in the percentage form of each constituent. We can see that from 2002 onwards India is keeping a small percentage of its reserve in the form of RTP.

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120

100

80 %SDR 60 %GOLD %FCA 40 %RTP

20

Exhibit 5 From this figure we clearly see that the percentage of gold in the foreign exchange reserve has declined over the years and it has been replaced by FCA.

5. Conclusions: 5.1 World Trend: 5.1.1 Role of Developing Countries: The paradigm shift in the world of
foreign exchange reserve from developed countries has brought in a new world order. The excessive accumulation of dollar by China has become a matter of concern. The talk of a currency war is also in the air. In a paper from IMF The Impact of the Great Recession on Emerging Markets' showed that during the current financial crisis, countries with higher foreign exchange reserve used it efficiently to minimize the effect of recession. 5.1.2 Importance of US policies: since most of the foreign reserve are in the form of dollar so the monetary policies taken by US are of much importance. Recently, the US has tried to weaken the dollar in order to improve competitiveness of their export. This could lead to the decrease in the value of foreign exchange reserve of the countries. Moreover inflation in US can
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dampen the large reserve that Chinese have as trade surplus. Chinese are having reserve consisting of US bonds. So if the inflation rate becomes more than the interest rate on those bonds, then they will be having negative returns. 5.2

Indian Reserve

5.2.1 Benefits: One benefit that we think of keeping such a large amount of foreign reserve is that India could now effectively handle the situation such as of oil shocks or global recession. 5.2.2 Shift of constituents: from the exhibit 5, we conclude that over the past decade India has replaced gold with FCA. There has been a continuous decline in the percentage of gold in the foreign reserve complemented by an increase in the percentage increase in FCA. 5.2.3 Introduction of RTP: from exhibit 4 we can say that India is keeping a small percentage of its reserve in form of RTP. This is a great move as it could hedge India from any balance of payment risk in the future. 5.2.4 Adequate Level: We can say that India has clearly surpassed the adequate level of foreign exchange reserve. The foreign exchange reserves of the country, at present, exceed 17 months of imports or about five years of debt servicing. 5.2.5 Buying of Gold in 2009-10: For us, it appears to be a very bad step taken by RBI of primarily discontinuing with the gold in the reserve. In this last decade we have seen a steep increase in the price of gold. Moreover if the RBI was maintaining lower percentage of gold in its reserve, it should not have bought gold from World Bank at this point of time when the prices are very high. From security and safety point of view also, government has to shed a large amount of money in keeping, transferring of money in its reserve.

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6. Suggestions:
a. World should gear up for a new world economy, as dollar will soon lose its importance. Weakening of dollar is bound to happen as US can compete with other countries with a strong currency. b. Instead of decreasing the value of dollar, US should try to increase the competitiveness of there export by bringing innovative technologies in. Americans have many world class research and design centers. Utilizing these resources, which apart them from rest of the world, can bring in ever lasting growth in economy.

c. India should use this foreign exchange reserve to give a boost to infrastructure sector. The great pace of Indias is showing the sign of overheating. Frequent power cuts in major cities are a matter of concern. India could face a slow down in the economy if we dont built infrastructure fast enough. d. Should pay the high cost foreign debt. A large amount of money is getting spent in servicing these loans. A reason behind Indias large amount of budget deficient is these loans. Now when we ample reserve for almost 5 years of debt servicing, we should repay these debts.

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