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Foreign exchange reserves (FERs) are imperative in preventing crises situations and mitigating their impact, but there is a cost involved in holding them and they are subject to diminishing returns, the Economic Survey 2022-23 has said.
“The costs borne by an economy for holding FER include the opportunity cost, in terms of the difference between domestic and foreign borrowing rates and loss due to the value reduction in the denominated FER,” it said.
The observations are important given concerns over foreign exchange reserves falling by $70 billion in 2022 to $562.85 billion.
“As of end-November 2022, India was the sixth largest foreign exchange reserves holder in the world according to data compiled by the IMF. …the import coverage of foreign currency reserves has declined since the pre-pandemic levels in most emerging market economies; however, that of India has increased from 95 per cent in Q4 2019 to 96.5 per cent in Q3 2022,” the survey observed highlighting the brighter side of the situation.
The survey cited various measures available conventionally to measure the adequacy of reserves, which includes ratios of reserves to imports, to monetary aggregates, and measures of external debt, and said the rich literature available presented very useful background information and empirical analysis for policy choices and likely outcomes.
Quoting a study by economist D Rodrik (2006), the survey points out that it examines the social cost of FERs and finds that the income loss to most developing countries amounts to close to one per cent of GDP.
“Fukuda and Kon (2010) evaluate the macroeconomic impact of reserve accumulation and find evidence that an increase in FERs raises external debt outstanding but shortens debt maturity. In the long run, consumption declines, and exports, are promoted by encouraging a switch from the non-tradable sector to the tradable sector through higher investment and growth,” it said.
Further, FERs could be inflationary through exchange rate effects and moral hazard and incentive effects, the survey added.
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