In the last two decades, the Indian economy has witnessed a dramatic transformation from a regulated environment to the one which is more market-oriented. Over this period, a crisis-hit economy with limited resources to finance even three months of imports in 1991, accumulated a huge stock ($ 321 billion on September 2, 2011) of international reserves that is enough to fund almost a year of import.
Interestingly over the last decade, the pace of accretion in the stock of international reserve has been so striking that it has registered more than 1000 per cent growth, despite the fact that India has entered into flexible exchange rate system since March 1993. Now it seems reasonable to argue that India has surpassed many standard measures of reserve adequacy to rest in a somewhat protected zone.
REASONS FOR RESERVES
Theoretically, it was believed that under flexible exchange rate system countries will need to keep less stock of international reserves, since central banks were not obligated to defend their parities through frequent interventions.
While a regime shift from fixed exchange rate to floating system theoretically reduces the need for holding international reserves, on empirical and practical grounds this may not hold good as precautionary motives play a predominant role in reserve accumulation. Nations hold international reserves for several reasons: to smooth out temporary fluctuations in external payment imbalances, to neutralise speculative attacks on currencies, for boosting international confidence on domestic economy, for prestige and as collateral for international borrowing. Alternatively, reserve accumulation can also be used to keep the exchange rate favourable for export growth which maylead to higher economic growth and more employment in the domestic economy.
But, on the other hand, massive outward movement of capital may expose the country to a greater risk of liquidity squeeze, which occasionally leads to a full-fledged financial crisis. Therefore, holding international reserves may be a quick-fix solution for this possible threat. The precautionary benefits of keeping huge stockpiles of international reserves are numerous. However, reserve accumulation also involves incurring some opportunity costs beyond a certain limit. In the words of Prof. Dani Rodrik, “central banks hold their foreign exchange reserves mostly in the form of low-yielding short-term US treasury (and other) securities. Each dollar of reserves that a country invests in these assets comes at an opportunity cost that equals the cost of external borrowing for that economy.”
In the case of a developing country like India, where the demand for financial resources to support developmental projects is always greater than the available supply, it is not completely justified to keep these precious funds unemployed for a longer period.
The broad conclusion (reflected even in RBI's reports) suggests that India has accumulated more excess reserves than necessary to avoid any unforeseen financial calamity in the near future. The opportunity cost of reserves holding is high for the Indian central bank, as returns from the foreign currency asset (FCA) deposits are too low, whereas the domestic interest rate is comparatively very high. This poses a couple of relevant questions: what is the adequate level of international reserves for India, and what is the opportunity cost of excess reserves?
RIGHT LEVEL OF RESERVES
In our recent research we have attempted to answer these questions. First, the level of adequacy and excess reserves holding is measured. This is performed using the rule of thumb of holding international reserves equal to three months' import coverage plus short term external debt in addition to 30 per cent of foreign stock market holding. Furthermore, the issue of ‘internal drain' is also included; this is mainly because of the fact that the quality of the financial system is an important consideration in capital flight from the country.
Money supply is used as proxy for this purpose. Another important factor that can be included in the analysis is the country's risk. This factor is considered on the argument that any increase in the country's risk increases the risk of capital flight. This measurement has broadened the adequacy measure of reserves. This analysis suggests that in 2001-02, reserves adequacy was $24,062 million and excess reserves was $26,987 million. Over the analysis period, reserves adequacy has been increasing; however, excess holding of reserves too has been growing. This suggests the opportunity cost of reserves holding and excess reserves were US$ 3502 million and US$ 1851 million, respectively in 2001–02, which is 0.41 per cent of India's GDP. The trend of growth in adequacy, excess reserves and cost has been increasing over the period till 2007-08. The excess reserves holding rose to 1.13 per cent of GDP in 2007–08, while it observed a marginal decrease of 0.87 per cent in 2008–09. Therefore, it is evident that excess holding of reserves and its cost of holding is too high to bear on the argument of safety.
USE IN INFRASTRUCTURE
Therefore, RBI needs to act and consider alternative uses of the excess reserves such as investment in infrastructure, re-capitalisation of public sector banks, investment in overseas financial markets or repayment of costly external debt. To start with it would be reasonable to argue for a safe option of employing a smaller portion of reserves, excess or otherwise, towards productive investments such as infrastructure. This way, one would be clear about the pros and cons of such usage of excess reserves.
(The authors are with National Institute of Financial Management, Faridabad, and National Institute of Public Finance and Policy, New Delhi, respectively. The views are personal.)