India's Surging Forex Reserves Boon or Bane

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Authors: Abdul Khader, Sanjib Datta,
Faculty Associate, Faculty Member
ICMR (IBS Center for Management Research).

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Is the foreign exchange reserves growth of India, a factor to worry about?

India's Foreign exchange reserves touched $106 billion in February 2004. Millions more are pouring in every day. The continuous surge in foreign exchange reserves is very encouraging keeping in mind the state of affairs in the early 1990s when the country was on the verge of defaulting on its foreign debt.

Having said that we also need to understand that in the present scenario effective utilization of the reserves is crucial. There was a sea change in the approach to foreign reserves management with the acceptance of the recommendations made by the Rangarajan Committee on Balance of Payments. The Committee emphasized on the maintenance of the target level of reserves and also emphasized that attention should be given to the payment obligations apart from the level of imports. The Committee was of the opinion that the targets of foreign exchange should be fixed, in a manner by which it should be able to meet the import requirements for three months. The Committee recommended various factors that need to be addressed while determining the desirable level of reserves.

The committee was of the opinion that a positive image regarding the country's capacity to honor its obligations needs to be built up in the international financial community. The Committee also recommended that a foreign currency reserve should be maintained to address any speculative tendencies by the players in the foreign exchange market. At the same time, the cost of carrying the liquidity should be minimal.

The Importance of Managing Forex Reserves

In the recent past the focus on management of foreign exchange reserves has increased. There are various reasons for this. Emergence of Euro as an alternate currency to dollar; change in the exchange rate regimes; change in perception on adequacy of reserves and its role in managing crisis; and operational use of "reserve targets" while calculating financing gaps by IMF. Apart from these 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. Central bank of a country acts as the reserve management entity. As the chief monetary authority of the country, it is central bank's responsibility to ensure a 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.

A survey done by IMF in 2000 reveals distinct characteristics in the foreign exchange reserves management of various countries. It says that many countries maintain reserves to support monetary policy. The primary objective of the countries, while maintaining the reserves is to cope up with the short-term fluctuations in exchange markets. Many countries use foreign exchange reserves for stability and integrity of the monetary and financial system as well.

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