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Adequacy of foreign reserves:
Adequacy of reserves has emerged as an important parameter in gauging the country’s ability to absorb external shocks. With the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. The High Level Committee on Balance of Payments, which was chaired by Dr. C. Rangarajan, erstwhile Governor of Reserve Bank of India, had suggested that, while determining the adequacy of reserves, due attention should be paid to payment obligations, in addition to the traditional measure of import cover of 3 to 4 months. The traditional approach of measuring foreign exchange reserves is by measuring Reserves to Import (R/M) Ratio. Judging India’s reserve on R/M ratio since 1990-91, it looks very healthy except in economic crisis period of 1990-91, after that the reserves is always more than three months import coverage. A comparison of Foreign exchange reserves of different countries and the import coverage from these reserves is shown below.
IMPORT PER MONTH (MILLION USD) 33000 29733.33 4400 15479.08
ANNUAL IMPORTS COUNTRY (MILLION USD) SINGAPORE 396000 KOREA 356800 ISRAEL 52800 INDIA 185749
RESERVES IMPORT (MILLION COVER USD) (MONTHS) 4.91 162,174 7.14 212,253 8.05 35,425 16.34 252,883
(Source: www.wikipedia.org) From the table it can be seen that India has foreign exchange reserves to support 16 months of import bills which is 4-5 times more than the traditional requirement of 3-4 months. A measure of adequacy of foreign exchange reserves can be expressed in terms of Reserves to Short term External Debt (R/STED) Ratio. The economic crisis of South-East Asia in 1997 reflected several deficiencies involved in keeping R/M ratio as a criterion of reserves adequacy. Hence R/STED ratio is considered an important indicator for adequacy of foreign exchange reserves. Short term debt provides a measure of all debt repayments to non-residents over the coming year and, as such, constitutes useful information of how fast a country would be to adjust the external sector if it were unable to access external flows Moreover R/STED ratio also provides a useful indicator of the threshold at which the investors lose confidence. It is widely recommended that countries should hold reserves for four to five quarters STED in advance. In India, Short term external debt (STED) hasn’t increased since 1990-91, while foreign currency assets (FCA) have grown around hundred times. This has made R/STED ratio better in last decade. The ratio
reveals that there is a minimum chance of occurrence of currency crisis as the reserves are comparatively very high. The figure 2 shows the trend for Reserves and STED in India from 1990 to 2006.
Source: Handbook of statistics on Indian Economy, RBI, (2007-08) In terms of Total external liabilities India has foreign reserves to meet 100% of its external liabilities, as shown in the figure below. India also has assets in other countries in the form of private as well as public investment. Hence considering the net external liability i.e. External liability-external assets, India has enough surpluses in its foreign exchange reserves.
EXTERNAL LIABILITIES COVERAGE
300,000 RESERVES, 252,883 250,000 EXTERNAL LIABILITY, 224000
200,000 150,000 100,000 50,000 0 1 NET EXTERNAL LIABILITY, 73900
Yet another measure of adequacy followed by some countries is the thumb rule to maintain foreign exchange reserves at 10% of their GDP. Considering this measure we can find out that India maintains Foreign exchange reserves at 23% of its GDP. The table below shows the value of foreign exchange reserves as a percentage of GDP.
FOREX AS PERCENTAGE OF GDP 100.51 21.88 21.59 22.97
GDP COUNTRY (MILLION USD) SINGAPORE 161349 KOREA 969871 ISRAEL 164103 INDIA 1100695
(Source: www.wikipedia.org) Thus considering the above mentioned measures of determining adequacy of foreign exchange reserves, we deduce that Foreign exchange reserves are adequate in India.
Utilization of Foreign exchange reserves by India Vis-à-vis other countries.
The guiding objectives of foreign exchange reserves management in India are similar to those of any emerging market economies in the world. The demands placed on the foreign exchange reserves may vary widely depending upon a variety of factors including the exchange rate regime adopted by the country, the extent of openness of the country’s economy, the size of the external sector in a country’s GDP and the nature of markets operating in the country. Even within this divergent framework, most countries have adopted the primary objective of reserve management as preservation of the long-term value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns. While safety and liquidity constitute the twin objectives of reserve management in India, return optimization becomes an embedded strategy within this framework. There are 4 types of risk factors that the government of India considers while deciding the investment of its foreign exchange reserves. 1. Credit risk 2. Market risk 3. Liquidity risk 4. Operational risk and control system
(i) Credit Risk: Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms. RBI has been extremely sensitive to the credit risk it faces on the investment of foreign currency assets and gold in the international markets. Investments in bonds/treasury bills, which represent debt obligations of Triple-A rated sovereigns and supranational entities do not give rise to any substantial credit risk. Placement of deposit with BIS and other central banks like Bank of England is also considered credit risk-free.
However, placement of deposits with commercial banks as also transactions in foreign exchange and bonds/treasury bills with commercial banks/investment banks and other securities firms give rise to credit risk. Stringent credit criteria are, therefore, applied for selection of counterparties. Credit exposure vis-a-vis sanctioned limit in respect of approved counterparties is monitored on line. The basic objective of an on-going tracking exercise is to identify any institution (which is on the RBI’s approved list) whose credit quality is under potential threat and to prune down the credit limits or de-list it altogether, if considered necessary. A quarterly review exercise is also carried in respect of counterparties for possible inclusion/deletion. (ii) Market Risk: Market risk contains two different types of risks as given below: (a) Currency Risk: Currency risk arises due to uncertainty in exchange rates. Foreign exchange reserves are invested in multi-currency, multi-market portfolios. In consultation with Ministry of Finance, decisions are taken regarding the long-term exposure on different currencies depending on the likely currency movements and other considerations in the medium- and long-term (such as, the necessity of maintaining major portion of reserves in the intervention currency and of maintaining the approximate currency profile of the reserves in line with the changing external trade profile of the country as also for diversification benefits). The Top Management of RBI is kept informed of the currency composition of reserves through a weekly Management Information System (MIS) report. (b) Interest Rate Risk: The crucial aspect of the management of interest rate risk is to protect the value of the investments as much as possible from the adverse impact of the interest rate movements. The focus of the investment strategy revolves around the overwhelming need to keep the interest rate risk of the portfolio reasonably low with a view to minimizing losses arising out of adverse interest rate movements, if any. This approach is warranted as reserves are viewed as a market stabilizing force in an uncertain environment. (iii) Liquidity Risk: The reserves need to maintain a high level of liquidity at all times in order to be able to be able to meet any unforeseen and emergency needs. Any adverse development has to be met with reserves, and hence a highly liquid portfolio is a necessary constraint in the investment strategy. The choice of instruments determines the liquidity of the portfolio. For example, Treasury securities issued by the US government can be liquidated in large volumes without much distortion to the price in the market, and thus can be considered as liquid. Also, most of the investments with BIS can be readily converted into cash. In fact, excepting fixed deposits with foreign commercial banks , almost all other types of investments are in highly liquid instruments which could be converted into cash at short notice. RBI closely monitors the portion of the reserves which could be converted into cash at a very short notice to meet any unforeseen/emergency needs. (iv) Operational Risk and Control System: Internally, there is a total separation of the front office and back office functions and the internal control systems ensure several checks at the stages of deal capture, deal processing and settlement. There is a separate set up responsible for risk measurement and monitoring, performance evaluation and concurrent audit. The deal processing and settlement system is also subject to internal control guidelines based on the principle of one point data entry and powers are delegated to officers at various levels for
generation of payment instructions. There is a system of concurrent audit for monitoring compliance in respect of all the internal control guidelines. Further, reconciliation of accounts is done regularly. In addition to annual inspection by the internal machinery of the RBI for this purpose and statutory audit of accounts by external auditors, there is a system of appointing a special external auditor to audit dealing room transactions. The main objective of the special audit is to see that risk management systems and internal control guidelines are adhered to. There exists a comprehensive reporting mechanism covering all significant areas of activity/operations relating to reserve management. These are being provided to the senior management periodically, viz., on daily, weekly, monthly, quarterly, half-yearly and yearly intervals, depending on the type and sensitivity of information. The essential legal framework for reserves management is provided by the Reserve Bank of India Act, 1934. Specifically, sub-sections 17(12), 17(12A), 17(13) and 33(1) of the Reserve Bank of India Act, 1934 define the scope of investment of external assets. Considering the risk factors , the law broadly permits the following investment categories: i. ii. iii. iv. Deposits with other central banks and Bank for International Settlements (BIS). Deposits with foreign commercial banks. Debt instruments representing sovereign/sovereign-guaranteed liability. Residual maturity for debt papers should not exceed 10 years. Other instruments/institutions as approved by the Central Board of RBI
Hence we see from the legal restrictions imposed by RBI that there is no room for investment of foreign exchange reserves in equities. We find that for India majority of its foreign exchange reserves are invested in the central banks of other countries or as securities. Under securities India generally invests in triple A bonds. For other emerging economies such as Korea, China or Singapore we find that these countries have also invested their foreign exchange reserves in the equity market to achieve higher returns. India on the contrary is following a very conservative approach in terms of utilization of its foreign exchange reserves. India’s Investment of Foreign exchange reserves vis-à-vis other countries is shown below. Utilisation of Foreign Exchange Reserves in US million $(Oct 2008) Singapore Korea Israel Official reserve assets 162,173.90 212,253 35,425 Securities 150,245.00 192,119 31,375 Other national central banks, BIS and IMF Domestic Banks Foreign Banks IMF reserve position SDRs Gold (Source: www.imf.org)
298.8 1,174 14,118 94.1 339.8 211.7 454 195.21
252,883 102,107 136,728 0 5,210 447 9 8,382
20,213 313 82 75
2,332.46 99.49 13.45 0
The percentage distribution of India’s foreign exchange reserves’ investment is shown below. Note: Securities include investment in equities for China, Israel, Korea and Singapore. PERCENTAGE UTILIZATION AS ON OCTOBER 2008
100 90 80
Singapore Korea Israel India
70 60 50 40 30 20 10 0 Securities Other national central banks, BIS and IMF Domestic Banks Foreign Banks
IMF reserve position
As a result of India’s conservative investment policies, the percentage returns have been around 2.1 to 4.6 percent in the last seven years as shown below. %RETURN ON FOREIGN CURRENCY ASSETS AND GOLD
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0
4.1 2.8 2.1 3.1 3.9
Utilization of Foreign exchange reserves by other countries: Countries like Singapore, China and Korea have used their foreign exchange reserves very well by creating sovereign wealth funds. These sovereign wealth funds invest money in equities, real estate investments and other financial instruments. Singapore: The Government of Singapore Investment Corporation (GIC), established in 1981, invests internationally in equities, fixed income, money market instruments, real estate and special investments. GIC notes that it manages assets owned by the Government of Singapore (GIC's parent) and the Monetary Authority of Singapore. It has extensive retail property investments in Australia. The present value of its assets is around 330 billion US dollars. The government also wholly owns Temasek, an unwieldy conglomerate (with assets estimated at over US$100 billion) with substantial offshore holdings that include a controlling stake in Australia's Optus and Thailand's Shin telecommunications and broadcast group. The trend graph shows that Singapore has been aggressively investing in securities. Its investments in other instruments are not very significant.
Forex reserves Singapore
200000 180000 160000 140000 US million $ 120000 100000 80000 60000 40000 20000 0 Mar/01 May/02 Mar/08 Aug/00 Nov/05 Aug/07 Feb/04 Dec/02 Sep/04 Apr/05 SDRs gold other national central banks, BIS and IMF banks headquartered in the reporting country banks headquartered outside the reporting country IMF reserve position Total Reserves Securities
Korea: Korea has also established its own sovereign wealth fund in the year 2005. The SWF was named as Korea Investment Corporation and 17 billion US dollar worth of foreign exchange reserves were invested in it. The trend shows that since 2005 Korea has followed in the footsteps of Singapore and has its major investments in Securities and foreign banks.
Forex Reserves Korea
300000 Total Reserves 250000 Securities other national central banks, BIS and IMF banks headquartered outside the reporting country IMF reserve position SDRs 50000 gold 0 Jan/05 Jan/06 Jan/07 Sep/05 Sep/06 Sep/07 Jan/08 May/05 May/06 May/07 May/08 Sep/08 banks headquartered in the reporting country
200000 US million $
Israel: Traditionally Israel has been investing in most of the reserves in Securities and foreign banks. But since January 2008, it has started to decrease its investments in foreign banks and increase its investments in Securities.
Forex Reserves Israel
40000 Total Reserves 35000 30000 US million $ 25000 20000 15000 10000 5000 0 Jun/02 Jun/03 Jun/04 Jun/05 Jun/06 Jun/07 Dec/01 Dec/02 Dec/03 Dec/04 Dec/05 Dec/06 Dec/07 Jun/08 Securities other national central banks, BIS and IMF banks headquartered in the reporting country banks headquartered outside the reporting country IMF reserve position SDRs
China: In 2007 China created its SWF known as China Investment Corporation to manage 200 billion USD foreign exchange reserves. Conclusion: From the above examples we can see that foreign exchange reserves can provide better returns if it is invested accordingly. Considering the examples of these South Asian countries, India can also start its own SWF and to increase the returns it earns on Foreign exchange reserves. Considering the fact that India has Foreign exchange reserves to suffice 16 months of import bills, India can go for investing up to 25% of its foreign reserves in SWF. Even after investing 25% of the existing reserves, India would be left with enough reserves to suffice 12 months of import bills. This is sufficient considering the present FII pullouts from the country on account of economic turbulence. However India should avoid using its Foreign exchange reserves in Infrastructure as these projects yield low returns on account of political and economic difficulties especially in adjusting the tariff structure. The use of FER to finance infrastructure may lead to more economic difficulties, including problems in monetary management.
International Trade and Finance
The doc includes topics like foreign reserves and risk in its investment
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