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Forex reserves: Another milestone reached... - Views on News from Equitymaster
 
 
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  • Apr 17, 2007

    Forex reserves: Another milestone reached...

    India's forex reserves during the week ended April 6, 2007 reached US$ 200 bn for the first time (US$ 145 bn as on March 2006). This is a far cry from the crisis in 1991 when these reserves were barely enough to cover only three weeks of imports. India is now the fifth Asian country after China, Taiwan, Japan and South Korea to have forex reserves touching US$ 200 bn.

    India's initial policy was to maintain enough reserves sufficient to cover the import of essential goods namely food grains and petroleum products. However, since then, the change in the nature of capital inflows prompted the government to broaden the scope of the same. With changing nature of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has broadened to include a number of factors. This takes into account the size, the risk profiles of the capital flows and the nature of the external shocks to which a country is vulnerable.

    Besides the traditional import cover definition, which improved from a low of 3 weeks of imports at the end of December 1990 to around 10 months at the end of December 2006, another indicator of reserve adequacy has stressed that the usable foreign exchange reserves should exceed the scheduled amortization of foreign currency debts during the following year - assuming that there are no rollovers. To put things into perspective, India's ratio of short-term debt to foreign exchange reserves fell down significantly from a high of 146.5% at the end of March 1991 to 6.4% at the end of September 2006 (Source: RBI).

    The three main contributors to the forex reserves are (a) foreign capital (both Foreign Institutional Investors (FIIs) and FDI) (b) external commercial borrowings (ECB) and (c) banking capital, of which NRI deposits form a part. In recent times, FII inflows into India have played a significant role in impacting the exchange rate and have also contributed to the strong accretion to the country's forex reserves. FII's interest in Indian equities has largely been prompted by the strong GDP growth that the country has been witnessing. To add to this, the intervention by the Reserve Bank of India (RBI) in the forex market, to check the sharp appreciation of the Rupee for making exports competitive, has also led to the accumulation in forex reserves.

    Amongst the three, we believe that foreign direct investment i.e. FDI is the more important as it plays a key role in boosting domestic capital, productivity and employment, all of which are important to sustain the growth of any economy. For a developing economy like India, FDI especially in developing the country's infrastructure (one of the largest challenges facing the Indian economy today) will go a long way in sustaining the growth momentum of the Indian economy in the future.

    The robust growth in the forex reserves has also brought to the fore the issue of capital account convertibility (CAC). It must be noted that during the Asian crisis in 1997, India was relatively unscathed as compared to its Asian peers, due to the imposition of stricter capital controls. However, apart from the long-term benefits of CAC in India, it should be noted that, if there is a financial contagion, an open capital account has the ability to throw the financial system into a state of mess. This is on the back of a financial system's 'unholy trinity', according to which a country may not simultaneously have an open capital account, a fixed exchange rate and an independent domestic monetary policy.

    To sum up...

    The strong growth in the forex reserves has led to the sharp appreciation of the rupee, which touched a nine-year high of Rs 41.9 per dollar yesterday. Despite the RBI intervening in the forex market, the level of intervention has not been high owing to its stance of reducing the liquidity in the financial system. The fact of the matter is that an unnecessarily large amount of foreign exchange reserves may not always be good for the overall economy. The key factor here is the deployment of the same. Given the poor infrastructure level in the country, the reserves can be put to more productive uses going forward. At the end of the day, improvement in infrastructure amongst other things will ensure the growth of the economy, which in turn will contribute to the financial health of the country in the future.

     

     

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