X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Forex reserves: Over hyped and under utilized - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Dec 12, 2003

    Forex reserves: Over hyped and under utilized

    Ever since our forex reserves have started reaching unprecedented levels (US$ 95 bn plus at the last count), the policymakers have been confronted with a dilemma of a different kind. How to cope with this embarrassment of riches? A lot of people have started arguing that rather than allowing the reserve to idle away in low interest earning dollar deposits, it would be prudent to use those reserves in a manner that would help in the overall development of the economy. Therefore, what should be the ideal level of reserves (to withstand shocks such as the rise in oil prices or sudden capital flight), and what part of the reserves should be put to proper use? Let's try and find out.

    Forex reserves are mainly held by a country to maintain balance between the demand and supply of money, help the central bank to intervene in the market during crises and also to preserve confidence in the ability of an economy to meet its external obligations. In order to perform all these functions, the economy requires a certain level of reserves and the thumb rule that is usually followed is that the reserves should be adequate to meet the import bill of the country for a certain number of months.

    The Rangarajan committee set up for this purpose recommended that the reserves should be adequate to meet the import bill for three months. But that was 1993 and a lot of changes have taken place in the markets since then. Prominent among these is the fact that in addition to trade flows and economic growth, capital flows have also emerged as one of the major determinants of exchange rate.

    As has been proved by the East Asian economic crisis, these capital flows can be taken out of the economy at a very short notice and this can trigger a series of events, which can put the currency of a country at serious risk. Therefore, in order to avoid any such risk, some cushion in the form of reserves, over and above that required to meet the import bill should be set aside to prevent any volatility in the capital flows. To make things simpler, if we assume this figure to be equivalent to say around three months of import bill then the total reserve requirement would stand at around six months of import bill (three months for actual import + three months to account for capital flow risk).

    At current levels, India can easily finance its import for 16 months. But does it really make sense for a developing country like India to hold such a high level of reserves and invest it in foreign currency bonds where interest rates are at an all time low.

    India is a developing economy with a relatively low savings rate as compared to other developing economies like China and as a result, has to rely on capital from abroad for its investment needs. We are living in an age of financial integration where developing economies compete against each other for funds, so that they can achieve a higher growth rate by making profitable investments. These funds are most likely to flow from developed world where there is a surplus of capital. The capital surplus economies would only be interested in an economy if the return on their investment were greater than what they get anywhere else in the world.

    There are primarily three ways in which capital can flow into the economy. These are the external commercial borrowings from overseas banks (short term and long term), investment in capital markets and foreign direct investment (FDI) in the form of plant and machinery.

    Out of the three forms, it is believed that investments in plant and machinery and other physical assets is the best indicator of faith that the overseas investor has in the long-term prospects of the economy. Therefore, developing nations should try and tap this form of capital investments if they really want to grow in the real sense. This is where our excess reserves can be put to good use. Given the poor infrastructure level in the country, the reserves can be used to invest in certain key infrastructure areas like road and power. This infrastructure along with our cheap and skilled manpower and also the enormous growth potential in the economy will definitely attract more foreign capital in the country.

    The comfortable position of India's forex reserves is making a lot of people to proclaim that the capital account convertibility process should be hastened. Capital account convertibility is nothing but giving someone an unrestricted freedom to convert his assets from one currency to another. Although full convertibility of the rupee has still not seen the light of the day, there has been a notable progress on the same. Companies have been allowed to retire overseas debt ahead of schedule. They have considerably more freedom in acquiring foreign companies. Banks in India have been asked to confer convertibility status on a significant portion of their non-resident deposits. Very recently, fungibility of shares listed in Indian stock markets has become a reality.

    A non-resident shareholder can easily shift his investments between instruments listed in India and the underlying ADR/GDR listed abroad. Thus it would be fair to say that as far as conveniences on the personal and business front is concerned, rupee is for all practical purposes convertible. However, there should be restrictions on short-term external commercial borrowings and also on the freedom given to domestic residents to convert their domestic bank deposits and idle assets in response to market developments as these can make an economy extremely vulnerable and emerging markets like India will find it difficult to come to terms with it in a volatile scenario.

    Despite these avenues, the government seems circumspect of employing these reserves just yet. Probably, policy makers are looking a little for sustainable trend on the forex inflows front before they go in for an alternate policy on gainful employment of forex reserves.

     

     

    Equitymaster requests your view! Post a comment on "Forex reserves: Over hyped and under utilized". Click here!

      
     

    More Views on News

    Insider Leaks Equitymaster Stock Picks (The 5 Minute Wrapup)

    Jul 25, 2017

    Equitymaster HQ has been infiltrated. Valuable stock ideas have been leaked. Who's responsible?

    Raymond and Other 'For Profit' Companies Who Don't Care about Shareholder Returns (The 5 Minute Wrapup)

    May 27, 2017

    What happens when minority shareholders are short-changed in the normal course of business?

    Why Commission Driven Model In Mutual Funds Should Be Eliminated... (Outside View)

    Feb 15, 2017

    PersonalFN believes SEBI has taken a step back-apparently in the admission of it going overboard with the regulations.

    This Book Changed How I Looked at the World of Man and Money (Vivek Kaul's Diary)

    Aug 24, 2016

    And here's your chance to claim a free copy of this book...

    The Developed World is Dying because of Demographics, Debt, and Deflation (Vivek Kaul's Diary)

    Aug 12, 2016

    And Why India's demographic dividend could turn out to be a doubtful debt...

    More Views on News

    Most Popular

    This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process)(The 5 Minute Wrapup)

    Aug 17, 2017

    A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

    The Most Important Innovation in Finance Since Gold Coins(Vivek Kaul's Diary)

    Aug 10, 2017

    Bill connects the dots...between money and growth, real money and real resources, gold and cryptocurrencies...and between gold, cryptocurrencies, and time.

    It's the Best Time to Buy IT Stocks(Daily Profit Hunter)

    Aug 16, 2017

    The IT Sector could be in an uptrend till February 2019. Are you prepared to ride the trend?

    Bitcoin Continues Stellar Rise(Chart Of The Day)

    Aug 10, 2017

    Bitcoin hits an all-time high, is there more upside left?

    5 Steps To Become Financially Independent(Outside View)

    Aug 16, 2017

    Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    MARKET STATS