What Are Forex Reserves?

6 comments Written on December 28th, 2013 by
Categories: Concepts, Demystify, ExchangeRates, Forex, RBI
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We keep talking about our “Forex Reserves” and worry if they fall from $300 billion to $290 billion, as if some politician just enriched their pockets by taking that much money out of somewhere in the trenches. But reserves need more explanation.

What are reserves?

The dollars that you have in your cupboard from that US visit in 2009 is not part of the reserves I speak of. It is also not a total of all the dollars brought in by importers. Forex dealers own “inventory” of dollars, which again are not counted. What “reserves” include is only what is owned by the RBI.

RBI owns foreign exchanges reserves, mostly in dollars. These dollars are usually short term US securities (like T-Bills), but will also include other currencies like Euros, Yen etc. Some of the other reserve elements are gold (which RBI owns), Special Drawing Rights (SDRs) and a Reserve Tranch Position of the IMF. The last two are fairly small. Here’s how the reserves look since 2001:

Forex Reserve Composition

How does the RBI acquire dollars?

There is a foreign exchange market which is “over the counter”. A foreign investor wishing to buy Indian stocks will have to pay for them in rupees. The investors goes to a bank and says I have X dollars, give me rupees. Now the bank may offer the rupees, but it wants to sell the dollars to someone else.

If there is no one else willing to buy dollars from too many foreign investors coming in, the demand for rupees is higher than the demand for dollars. In isolation, this would mean people would give less rupees per dollar, and the rupee-dollar equation could fall seriously.

The fall in the exchange rate has scared the central bankers because it doesn’t help “price stability”, a stated goal. To avoid the rupee exchange rate falling, the RBI buys dollars from banks and prints rupees to offset.

The RBI Balance Sheet and Inflation

The extra rupees comes into the system, and the RBI’s balance sheet looks like:

  • Extra Assets : These Dollars it has bought
  • Extra Liabilities: These rupees it has printed.

This is why, on your 100 rupee notes, you see a “I promise to pay the bearer a sum of one hundred rupees” by the RBI governor. Because it’s a liability of the RBI.

Now in general, why would we do this? Why would we print money to stabilize the exchange rate? Wouldn’t it introduce inflation?

Answer: of course it will! More rupees in the system will result in more rupees chasing the same products. (Unless we use the excess rupees to create that many more extra products to offset). Our “real” growth - that is, an increase in the total things that money can chase - has been about 8%. However, the amount of money we printed has been as much as 16%!

(Some of it was printed to buy dollars, some to buy Indian government bonds)

The problem is that inflation has a lag effect. What was printed in 2007 will result in inflation a few years later, especially as savings rates come down. (When you save less, you spend more, and that money actually chases those goods and inflates their prices)

Why do we bother about reserves?

Many people think it is to cover against imports. Others think it is to satisfy foreign investors. After the Asian Crisis of the 90s, the thinking has been that developing nations need to build forex reserves to protect against devaluation. There is a fear that “speculators” come with lots of money and manipulate the forex market. And then there’s the whole currency volatility issue mentioned above.

The rupee isn’t fully convertible. That is, other countries can’t hold Indian rupees in their “reserves”. One of the reasons why need reserves is that other people can’t take rupees for what we buy from them.

All of these contribute to the building up of reserves.

In 1992, India went through a massive crisis that saw currency reserves fall to as little as 15 days of imports. At the time, there was NO convertibility at all. Foreign investors were not even allowed in most cases. And to be honest, Indian investors weren’t exactly invited either. We were a closed economy,needing licences for everything. Reserves therefore are looked as as sacrosanct.

They haven’t really helped. While the RBI has bought dollars to protect the rupee from gaining value (gaining means lesser rupees to buy dollars) it has not been able to do it the other way around when the rupee lost value. In 2013, the rupee lost 10% and the RBI refused to sell dollars from its precious reserves.

The fear of “losing reserves” has prompted them to not sell dollars. Also they wanted the market to play out. Which means price stability only works in one direction: to not let the rupee rise.

Do we need forex reserves?

My opinion: not this much. We can do with half this amount, or even lesser.

We could make the rupee convertible, of course. We just don’t want to because intelligent people with white beards tell us that if we did that a great calamity would strike the nation and we happily believe them. But if we think through this, we can free our currency and let others own it, and allow them the complete freedom to sell it where they want, when they want.

Foreigners won’t just hold rupees, they’ll want to get Indian interest rates on the rupees they hold. So they should be allowed to freely hold Indian rupee bonds (there are tiny limits like $20 billion or such, at this point, for certain bonds).

If we did this, we wouldn’t need that much import cover. If you need to import, you can pay in rupees instead. If you need dollars you go to the market and pay market prices - someone will exist that holds dollars and wants rupees. (If not, you’ll have to pay more. And there are enough buyers or sellers at some price, we’ve seen this playing out).

RBI owning reserves introduces another element: market manipulation. RBI cannot buy government bonds without informing the market days in advance. It tells players how much it will buy, and has an auction inviting offers from banks and dealers. But it does no such thing for forex. It will directly buy or sell, and thus manipulate the market because it can print rupees whenever it wants or use its massive hoard. This is evil, because a market player being a market regulator is frightening as much as it may enrich a few people in the know. (Even if reserves are to be held, they should purchase dollars in auctions, with amounts known in advance)

The RBI should then pare its reserves down and hold mostly Indian government securities for its balance sheet. The only thing that should dictate printing money should be  Let the exchange rate be volatile, it doesn’t matter. The using of reserves has done NOTHING to protect us from volatility (the USDINR rate has fallen 50% in two years!) and it has brought us structural inflation that we just cannot deal with.

Luckily the RBI governor has mentioned we need to do some of this. That the rupee needs to be more involved in global trade, and foreigners need more access to our economy. Let’s hope, as we must, that things will change for the better.

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About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@gmail.com.

6 comments “What Are Forex Reserves?”

Some questions, which may look stupid but I can’t help asking:

1) Why can’t someone, let’s say ‘X’ hoard rupee in say another country and then start converting them in another currency and earn a decent spread? What’s stopping Mr. X?

2) If I remember correctly, while RBI promises the bearer 100 bucks for a 100 rupee note, in the US, the federal reserve does not do the same. Why can’t RBI do the same?

3) Another thing – I believe that our own currency derives it’s value from the reserves that our own country has – i.e. the gold, the other country currency etc. If the value of rupee falls, then the value of dollar rises, in effect, the value of RBI reserve is the same, essentially, the source from which it is deriving it’s value is the same, then why does the value of rupee fall?

4) One last thing, I understand your argument above ( I hope so), you are saying that in effect of the rising reserve, we have actually increased inflation coz these many reserves were not required. But Deepak, take yourself back to the same days when this process started – How could you have predicted that this much printing would have increased inflation beyond the comfortable limit. Now it’s very easy to say that the reserve should be less than half, thus putting an anchor as to where the inflation should be but you have this advantage of knowing what has already chanced now. How could it have been predicted in 2007 that these many reserves would lead to this much inflation?

If any of these questions are too asinine, I don’t care :P please bear with me – I’m an avid reader :)

My take – there are no stupid questions :)

1) This X hoard rupee as rupee notes is okay, because RBI can’t do anything about it. But foreigners will want to earn the interest on it? Then they have to own rupee bonds or such, which they can’t easily do right now.

2) The US used to have it till 1934, when they suddenly stopped :) We can, of course, but it would be pointless unless the government issued currency directly. (Note that the 1 rupee note does not have anything of the sort. The 1 rupee note is issued directly by the government, not by the RBI.)

3) Our currency does not derive its value from reserves. It derives its value from teh demand and supply of the currency vis a vis other currencies. There is no intrinsic value ot the rupee, as it’s just a promissory note and for hte most part, has no backing of any sort. (For example, RBI has issued only about 16 trillion rupees, but there is about 80 trillion worth of deposits in the banking system. No, it’s not really backed by anything :) )

4) Inflation printing beyond the comfort limit: if you grow reserve money (of whihc forex reserves are a part) by 20% a year, and you know that real growth is just 8% (expectations of RBi itself) then you have to be aware that the extra 12% is going to cause inflation. Btw, I’ve been writing about this for a while now. Check out http://capitalmind.in/2011/06/stop-buying-dollars-curb-money-supply-inflation/.

Thanks a tonne. :)

Hey DeepakVery Good Explanation my many doubts have been cleared .

But I haven’ts understood few thingss..
2) If I remember correctly, while RBI promises the bearer 100 bucks for a 100 rupee note, in the US, the federal reserve does not do the same. Why can’t RBI do the same?

$$$YOUR ANSWER$$$$

2) The US used to have it till 1934, when they suddenly stopped :) We can, of course, but ***** it would be pointless unless the government issued currency directly.*** (Note that the 1 rupee note does not have anything of the sort. The 1 rupee note is issued directly by the government, not by the RBI.)

Here , what is means “” it would be pointless unless the government issued currency directly. “”

Also as far as I know our Rupee is FIAT Currency means backed by NOTHING.

My last Question ,,RBI promises the bearer RS100 for a 100 rupee note….Does it mean that if the bearer brings a torn 100 rupee note than the RBI will replace it with FRESH.

If the government issued it then we could use the governments assets no? Like their stake in PSUs, land owned by central government etc. as the backing. RBI issued debt is a waste. Effectively it becomes debt of the government directly payable to us.

No the RBI promise is simply that this is a note saying whoever the bearer is, I will pay him Rs. 100. When you transfer it around, you are effectively giving someone else the right to claim Rs. 100 from RBI. RBI will just take your note and give you another note :)

why dont we design the financial instruement that will do the function of exchange between the Inr and dollar.
that will provide the free market to operate and controlled by rbi
the main important thing is that here rbi can introduce some feature what they want and they can be traded in the market


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