Article Type: Research Article Article Citation: Bhakri Suman, and Verma Aman. (2020). FOREIGN EXCHANGE
RESERVES IN INDIA- A POLICY PERIOD ANALYSIS. International Journal of Research
-GRANTHAALAYAH, 8(11), 204-210. https://doi.org/10.29121/granthaalayah.v8.i11.2020.2454 Received Date: 15 November 2020
Accepted Date: 30 November 2020
Keywords: Foreign Exchange
Reserves (FER) External
Commercial Borrowings (ECBs) Liberalization Globalization World Recovery Motivation/Background: Foreign exchange reserves (forex reserves) received large-scale interest among the developing economies because of rapid increase in globalization, the acceleration of capital flows and the integration of capital markets domestically and globally as well. The expansion in the volume of trade activities and capital inflows in the form of investments and external commercial borrowings (ECBs) has led to the emergence of importance of managing the foreign exchange reserves. Foreign exchange reserves (FER) are regulated and managed by the various countries’ central banks. Method: The study is divided into four policy periods, namely, Liberalization, Globalization, World Recovery and Global financial crises. It will be using semi log growth equation model with dummy variables to find out the growth rates in foreign exchange reserves for different policy periods. Trends in foreign exchange reserves have been analysed for the period 1991-2017. Results: The finding of the study presents that the level of foreign exchange reserves are statistically significant in all the policy periods except world recovery, and the growth rates are also significant in all the policy periods. Conclusion: The current paper can be of great use for the policy makers as it will help them to analyse the trends in foreign exchange reserves in India not only during various policy periods but also in predicting the future trends of the foreign exchange reserves.
1. INTRODUCTIONForeign
exchange reserves (forex reserves) received large-scale interest among the
developing economies because of rapid increase in globalization, the
acceleration of capital flows and the integration of capital markets
domestically and globally as well. This has also posed various challenges to
emerging market economies. The debt crises in some developing economies in the
nineties have posed several issues and dilemmas to the policy makers on foreign
exchange reserves. The policy makers and academicians have started paying considerable
attention towards foreign exchange reserves management. The
expansion in the volume of activities related to trade and inflow of capital in
the form of investments and commercial borrowing has led to the emergence of
importance of managing the foreign exchange reserves. Globally there is no
unique definition of foreign exchange reserves because there have been a lot of
divergence of views in terms of ownership of assets, liquidity aspects,
coverage of items and need for a distinction between owned and non-owned
reserves. However, for operational purposes, most countries in the world have
adopted the definition suggested by International Monetary Fund (Balance of
Payments Manual, and Guidelines on Foreign Exchange Reserve Management, 2001),
which defines reserves as “external assets that are readily available to and
controlled by monetary authorities for direct financing of external payments
imbalances, for indirectly regulating the magnitudes of such imbalances through
intervention in exchange markets to affect the currency exchange rate, and/or
for other purposes.” Reserves are held in one or more currencies, mostly in
dollar (US$) and to a less extent in European Union’s euro, the British pound
sterling and the Japanese yen. Foreign
exchange reserves are classified into two inter-linked areas, namely, the
theory of reserves, and the management of reserves. The theory of reserves
encompasses issues relating to legal and institutional arrangements for holding
reserve assets, definitional and conceptual aspects, and objectives for holding
foreign reserve assets, exchange rate, and determining the appropriate level of
foreign reserves. In essence, a theoretical framework for reserves provides the
basis for holding forex reserves. On the
other hand, reserve management mainly involves the portfolio management of
foreign reserves i.e., how best to deploy foreign reserve assets. The portfolio
considerations take into account inter alia,
liquidity, safety and yield on reserves as the major objectives of reserve
management. Foreign exchange reserves are called reserve assets in the balance
of payments and are recorded in the capital account. The reserves are regarded
as assets under functional category. In terms of financial assets
classification, the reserve assets are classified as gold bullion, unallocated
gold accounts, currency, special drawing rights, reserve position in the IMF,
interbank position, other deposits, other transferable deposits, debt
securities, loans, equity (listed and unlisted), financial derivatives, such as
forward contracts and options and investment fund shares. There is no
corresponding item for reserve assets in liabilities of the international
investment position. Usually, when the monetary authority of a country has some kind of liability, this will be included in other
categories, such as other investments. In the Central Bank’s Balance Sheet,
foreign exchange reserves are assets, along with domestic credit. The
standard approach of measuring foreign exchange reserves takes
into account the unencumbered foreign reserve assets held by the
respective monetary authorities, however, the foreign currency and securities
held by the general public, corporate bodies and the banks are not accounted
for in the definition of official holdings of reserves. In India, the Reserve
Bank of India Act 1934 contains the provisions for the RBI to act as the
custodian of foreign reserves and manage them with the defined objectives. The
term ‘reserves’ refer to both foreign securities held by the Issue Department
and foreign reserves held in the form gold assets in the Banking Department and
domestic reserves in the form of bank reserves. It is the RBI, as custodian of
forex reserves lays down the rules and norms regarding such reserves. The
traditional approaches to reserve determination are considered to be pure trade based models comprising mainly measures of import
cover, opportunity cost and foreign exchange market intervention. The approach
of India for reserve management, until the balance of payments crisis of 1991
was essentially based on this traditional approach, i.e., to maintain an
adequate level of import cover defined in terms of number of months of imports
equivalent to reserves. The approach to reserve management underwent a paradigm
shift when other areas were also noticed and the need for short term debt
discharging and medium term debt servicing was felt. Unlikely,
the contemporary reserve demand models incorporate features like free capital
mobility, inflation targeting, return-risk trade-off and complications arising
from intermediate exchange rate regimes. Earlier studies on optimum reserves
mainly identify three primary motives for accumulating reserves, namely,
transaction motive, precautionary motive and
speculative motive (Reddy, 2002). While transaction motive applies to reserve
demand by the commercial banks, precautionary motive dominates the central bank
reserve accumulation behaviour. Besides keeping
reserves for meeting the balance of payments deficits, countries also keep certain
amount of reserves for meeting unforeseen
contingencies. While
considering the management of reserves, the costs and benefits associated with
holding reserves should constantly be assessed. On the risks and costs side,
maintaining high level of foreign reserves to tide over external shocks
involves opportunity costs. It is basically the foregone investment because the
resources have been used to purchase foreign exchange reserves instead of
increasing domestic capital. On the
benefits side, during financial crises, it has been seen that maintaining and
holding sufficient reserves and disclosing adequate information to markets
helps a country to prevent itself from external crises, especially those
stemming from the capital account, mainly financial institutional investments and external commercial borrowings. The reserve
management plays a central role because of its growing importance of reserves
in crises prevention and as a buffer to manage exchange market pressures.
Therefore, we can say that opportunity cost of holding reserves is the marginal
productivity of domestic capital and the reserve management authority seeks to
minimize this opportunity costs against the benefits that accrue from holding
reserves. Mohanty
and Turner (2006) noted that effective sterilization can bring fine results to
a country. Green and Toregerson (2007) proposed that
sterilization basically neutralizes the inflationary monetary impact of reserve
accumulation by offsetting the corresponding increase in money supply with a
domestic money market operation, typically domestic debt issuance. However,
Mohanty and Turner (2006) emphasized ineffective sterilization may obstruct the
growth of the economy and may also bring macroeconomic instability. Sen (2005)
noted that RBI intervention to keep the real effective exchange rate (REER)
constant, especially in the initial stages of the inflows when it was viewed as
temporary. The purchase of foreign exchange reserves raises the monetary base but RBI neutralizes (sterilizes) through a
contractionary open market operations, i.e., via the sale of government bonds. According
to Sahu (2015), India maintained the import coverage
ratio, which far exceeded the global benchmark of 3 months. The commonly
accepted ratio for covering short term external debt is 1 and in India, it was
found that this ratio has always been more than 1. India’s forex reserves have
always been sufficient during his period of study. India not only covered its
100% short term external debt, but also more than 50% of total external debt
(TED) as against globally accepted norm of at least 40% coverage.Kapteyn (2001) noted that India maintains
market determined exchange rate system and its ratio of foreign exchange
reserves to broad money (M2) has always been more than 10 percent. Polterovich and Popov (2003) stated that the accumulation
of foreign exchange reserves (FER) contributes to the economic growth of a
developing country by increasing both the Investment/GDP ratio and capital
productivity. 2. MATERIALS AND METHODSThe paper
has used annual time series data for the period of 1991-2017 for foreign
exchange reserves in India. Data in this study has been extensively used from
secondary sources. All the figures that are used in this study are collected
from the national and international publications.The
time period for the study has been divided into four big policy periods or
major changes in Indian economy namely, Liberalization, Globalization, World
recovery and Global financial crises. This has been done to analyseand
understand the impact of policy periods on the growth of foreign exchange
reserves in India. ·
Liberalization
1991-92 to
1994-95 - Policy period I ·
Globalization 1995-96 to
2001-02 - Policy period II ·
World
recovery 2002-03
to 2007-08 - Policy period III ·
Global
financial crises 2008-09 to
2016-17 - Policy period IV A
regression and graphical analysis are undertaken to determine the growth rates
of foreign exchange reserves during the period under consideration. Dummy
variables have been incorporated in semi log regression model for finding the
impact of policy periods on foreign exchange reserves in India. Dummy variable
takes the value of 0 and 1. Semi
log Equation with Dummy Variables (Policy Period Analysis) Following
is the regression equation for policy period analysis in which dummies have
been incorporated. Log(Y)-
Natural log of dependent variable, foreign exchange reserves a1-
intercept of policy period I b1-
slope or growth rate of policy period I b2-
difference in intercept of policy period I and II b3-
difference in intercept of policy period I and III b4-
difference in intercept of policy period I and IV b5-
difference in slope or growth rate of policy period I and II b6-
difference in slope or growth rate of policy period I and III b7-
difference in slope or growth rate of policy period I and IV µt- error
term Incorporation of
Dummies in Regression Equation D2- 0 for 1991-92 to 1994-95 1 for 1995-96 to 2001-02 0 for 2002-03 to 2007-08 0 for 2008-09 to 2015-16 D3- 0 for 1991-92 to 1994-95 0 for 1995-96 to 2001-02 1 for 2002-03 to 2007-08 0 for 2008-09 to 2015-16 D4- 0 for 1991-92 to 1994-95 0 for 1995-96 to 2001-02 0 for 2002-03 to 2007-08 1 for 2008-09 to 2015-16 By using
above regression equations for different policy periods, growth rates and
intercepts can be computed. These are as follows: For Intercept Policy
period I - a1 Policy
period II - a1 + b2 Policy
period III - a1 + b3 Policy
period IV - a1+ b4 For Slope Policy
period I - b1 Policy
period II - b1 + b5 Policy
period III - b1 + b6 Policy
period IV - b1+ b7 Hypotheses There are
hypotheses which have been tested at 5% level of significance and the null hypotheses
are as follows: H10:
There is no difference in the level of foreign exchange reserves between the
period of liberalization and globalization H20:
There is no difference in the level of foreign exchange reserves between the
period of liberalization and world recovery H30:
There is no difference in the level of foreign exchange reserves between the
period of liberalization and global financial crises H40:
There is no growth in the value of foreign exchange reserves during the period
of liberalization H50:
There is no growth in the value of foreign exchange reserves during the period
of liberalization and globalization H60:
There is no growth in the value of foreign exchange reserves during the period
of liberalization and world recovery H70:
There is no growth in the value of foreign exchange reserves during the period
of liberalization and global financial crises 3. RESULTS AND DISCUSSIONSThe
regression statistics, for the growth of different policy periods, explains
significant or insignificant levels of different growth rates of foreign
exchange reserves in India for different policy periods (Table 1 and Table 2). Table 1: Regression Statistics of Foreign
exchange reserves in India
Table 2: Growth rate of Foreign exchange
reserves for different policy periods
The
findings of the study clearly indicates that during
the period of liberalization, the initial level of foreign exchange reserves of
India was positive and it grew at 43.99%, which is statistically significant
also, as P-value is less than 0.05 (5%). During the period of globalization,
the level of foreign exchange reserves increased in comparison to
liberalization, but the growth rate decreased drastically from 43.99% to
10.85%. This is a situation of “euphoria”. Both the level of foreign exchange
reserves and the growth rate are statistically significant. This means that
globalization had a significant impact on the foreign exchange reserves of
India. As far as the period of world recovery is concerned, it is observed that
the level of foreign exchange reserves has not changed as compared to
liberalization, as the value of D3 is not statistically significant. But the
growth rate has decreased to 28.62% as compared to liberalization, which is
statistically significant also. This implies that world recovery period had a
significant impact on the growth rate of foreign exchange reserves in India. The
period of global financial crises witnessed large amount of increase in the
level of foreign exchange reserves in India in comparison to liberalization (intercept
D4) and it is statistically significant also, but the growth rate has decreased
drastically as compared to liberalization. This was mainly due to the outward
flow of funds from India. India was less affected from the crises, as compared
to other countries, due to increased level of foreign exchange reserves during
the period of crises as compared to liberalization. Figure 1: Growth curve of Foreign exchange reserves for
different policy periods The
growth curve clearly indicates that during the entire period of study
(1991-2017), there was significant growth in the value of foreign exchange
reserves in India. The figure 1 basically shows the upward trend in the
differential growth of foreign exchange reserves between liberalization and
other policy periods. During liberalization, there was growth in the value of
foreign exchange reserves. As far as the globalization period is concerned,
there was again significant growth in the value of foreign exchange reserves.
This was mainly due to increasing FDI inflows into India. The value of foreign
exchange reserves declined during the period 2007-2009, due to global financial
crises as can be seen in the figure 1. One of the reasons identified for
decline in foreign exchange reserves during the above said period was outflow
of FDIs and FIIs from India. Still, India was less affected from the global
financial crises and soon observed rise in the foreign exchange reserves. India
witnessed an upward trend in foreign exchange reserves 2009 and thereafter. 4. CONCLUSION AND RECOMMENDATIONThe paper
hasanalysed the impact of different policy periods on
trends in foreign exchange reserves in India. The study has rejected six
hypotheses out of a total of 7 hypotheses. The hypotheses H20, is
not rejected, because its P-value is not coming out to be significant. The four
policy periods, i.e., Liberalization, Globalization, World Recovery and Global
Financial Crises are being considered for the analysis. The above
analysis conclude that the level of foreign exchange reserves are statistically significant in all the policy periods
except world recovery, and the growth rates are also significant in all the
policy periods. The current paper can be of great use for the policy makers as
it will help them to analyse the trends in foreign
exchange reserves in India not only during various policy periods but also in
predicting the future trends of the foreign exchange reserves. The present study has mainly concentrated on the trends in foreign exchange reserves during various policy periods. However, there are various factors like exports, FDIs, FIIs, ECBs, debt repayment etc. which also influence the level of foreign exchange reserves. Further researches can be undertaken in examining the impact of these factors influencing the level of foreign exchange reserves in India. Though the current paper has focussed only on one country (India) leaving the scope for further research by doing comparative analysis for other emerging economies. SOURCES OF FUNDINGThis research received no specific grant from any funding agency in the public, commercial, or not-for-profit sectors. CONFLICT OF INTERESTThe author have declared that no competing interests exist. ACKNOWLEDGMENTNone. REFERENCES [1] Barnichon, R. (2008). International
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