The Hindu Business Line : Nothing macho about forex reserves

Foreign exchange reserves play an irreplaceable role in many emerging economies. Any comparison of India and China harps on the reserves of the latter. But the accretion to China's reserves is a necessity that fills a critical gap. It is inapt to make a virtue of such a necessity. There is nothing macho at all about China's reserves of $610 billion. India needs forex reserves only because it does not trust the market to dynamically fill the demand-supply gap, says G. Ramachandran.

SOME emerging market economies have a macho view of foreign exchange reserves. Reserves evoke masculine pride. They are regarded as the equivalent of tough human muscles. Muscles are the well-earned assets of those that pump iron to acquire sculpted brawn. They are the rewards for unwavering focus, determination, effort and regularity.

To be sure, foreign exchange reserves play an irreplaceable role in many emerging economies. They lubricate and smooth the trade and capital flows of these economies. But reserves are quite unlike muscles. Foreign exchange reserves are a nation's assets, but they are not the rewards for hard work and diligence.

Quite simply, foreign exchange reserves are not earned. They are created by expanding domestic money supply. The central, or reserve, bank creates and then uses domestic money to buy foreign exchange. If a central bank creates more domestic money, it can buy more foreign exchange. It does not have to pump iron to build reserves. It does not have to sweat it out. It has to merely pump domestic money into the domestic economy and coolly build foreign exchange reserves. The creation of foreign exchange reserves is wholly a white-collar job.

Revered by media

It is surprising that emerging economies assign an extraordinarily high value to reserves so created. It is puzzling that the self-worth of nations should rise when foreign exchange reserves rise to touch new highs. It is equally puzzling that declining reserves cause despair and diffidence.

The accretion of reserves is regarded as the reward for managing the economy well. Reserves are also regarded by many as an antidote to the adverse impact of any payments crises in the future. The scars left by past payments crises and the rushing out of foreign capital could be at the bottom of these notions. The fear of recurrence of any crisis could stoke positive emotions towards the accretion of reserves.

An analysis of media reports in India since 1991 shows that rising reserves cause significant mood upswings. The payments crisis that India faced in 1991 remains fresh in the minds of many. The mood upswings are on a larger scale in some South-East Asian economies, especially since 1997. The magnitude of foreign exchange reserves of these economies and the feel-good index of their citizens are more strongly and more directly related now than in the past.

Revered by academia

Asia's academia has matched the enthusiasm of the media. In the past seven years, more than 600 term papers have focussed attention on foreign exchange (Forex) reserves. Scholars attending business schools have submitted three-fourths of these `Forex reserves' papers. These term papers uniformly treat reserves with unalloyed reverence.

Their common two-part hypothesis is that a nation earns its reserves and, therefore, large reserves are good for the stock markets, trade, price stability, employment, wages, savings, investments, electoral outcomes and more. But few term papers explain why their hypotheses are internally valid. Their statistical tests using empirical data fail to show that their hypotheses are externally valid.

Country is not a firm

The reverence that the media and academia have towards reserves is most likely the result of their inability to distinguish corporate reserves from country reserves. A firm or company is a unified accounting entity. Incomes, expenses, profits and losses; and assets, uses of funds, liabilities and sources of funds are of that firm.

The firm's reserves typically represent ploughed-back profits that are reinvested in assets. Profitable firms are most likely to have large reserves. Reserves represent muscles earned by the firm. But reserves are merely numbers that state how much profit has been ploughed back.

A country, by contrast, is not one accounting entity for exports, foreign direct investment (FDI) and foreign institutional investment (FII). It is also not one accounting entity for imports, outward FDI, outward FII and disinvestment by FIIs. Exporters, importers, companies, projects and investors cause and then record the accounting impact of these. They act independently of one another.

For example, India does not buy or sell the rupee and other foreign currencies. Exporters and inward investors sell foreign exchange and buy the rupee. They cause the inflows of foreign exchange. Importers, outward investors and exiting investors sell the rupee and buy foreign exchange. They cause the outflows of foreign exchange. India, to be candid, is merely a spectator.

Inflows equal outflows

India is not a company. It is not one economic entity for accounting inflows and outflows of foreign exchange. It comprises firms that act independently to buy and sell currencies. Buyers of foreign exchange meet sellers of foreign exchange in the currency markets.

Buyers of the rupee meet sellers in the same markets. The demand for foreign exchange should somehow be met by the supply of foreign exchange. The demand for the rupee should somehow be met by the supply.

That is, all inflows of foreign currencies should equal all outflows of foreign currencies. For this to happen, each foreign currency, say, the US dollar, the euro and the yen, will have to achieve an equilibrium price at every instant against the rupee.

Dynamic equilibrium price

When each foreign currency is allowed to achieve a dynamic clearing price against the domestic currency by reckoning with the demand and supply of that currency, the domestic currency is said to be in full float or floating freely. The clearing price dynamically matches inflows with outflows.

The domestic currency's value rises when foreign exchange inflows exceed foreign exchange outflows. When the domestic currency's value rises, say, from Rs 44 per dollar to Rs 40 per dollar, the supply of the dollar will equal the demand for it at the new clearing price.

By contrast, the domestic currency's value falls when foreign exchange outflows exceed foreign exchange inflows. When the domestic currency's value falls, say, from Rs 44 per dollar to Rs 48 per dollar, the demand for the dollar will equal the supply of it at the new clearing price.

Filling the gap

When the domestic currency's value rises or falls to match the supply of the dollar with the demand for it, the market fills the gap that separates supply from demand. The market cannot fill this gap if a country's exchange-rate policy does not allow the domestic currency to rise or fall freely.

Consider China. It has a fixed exchange rate policy. China has equated 8.28 yuan renminbi (CNY) to the dollar, the peg. The value cannot rise to, say, 7 CNY per dollar as a dynamic response to ever-rising exports and unceasing capital inflows.

China's imports and outward capital investments are insufficient to soak up the foreign exchange inflows. So, China's central bank buys the excess of the dollar inflows over outflows. It pays in CNY. If it does not, it would be impossible for China's exporters to make payments in CNY to their domestic employees and suppliers.

Therefore, the accretion to China's reserves is a necessity that fills a critical gap. It is inapt to make a virtue of such a necessity. There is nothing macho at all about China's reserves of $610 billion.

India's necessity

India too has a necessity to create reserves. Why? Its rupee cannot float freely. India's exporters may be very uncomfortable if the rupee strengthened from Rs 44 per dollar to Rs 40 per dollar in response to strong inflows of foreign exchange.

At the same time, India's importers may be wrecked if the rupee weakened from Rs 44 per dollar to Rs 48 per dollar in response to strong outflows of foreign exchange.

Hence, the Reserve Bank of India creates reserves that work against the strengthening of the rupee from Rs 44 per US dollar to Rs 40 per dollar. The RBI releases the rupee to soak up some of the foreign exchange inflows. The rupee may then gently rise to Rs 43 per dollar.

When outflows of foreign exchange threaten to weaken the rupee to Rs 48 per dollar, the RBI may release the dollar to soak up some rupees. The rupee may then gently fall to Rs 45 per dollar.

So, India needs foreign exchange reserves because it does not trust the market to dynamically fill the demand-supply gap. The RBI first weakens the rupee to stop it from strengthening. It then restores its strength to stop it from weakening. This is like going round in circles. It is also like digging holes and then filling them.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com)

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