The Hindu Business Line : Forex Reserves Management: IMF guidelines and Indian practice

In terms of holding reserves in forms other than cash, liquidity assumes top priority. That comes at a cost — relatively lower returns and moderate risk on the chosen investments. It is imperative, therefore, for the managers of reserves to seek an acceptable level of earnings within acceptable levels of liquidity and risk.

Bhanoji Rao

In its guidelines on FERM (Foreign Exchange Reserve Management) issued in September 2001, the International Monetary Fund (IMF) noted that official foreign exchange reserves are held in support of a range of objectives, notably the following:

to support and maintain confidence in the policies for monetary and exchange rate management, including the capacity to intervene in support of the national or union currency;

to limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed;

to provide a level of confidence to the markets that the country can meet its external obligations;

to demonstrate the backing of domestic currency by external assets;

to assist the government in meeting its foreign exchange needs and external debt obligations; and

to maintain a reserve for national disasters or emergencies.

Assume, for instance, a country has accumulated a hundred billion dollars worth of reserves and keeps all of it in dollar-denominated bonds earning almost no interest. If the dollar goes down the drain, the accumulated reserves would no longer command the same purchasing power as before and the country would have incurred a loss due to inappropriate reserves management. If only the reserves could be kept in diverse currencies, the loss could have been either minimised, or not incurred at all.

As the IMF rightly avers, “weak or risky reserve management practices can also have significant financial and reputational costs. Several countries, for example, have incurred large losses that have had direct, or indirect, fiscal consequences.”

It is, therefore, imperative for countries to adopt “appropriate portfolio management policies concerning the currency composition, choice of investment instruments, and acceptable duration of the reserves portfolio, and which reflect a country’s specific policy settings and circumstances, to ensure that assets are safeguarded, readily available and support market confidence.”

Timely Availability

According to the IMF Guidelines, reserve management is essentially to ensure the availability of adequate foreign exchange reserves for meeting the defined range of objectives, for controlling liquidity, market, and credit risks and, last but not the least, for obtaining reasonable earnings over the medium to long term on the funds invested.

Thus, in terms of holding reserves in forms other than cash, liquidity, “which is the ability to convert quickly reserve assets into foreign exchange” assumes top priority. That comes at a cost, namely, relatively lower returns and moderate risk on the chosen investments.

It is imperative, therefore, for the managers of reserves to seek an acceptable level of earnings within acceptable levels of liquidity and risk.

Liquidity requirements are also a function of the monetary and exchange rate (ER) arrangements that a nation follows. Under a free float, liquidity requirements are governed by the need to ensure orderly changes in ER and avoidance of unacceptable volatility.

The extent of intervention in the markets will be that much more if a country follows a fixed ER regime. Adequate reserves and liquidity are needed to fight back speculative attacks on the currency. Intermediate to the needs of free float and fixed ER is the requirement of a managed float.

Public Disclosure

An important component of the IMF guidelines is the set of provisions on public disclosure of objectives of reserve management and the broad contours of changes in the key parameters. “Information provided concerning, for example, the currency composition of benchmarks or the classes of assets would generally be couched in broad terms rather than by the provision of specific details of underlying assets and operations, which in some circumstances could be destabilising. Some reserve management entities also include in their annual reports and, in broad terms, information relating to investment performance relative to the benchmarks adopted.”

The latest (July 19, 2007) issue of Report on Foreign Exchange Reserves by the Reserve Bank of India is very much along the lines recommended by the IMF. It begins with the following statement: “The Reserve Bank of India (RBI) undertook a review of the main policy and operational matters relating to management of the reserves, including transparency and disclosure and decided to compile and make public half-yearly reports on management of foreign exchange reserves for bringing about more transparency and also for enhancing the level of disclosure in this regard.

These reports are being prepared with reference to positions as of March 31 and September 30 each year …This is the eighth report on foreign exchange reserves with reference to March 31, 2007.”

(Note: A more recent issue of the Report was due in January 2008. It is not yet available on the RBI Web site.)

RBI Report 2007: Salient Points

The level of foreign exchange reserves stood at $199.2 billion as at end-March 2007. Of this, close to $192 billion were foreign currency assets maintained as a multicurrency portfolio, comprising major currencies (US dollar, euro, pound sterling, Japanese yen, etc.) and valued in US dollars.

The increase in reserves from $5.8 billion as at end-March 1991 to $199.2 billion as at end-March 2007 has been made possible via the following components of the balance of payments accumulated over the 16 year period: Current account balance of $ -34.1 billion, capital account balance of $212.2 billion and valuation change of $15.3 billion.

The composition of the capital account balance is as follows (in $ billion): Foreign investment (109.3), NRI deposits (29.2), external assistance (13.9), external commercial borrowings (37.6), and other items (22.2).

It is clear from the above account that foreign investment has been a major component that has helped boost the reserves.

In that context, the following passage from the Report is noteworthy. “FII investments in the Indian capital market, which commenced in January 1993, have shown significant increase over the subsequent years.

Cumulative net FII investments increased from $827 million at end-December 1993 to $45.3 billion at end-March 2006 and further to $52.0 billion as at end-March2007.”

What does such increase in FII investment imply? The ratio of volatile capital flows — defined to include cumulative portfolio inflows and short-term debt — to reserves was 35.2 per cent as at end-March 2004, 36.9 per cent (end-March 2005), 43.4 per cent (end-March 2006) and 38.2 per cent end-March 2007.

Thus, at end-March 2007, when reserves amounted to $199.2 billion, the volatile flow (38.2 per cent) at $76 billion, was certainly not insignificant. Of this, the major chunk is FII investment of $52 billion, which enters the stock market and leaves just as easily.

It would be useful if the RBI were to bring out a policy paper on what sort of benefits the country (that is, its people including the not-so-rich) derives from such short-term flows.

Investment Profile

The forex reserves of about $192 billion as at end-March, 2007, were invested as follows: 26.7 per cent securities; 46.4 per cent deposits with other central banks, BIS & IMF; 23.5 per cent deposits with foreign commercial banks; and 3.4 per cent gold.

Return on investment in the earlier year was 3.9 per cent, which is not too high, given the need to maintain a sound liquidity position.

As the foreign currency holdings rise to, say, $350-$400 billion, it is worth considering setting up a Government of India Investment Corporation to obtain relatively better returns, including the prestige of owning precious real-estate in key nations of the world.

(The author, formerly with the National University of Singapore and the World Bank, is Visiting Faculty, Sri Sathya Sai University, Prasanthi Nilayam. He can be reached at bhanoji@gmail.com)

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