Study of foreign exchange reserve management policy of India: comparisons with other emerging market economies

Abstract

Foreign Exchange Reserves Policy of India and other Emerging Market Economies are in limelight since last few years due to their incredible rise in the current decade. The economists from the western world, especially the IMF experts, have lambasted this fetish of accumulation of reserves by the EMEs. Experts have pointed out that excess FOREX reserves are liabilities rather than assets on account of various costs associated with them. Besides, the costs, this has led to flow of capital from the developing (EMEs) countries to developed countries as most of these excess reserves end up being invested in low yield but highly liquid and secure US Treasury Bonds. India has come a long way forward from the embarrassment of 1991 to the embarrassment of riches in 2008. This miracle happened because of liberalization and globalization policies which made the FDI and Portfolio Investments attractive. Incentives provided to exports and remissions from abroad further boosted the reserves. The managed float of currency policy forced the RBI to periodically mop up the FOREX from the market to preclude the currency appreciation. Though, the global recession caused due to US sub-prime crisis and the terror strikes have caused huge outflow of FOREX, the reserves are still hovering around US $250 billion, which is decent by all standards. In this paper, various benefits of reserves are discussed and costs associated with the excess reserves have been discussed and notional computations of the costs have been carried out. There are number of criteria to test the adequacy of reserves, as suggested by various experts and by multilateral organizations like IMF, BIS etc. All these criteria suggest that the FOREX reserves of India are certainly in excess. In this paper, an Artificial Neural Network (ANN) model using data-mining technique has been developed using the data, consisting of economic indicators as well as social/political indicators, of more than 100 countries. This model has also indicated the same result. Though, the reserves have depleted by around US $50 billion since May, 2008, still the reserves are in excess keeping in view the fact that the Indian economy is severely affected like other economies and even the IMF has put a rather encouraging future and a turnaround is expected in a couple of years. The facts that oil prices have crashed to an incredible level and renewed interests of FII would help India in sustaining a huge reserves. Excess reserves can be effectively and efficiently utilized in infrastructure, using innovative methods like issuing of Dollar Bonds so that money supply is not affected, and also in creating a Sovereign Wealth Fund (SWF), which has become extremely popular among the EMEs. A small amount can also be earmarked for the Indian companies who are facing extreme hardship in paying international loans due to liquidity crisis in the market. RBI is also required to be made more independent and professional. It has been observed that RBI is extremely reluctant to admit the existence of excess reserves without actually carrying out any detailed mathematical study or building statistical model. RBI defence of its extremely precautionary approach is entirely based on intuitive reasoning. All the tests which have been carried out in this paper and all the notional computations about the costs associated with them have not been attempted either by RBI or any other economist or expert. This paper has made the attempt to fill this research gap. These tests, including the ANN model, can always be used to determine the adequacy of reserves at any point of time and the excess reserves can be utilized in the manner discussed in the dissertation.