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Global Journal of Finance and Management

ISSN 0975 - 6477 Volume 2, Number 2 (2010), pp. 295-306

© Research India Publications

Foreign Exchange Reserves Management in India:

Accumulation and Utilisation

M. Rama Krishna Prasad and G. Raghavender Raju*

Department of Economics, Sri Sathya Sai University

Prasanthinilayam – 515134, India


This study aims to examine the adequacy and utilization aspects of the foreign
exchange reserves in India and in addition aims to identify the factors that
determine international reserves hoarding in India on the basis of quarterly
data for the period 1996 to 2009. The recent rapid reserve accumulation by
India has brought the attention of the world on to it. During this period the
foreign exchange reserves have swelled and are now well ahead of the reserve
adequacy parameters. The total reserves which now stand at about US $ 275
billion are far in excess of the generally accepted benchmark levels. The
disadvantages of hoarding surplus reserves are: appreciation of the currency,
opportunity cost, sterilization costs, inflationary impact and so on. Thus there
is a case for better management of these excess reserves in India. Our
emphasis is on overall movements, rather than on volatility, caused by
fundamentals such as GDP, exchange rates, exports, and openness (proxied
using marginal propensity to import). Applied econometric methodology of
modern time series is utilized to ensure rigorous analysis. The most significant
determinants turn out to be openness followed by exports and GDP with
exchange rate being the least significant.

Keywords: Foreign Exchange Reserves Management, India, International

Reserves Hoarding, Economic Fundamentals, Econometric Methodology,
OLS Estimation.
JEL Classification: F 31

We are grateful to Prof. Vishwanath Pandit, Vice-Chancellor, Sri Sathya Sai
University, Prasanthi Nilayam and Prof. K Krishnamurthy, Administrative Staff
College, Hyderabad, for their help and valuable comments.
296 Rama Krishna Prasad M. and G. Raghavender Raju

The subject of exchange rate management, in particular foreign exchange reserves
management has of late been the topic of discussion at various domestic and
international forums among the policymakers and academicians. This renewed
interest in the subject may be attributed to various reasons but one reason that stands
out is the precautionary purpose to hold onto reserves. In the aftermath of the
currency crises that paralysed the economies in different parts of the world, be it the
East Asian crisis (1997) or the Argentinean crisis (1999-2002), the study of foreign
exchange reserves management assumes great importance. There is a belief among
the policy makers and academicians that, after these crises the tendency to hold
surplus reserves on the part of developing countries has increased. At this stage we
must be mindful of the repercussions of piling up reserves. It is generally not
advisable to pile up reserves beyond the adequacy levels because of the inflationary
impact they have on the economy and also the costs that the country pays. There is
also the issue of opportunity cost involved when one is dealing with surplus reserves.
Hence it is necessary to address the adequacy and utilisation aspects of the reserves.
India’s reserves position has seen a huge change from the early nineties when we
did not have reserves to meet even three weeks of imports. Now we have reserves
sufficient to meet 12.4 months of imports that is roughly more than a year, clearly
exceeding the traditional adequacy measure of import cover 3-4 months. Thus it is in
necessary to study the adequacy, utilisation and determinants aspects of these ‘excess
reserves’ so that the cost of holding excess reserves is minimised and are used

Composition of Foreign Exchange Reserves

The IMF defines Foreign Exchange Reserves (also called as forex 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 rate markets to
affect the country’s exchange rate and for other purposes ‘Reserves’ refers to foreign
exchange reserves held in the form of gold assets in the banking department, foreign
securities held by the issues department, domestic reserves in the form of bank
reserves, the Special Drawing Rights (SDR) and Reserve Tranche Position (RTP) are
held with the IMF. Thus we have:

FER: Foreign Exchange Reserves; FCA: Foreign Currency Assets; SDR: Special
Drawing Rights; RTP: Reserve Tranche Position.

Foreign Exchange Reserves in India since 1990-91

After adopting the market determined exchange rate regime the foreign exchange
reserves position improved steadily (from the abysmal level of less than three weeks
Foreign Exchange Reserves Management in India 297

of import cover) and the RBI had to intervene in the foreign exchange market to mop
up the excess liquidity in-order to prevent the currency from appreciating. The
reserves which stood at US $ 5.8 billion at the end of March 1991 increased to US $
25.2 billion by the end of March 1995. The growth continued in the second half of the
1990’s, with the reserves touching the level of 38.0 billion US $. The quantum of
reserves rose impressively to US $ 113.0 billion by the end of March 2004. In March
2005 the reserves touched US $ 141.5 billion, US $ 151.6 billion in 2006 March and
rose further to US $199.9 billion by the end of March 2007. The reserves have further
increased and shot up to US $ 309.7 billion, end March 2008. Thereafter the reserves
declined to US $ 251 billion by end March 2009. The reserve accumulation picked up
since then and stands at US $ 278 billion as on 5 March 2010. The growth of reserves
from 1991 has brought the attention of world on India. This phenomenal rise in
reserves testifies the fact that the fundamentals of the economy are well reflected in
the external value of the rupee.

Composition of Reserves 1900-91 to 2009-10


(in US $ Million)
1990-91 102 3496 2236 0 5834
1991-92 90 3499 5631 0 9220
1992-93 18 3380 6434 0 9832
1993-94 108 4078 15068 0 19254
1994-95 7 4370 20809 0 25186
1995-96 82 4561 17044 0 21687
1996-97 2 4054 22367 0 26423
1997-98 1 3391 25975 0 29367
1998-99 8 2960 29522 0 32490
1999-00 4 2974 35058 0 38036
2000-01 2 2725 39554 0 42281
2001-02 10 3047 51049 0 54106
2002-03 4 3534 71890 672 76100
2003-04 2 4198 107448 1311 112959
2004-05 5 4500 135571 1438 141514
2005-06 3 5755 145108 756 151622
2006-07 2 6784 191924 469 199179
2007-08 18 10039 299230 436 309723
2008-09 1 9577 241426 981 251985
2009-10* 5054 18056 254696 1393 279199
*As on 12 Feb 2010

Source: Reserve Bank of India

298 Rama Krishna Prasad M. and G. Raghavender Raju

Foreign Exchange Reserves in India 1990-91 to 2009-10

Source: Reserve Bank of India

This unparalleled rise in reserves may be attributed mainly to increased foreign

capital inflows in the form of foreign portfolio investment and foreign direct
investment. The FDI rose from a meagre US $ 97 million in 1990-91 to US $ 22826
million in 2006-07. The portfolio investments too rose impressively, from US $ 6 to
US $ 7003 million during the same period. The capital inflows peaked to US $ 61633
Million by the end of 2007-08 and subsequently dropped to 21313 US $ million end
of March 2008-09.

Reserve Adequacy in India

In the light of the recent reserve accumulation by India it is important to understand
the commonly used reserve adequacy indicators and explore the reserve utilisation
process in India.
The adequacy of reserves has emerged as an important parameter in gauging the
ability of an economy to absorb external shocks. With the changing profile of capital
flows, the traditional approach of assessing reserve adequacy in terms of import cover
has proved to be inadequate and has necessitated the inclusion of the other parameters
that take into account the size composition and risk profiles of various types of
external shocks to which economies across the globe are vulnerable to. In India the
adequacy parameters have been broadened based on the recommendations of the high
level committee on balance of payments chaired by Dr. C. Rangarajan. The
Foreign Exchange Reserves Management in India 299

committee on capital account convertibility headed by S.S. Tarapore suggested four

alternative adequacy measures including money based indicators and debt based
indicators in addition to the trade based indicators. Though the circumstances in every
country vary and there is no precise and specific level of reserves that can be
considered as optimal or sufficient, we discuss the most commonly referred measures
or ratios.

Reserves to imports
This is one of the conventional and traditional measures. This can be useful for low
income countries with limited access to international capital markets and are
vulnerable to current account shocks. It is considered that a reserve level sufficient to
meet the imports of about three to four months to be an adequate measure. At the end
of September 2009 the ratio stood at 12.4 months while the benchmark is 3 months
clearly showing the surplus reserve level.

Reserves to monetary base

This measure is also referred to as the money based indicator. Countries vulnerable to
capital flight may follow this measure. This is so because reserve balances, when held
in proportion of monetary base leads to enhanced confidence in domestic currency.
The ratio is found to be 0.89 while the benchmark is 0.05 to 0.20.

Reserves to short term external debt

Also known as the Greenspan-Guidotti rule is named after Alan Greenspan and Pablo
Guidotti. It simply states that the developing countries must amass reserves equal to
all the external debt due within the next year. This measure has become the most
widely preferred benchmark for measuring vulnerability to capital account crises. The
benchmarks relevance to currency crisis prevention also has the greatest support.

Liquidity at Risk Rule:

Alan Greenspan in 1999 advocated this measure of adequacy. He opines that it would
be desirable to move beyond the simple balance sheet measures and switch to a
stochastic framework that takes into account the risks that countries may be prone to.
The approach here is to calculate a country’s liquidity position under a range of
possible outcomes for relevant financial variables such as exchange rate, commodity
price and credit spreads etc. It would be possible to express the standard in terms of
probabilities of different outcomes. Greenspan in addition sates that countries could
be expected to hold sufficient liquid reserves to ensure that they could avoid new
borrowings for a year with certain probabilities such as 95% of the time. Such
liquidity at risk rule could handle a wide range of innovative financial instruments-
Contingent Credit Lines with collateral.
It should be mentioned that India no longer needs to worry about the adequacy of
reserves and this notion has been testified by the fact that all the adequacy indicators
show that the reserve level are above the stipulated levels. The traditional trade based
indicator of adequacy import cover which fell to a low of three weeks of imports at
the end of December 1991 rose steadily to a comfortable level of 12.4 months of at
300 Rama Krishna Prasad M. and G. Raghavender Raju

the end of March 2007. The ratio of short term external debt to reserves declined from
146.5% at the end of March 1991 to 6% end March 2007. The ratio of volatile flows
to reserves declined from 146.6% end March 1991 to 38.2% end March 2007.

Utilisation of forex reserves in India

Deployment pattern of Foreign Exchange Reserves in India

Components of Reserves As on March 31, 2009

(in US $ Million)
1.Foreign Currency Assets 241,426
(a) Securities 134,792
(b) Deposits with other Central Banks, BIS, IMF 101,906
(c) Deposits with Foreign commercial banks 4,728
2. Special Drawing Rights 1
3.Gold 9,577
4. Reserve Tranche Position 981
Total Forex Reserves 251,985

Source: Half Yearly Report on Foreign Exchange Reserves, Reserve Bank of India

The forex reserves are invested in multi currency and multi asset portfolios as per
the existing norms which are similar to the international practises. At the end of
March 2009 out of total foreign currency assets of US $ 251.9 billion, around US $
134.0 billion was invested in securities, US $ 101.9 billion was deposited with other
central banks, BIS, IMF and US $ 4.7 billion in the form of deposits with foreign
commercial banks. During the year 2005-06 the return on foreign currency assets and
gold, after accounting for depreciation increased to 3.9% from 3.1% during 2004-05
owing to hardening of global short term interest rates.

India’s Foreign Exchange Reserves Management Policy

The approach to reserve management policy till 1991 was based on the traditional
import cover approach i.e. to maintain appropriate level of reserves to meet the
requirements of imports for a certain number of months. The RBI’s annual report
1990-91 stated that the import cover of reserves shrank to three weeks of imports by
the end of December 1990. This kind of approach continued till 1993-94.
The introduction of the market determined exchange rate led to change in reserve
management approach and the emphasis on import cover had to be supported with the
objective of smoothening out the volatility of the exchange rate, which has been
reflective of the underlying market condition. The emphasis was not only on the size
of the reserves but also on the quality of reserves.
Foreign Exchange Reserves Management in India 301

The RBI’s annual report of 1998-99 highlights the emphasis on prudent

management of reserves i.e. keeping the liabilities within manageable levels. The
1999-2000 annual report of the central bank stated that the overall approach to
management of India’s foreign exchange reserves reflects the changing composition
of Balance of Payments (BoP) and liquidity risks associated with different types of
flows and other requirements. The policy for reserve management is built upon a host
of identifiable factors and other contingencies, including inter alia the size of current
account deficit and short term liabilities, the possible variability in portfolio
investment and other types of capital flows, the unanticipated pressures on the BoP
arising out of external shocks and movements in foreign currency deposits of Non
Resident Indians (NRI’s).
The 2000-01 report elaborated on the liquidity risk associated with different types
of capital flows. The changing profiles of the capital flows necessitates a broader
reserve management policy not just based on imports but also including other
important factors like the size, quality, composition and risk profiles of various types
of capital flows as well as the various types of economic shocks to which the
economy is vulnerable.
The latest 2006-07 report of the RBI focuses on removing the impediments on the
path of liberalisation already in place and aims at framing policies that promote
flexibility and facilitate the transactions in the forex market in a well regulated

State of the Know-How

The subject of forex reserves may be broadly classified into two interlinked areas
namely the theory of reserves and the management of reserves. The theory of reserves
includes legal, institutional, conceptual and definitional aspects of holding reserves.
The management of reserves deals with the portfolio management considerations i.e.
how to deploy reserves in a safe and high yielding manner. The literature available
can be broadly classified under four different heads:
• The need to hold reserves.
• Costs and benefits of holding reserves.
• Adequacy of reserves.
• Utilisation of reserves.

Majority of the studies point out that the major reasons for holding reserves are
1. To prevent the crises i.e. insurance cover.
2. The mercantilist motive – to prevent the appreciation of the home currency.

With regard to adequacy of reserves there are notable contributions from Alan
Greenspan (1999), Reddy (1998), Singh (2006), Sachs, Torrnell and Velasco (1996),
Beaufort and Kapteyn (2001), Rajan (2002), Rodrik (2006), Green and Torgerson
It would be an interesting exercise to identify the variables that determine the
international reserves hoarding by countries. Gab-Je Jo in 2007 identified the
variables that influence the reserves hoarding in Korea. The same exercise was carried
out for China by Huang in 1995. Ana María Romero identified the factors that affect
302 Rama Krishna Prasad M. and G. Raghavender Raju

foreign currency reserves in India and China. Li and Rajan in 2005 explored the issue
of optimal precautionary demand for reserves by a central bank within a context of a
simple analytical model.
In this exercise of ours we have tried to identify the determinants of international
reserves hoarding for India using a quarterly series ranging from 1996 1st quarter to
the 1st quarter 2007. We posit that the variables determining the foreign exchange
reserves hoarding for India are: Gross Domestic Product, a ratio of imports to
GDP.Though the ratio of imports to GDP may not be a perfect measure for openness
but it captures the marginal propensity to import. Thus we use this ratio to proxy for
the openness. Exports, measured as the growth rate of the exports, this variable gives
a measure of the contribution of export receipts to the reserve accumulation.
Exchange rate, this variable is measured as the growth rate of exchange rates and
describes the effect of a fluctuating exchange rate on the reserve accumulation
process. Thus we have
FER: Foreign Exchange Reserves
GDP: Gross Domestic Product
OPEN: ratio of Imports to GDP, a measure of openness
EXP: Exports
EXC: Exchange Rate

It is posited that an increase in the Gross Domestic product of the country

increases the reserves hoarding. The relationship between Openness and reserves is
negative as propounded in a Keynesian open economy model. The need to hoard
reserves increases when high volatility is observed in the exports of the home country,
hence the positive relationship. Finally changes in exchange rates would lead to
movement of forex reserve levels in the opposite direction, thus we have a negative
relationship between the two.

Empirical Results
Unit Root Tests

Table 1: Unit Root Tests with Trend and Intercept: (1996:1 to 2009:1).

Variable Level Inference 1st difference Inference

FER -1.37 Nonstationary -5.79 Stationary
GDP -5.91 Stationary
EXC -5.65 Stationary
EXP -6.09 Stationary
OPEN -3.44* Stationary

*Implies MacKinnon critical value for rejection of hypothesis of a unit root at 10%
level. 1% critical value = -3.50, 5% critical value = -2.89, 10% critical value = -2.58
Foreign Exchange Reserves Management in India 303

From the table we observe that all the other variables GDP, Exports, Exchange
Rates and Openness are stationary at levels and thus there is no necessity to go for
differences. The only non stationary variable forex reserves has become stationary on
application of first difference.

Table 2: Estimation Results.

variables Equation 1 Equation 2

Estimation by: OLS Estimation by: ARCH-GARCH
Coefficients Coefficients
Constant -0.462571 -0.412136
(-2.369721) (-3.996534)
LNGDP(-2) 0.051263 0.049036
(2.855473) (6.422975)
LNOPEN(-2) -0.109436 -0.112451
(-3.746147) (-5.941450)
LNEXP 0.016455 0.013875
(3.080996) (3.346612)
LNEXC -0.008375 -0.009948
(-2.691258) (-4.253752)

*The figures in parenthesis in OLS and ARCH-GARCH models are t-statistic and z-
statistic respectively.

OLS Estimates: ARCH-GARCH Estimates:

R2 =0.604176 R2 = 0.589255
D-W Stat = 2.112802 D-W Stat = 2.018714

The following conclusions are drawn from the above estimation results:
R2 = 0.60 or 60%, implying that 60% of the variation in forex reserves is
explained by the explanatory variables.

The GDP has a positive relationship with reserve hoarding. This can be explained
by the fact that GDP is a measure of the economic activity in a country and gives the
size of the economy. Therefore higher the GDP higher would be the quantum of
reserves held. When the output (GDP) of the country increases, the forex reserves
level increases. GDP has a two period lag thus any increase in the GDP would result
in the increase in forex hoarding only after 2 time periods.
The openness (OPEN) measure is given by imports/GDP. Though imports to GDP
may not be a perfect proxy for openness we use it as a proxy for calculating the
Marginal Propensity to Import. The long run relationship between openness and
reserves must be negative according to the Keynesian Open economy model. Our
304 Rama Krishna Prasad M. and G. Raghavender Raju

results are in conformity with this principle1. This is because higher the marginal
propensity to import, more powerful the income reducing policy to restore the
Balance of Payments equilibrium and lesser the holding of reserves and this inference
is quite debatable as the sign of openness is ambiguous, Gab-Je Jo (2007). The
openness has a lag of 2 periods implying that any increase in the ratio would result in
a fall in the reserve levels only after 2 periods.
The exchange rate (EXC) is inversely related to the forex reserves. Any change in
exchange rate would lead to a movement of forex reserve levels in the opposite
direction. Implying that, with a weakening exchange rate or depreciating currency, the
forex reserve levels diminish. This phenomenon is observed because, with a
depreciating exchange rate the intervention in the forex market by the central bank
increases and thus the quantum of reserves decreases and thus the inverse
relationship between exchange rates and reserves.
When the exports (EXP) are highly fluctuating that is, in a situation of high
volatility in exports the need to hoard forex reserves increases. This is because, when
the export receipts are highly fluctuating, the earnings from them become unreliable
and the reserves needed for meeting the import bill increases and thus the need to
hoard more reserves increases. Thus, higher the volatility in export receipts, higher
the reserves to be held indicating the positive relation between exports volatility and
The Durbin-Watson statistic, an indicator of the presence or absence of the
problem of autocorrelation i.e. correlation among the error terms is found to be a
healthy 2.11. Any value around 2 indicates the absence of the problem of correlation
among the error terms.

Our present endeavour in this exercise was to identify the determinants of
international reserves hoarding for India. This work assumes importance a scenario of
increasing forex reserve levels in India; our Forex reserve are nearly around US $ 280
million. It aids in throwing more light on the reasons for increased reserve
accumulation by India and also in a situation where there has been a lot debate among
the academicians, policymakers and media on the logic behind this exercise.
In our model all the variables are statistically significant, with t statistic above the
value 2 and are according to the theory. Economic theory identifies that the exchange
rates’ coefficient must be negative. Another variable that is having a negative
coefficient is the openness. Studies so far have remained inconclusive about the sign
of this variable. Thus the sign of openness is debatable and ambiguous. The use of
dummy variable is justified as evident from the significant t statistic. When we
perform in sample forecasting, we observe that the Root Mean Square Percentage
Error (RMSPE) is 0.057 which is very good. The Thiel Inequality coefficient is 0.002,
The sign of the variable OPEN (openness) is ambiguous as earlier studies have shown that openness
can have both positive and negative relationships with reserves. Studies by Frenkel (1980) Karfakis
(1997) have shown a positive relationship, while studies by Huang (1995), Landel-Mills (1989) have
shown the existence of negative relationship between the two variables.
Foreign Exchange Reserves Management in India 305

which is very low and suggests that the predictive performance of the model is highly
satisfactory. It implies that the forecasted series in model is very close to the actual
series and there are no systemic tendencies to over or under estimate the actual data as
shown in the diagram below.







96 97 98 99 00 01 02 03 04 05 06 07


By co-integration tests i.e., Engle-Granger and Johansen is we conclude that there

exists one cointegrating equation.
To conclude both the government and the policymakers must look to utilise the
excess reserves and reduce the holding costs, in this process it must look at other
countries’ experiences and if need be reformulate our reserve management strategies
without compromising the safety aspects.

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