The Hindu Business Line : Why the Guv isn't walking grimly into the FM's room

THE International Monetary Fund's fortnightly IMF Survey dated March 21 leads with the Fund's Managing Director Rodrigo de Rato's plaudits for China and India. `Strong economy' got the pat for China, which Rato saw as moving gradually towards flexible exchange rates. As for India, he found the economy to be `vibrant', promising to gain momentum if only we managed to "reduce large deficits and open up to more trade and investment."

What seemed to worry Mr Rato more was that India's exports stood at less than 1 per cent of total world exports, and that our average trade tariffs were 22 per cent, with the goal of Asean levels of around 8 per cent still far away. But what had caught popular media attention about Mr Rato was his statement that tapping the country's foreign exchange reserves to fund infrastructure projects would be a mistake.

Thus, what was a two-hand game, with the Planning Commission on one side and the Reserve Bank of India on the other, suddenly had a new IMF dimension. Though you may not take sides in the current debate between Dr Y. V. Reddy and Mr Montek Singh Ahluwalia on whether India's forex reserves that have crossed $140 billion can be used for financing dams and bridges, it's time to start from the scratch to know what forex reserves are.

"A unique definition of forex reserves is not available," said Dr Reddy in a 2002 lecture at the National Council of Applied Economic Research. There is no unanimity on what should be covered, who should own the assets, how far reserves should be liquid, and so on.

However, for `policy and operational purposes', the appropriate definition is from IMF's Balance of Payments Manual and Guidelines on Foreign Exchange Reserve Management: "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."

To know how the RBI gets its `reserve' power, you'll have to travel no further than the Preamble of the Reserve Bank of India Act, 1934, which begins thus: "Whereas it is expedient to constitute a Reserve Bank of India to regulate the issue of Bank notes and the keeping of reserves with the view to securing monetary stability in India."

The preamble also states that "in the present disorganisation of the monetary systems of the world it is not possible to determine what will be suitable as a permanent basis for the Indian monetary system." It is, therefore, a sign of the times that the RBI began a new practice recently: publishing a half-yearly report on forex reserves. The latest one is for the period up to September 2004.

Though denoted in dollars, forex reserves include a multi-currency portfolio with the euro, pound sterling, yen and so on, all valued in US dollars; these are known as FCA or foreign currency assets, and account for almost 95 per cent of reserves.

The balance is made of SDR or `special drawing right' (an international reserve asset that the IMF created in 1969 to supplement the official reserves of member countries), gold (currently at 357 tonnes and the stock not changing much in recent times), and RTP or Reserve Tranche Position in IMF (a recent addition that refers to the extent to which India has provided reserve assets to the Fund).

But why reserves at all? Of the three traditional motives, viz. transaction, speculative and precautionary, what is predominant is the last; so, central bank reserves are seen as a last resort stock of forex for unpredictable flows.

Dr Bimal Jalan spoke of such contingencies when he addressed the National Assembly of Forex Association of India in 2003: "Today, our reserves are high and exchange rate movements are, by and large, orderly. Now, suppose there is an event that creates external uncertainty, as for example, what actually happened at the time of the Kargil or the imposition of sanctions after Pokhran, or the oil crises earlier."

At the time he spoke, domestic stock of bank deposits in rupees in India stood close to $290 billion, or nearly three-and-a-half times the total reserves then. "One can imagine what would have had happened to our external situation, if within a very short period, domestic residents decided to rush to their neighbourhood banks and convert a significant part of these deposits into sterling, euro or dollar," Dr Jalan visualised. Too distant a worst-case scenario, it may seem.

How much of forex is enough? Traditional measure of forex reserves is trade-based, that is, import cover. This fell to a dismal 3 weeks at the end of 1990; and you may remember how the RBI had to temporarily pledge gold in July 1991. Those days, "the Governor and Deputy Governor would quietly walk in to the finance minister's room and show him a small piece of paper on which the days forex reserves would be written down," reminisced Finance Minister, Mr P. Chidambaram at a panel discussion in 2002.

Now, the import cover is around 14 months. A comfortable reserve position affords us the luxury of prepaying high-cost foreign currency loans and saving on debt-servicing, and also of graduating from debtor status to that of creditor in the books of the IMF's FTP or Financial Transaction Plan.

There are newer measures of adequacy such as the `liquidity at risk' or LAR rule, where the Guv puts into a risk model many financial variables such as exchange rates, commodity prices, and credit spreads, and then adds a dose of intuition. Please note that, on the upper limit, there is no consensus yet among central bankers.

Interestingly, a new research paper from the IMF proposes CIF or `country insurance facility' in the place of self-insurance that countries resort to by accumulating reserves. Reason: "The cost of holding reserves — that is, the country's borrowing costs in excess of the returns offered by high-grade liquid assets— can be substantial," as the latest issue of IMF Survey explains. `

Diversification' of forex reserves is also in hot debate. Japan, which holds the largest of reserves, sent shivers down the dollar's spine, when the country's Prime Minister Junichiro Koizumi spoke of forex diversification. Closer home, Mr Ahluwalia is perhaps concerned that the return on forex reserves — deployed as deposits with other central banks, foreign commercial banks and BIS, and also in securities — is a measly 2.1 per cent. Why not reap a higher return by funding infrastructure projects, he asks.

But, if Dr Reddy seems belligerent in his views about reserves, that's because he has experienced the `agony' of 1990 — when sitting in North Block, he was one of those who had to ensure that "there was enough cash balance to permit day-to-day forex payments of even a million US dollars".

The threat of national humiliation and discomforting relations with foreign agencies obviously touched on personal pride, he mused over in his 2002 talk. To him, therefore, what is important in reform is to be "acutely aware of the judgements and risks involved at every step in forex reserves policy and management." With a large hoard in the vault, a conservative attitude seems to be the most relevant.

ZeroBase@TheHindu.co.in

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