High costs of foreign exchange reserves

Globalization has been hailed by many as a remarkable system for more efficient global allocation of resources. However, financial globalization has been accompanied by frequent and painful financial crises. Since the debt crises of 1982, financial crises have occurred every now and then. Some of the most famous ones are Mexican crisis in 1995, East Asian crisis in 1997, Russian crisis in 1998, Turkish crisis in 1994 and 2001, Brazilian crisis in 1999, Argentine crisis in 2002 and the current crises which has the unique feature of having originated in the developed countries.

The developing countries found a way to protect themselves from such crises and the painful process of IMF conditionalities by accumulating reserves. Countries with higher level of liquid foreign assets are able to withstand panics and sudden reversal of capital flows. Therefore, developing countries including India started accumulating foreign exchange reserves on an unprecedented scale. The total foreign exchange reserve holdings in most emerging economies far exceed all the rules of reserves accumulation. However, accumulating excess foreign exchange reserves is a costly means of averting crisis.

There are essentially three ways in which the cost of holding excess foreign exchange reserves can be ascertained.

• The spread between the private sector’s cost of short-term borrowing abroad and the yield that the Central Bank earns on its liquid foreign assets.
• The spread between the interest on domestic government bonds and the yield on reserves. This is known as the fiscal cost of reserves.
• Lastly, reserves could have been alternatively used to augment the public capital stock of the economy, and the social opportunity cost of (public) capital can be used as the relevant benchmark for the cost of foreign borrowing.

The objective of this paper is to compute the first kind of cost i.e. spread between the private sector’s cost of short-term borrowing abroad and the yield that the Central Bank earns on its liquid foreign assets for India.

Phenomenal growth of Reserves

India’s foreign exchange reserves have risen dramatically since the crisis year of 1990-91 when reserves were barely sufficient to cover 3 weeks of imports. In the year 1991-92 total foreign exchange reserves were at US$ 9,220 mn whereas in the year 2007-08 India’s foreign reserves stood at US$ 309,723 mn. Reserves begin to increase steadily from 1991-92 which is identified with the onset of the era of globalization. Note that there is a decline in the reserve holdings in 2008-09 to US$ 251,985 mn. The decline in reserves can be attributed to the financial crisis in the developed world which led to the reversal of capital inflows.

Prior to the era of financial globalization, countries held reserves mainly to manage foreign exchange demand and supply arising from current account transactions. The traditional rule of thumb for Central Banks was that they should hold a quantity of foreign exchange reserves equivalent to three months of imports. However, in the age of financial liberalization when panics and sudden reversal of capital flows are very common this rule of thumb was clearly insufficient. All developing saw the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. Infact the policy guideline that the IMF provided to the developing countries with uncertain access to capital markets also encouraged the accumulation of reserves equal to short term debt. The rule that countries should hold liquid reserves equal to their foreign liabilities coming due within a year is known as the Guidotti-Greenspan rule.

India's short-term debt/reserve ratio was significantly above unity in the early 1990s. Since then, India has built up enough reserves to abide by the Guidotti- Greenspan-IMF rule, and the short-term debt/reserve ratio has stabilized at around 0.5 from 2.07 in the year 1991 – 92.

The Cost of Reserve Holdings

India like many other developing countries has been accumulating reserves far in excess of the conventional bench marks. For every $1 of reserve assets India accumulates in excess of the optimal level, it pays a cost equal to the spread between the private sector’s cost of short-term borrowing abroad and the yield that the Central Bank earns on its liquid foreign assets.

The natural question that arises in this exercise is what constitutes optimal amount of reserves. However, there is no clear answer to this question because even countries with sound macroeconomic policies can be hit by contagion from elsewhere in the world of liberalization. Hence the bench mark for optimal reserves keeps increasing. Keeping in mind the self – insurance motive it is assumed that the optimal amount of reserves equals the sum of short term debt, six months of imports and foreign portfolio investments. Reserves in excess of this amount are considered unnecessary. With this definition of optimal reserves, I find that excess reserves have been increasing steadily from negative levels in 1991 – 92 to a high of US$ 140,076 mn in India.

To ascertain the loss in income associated with holding excess reserves, potential investment rate has been calculated by adding excess reserves as a percentage of GDP to the actual rate of growth of investment. Once this potential investment rate has been calculated, the potential rate of growth of GDP can be calculated by dividing potential investment rate by the incremental capital output ration. The loss in growth is the difference between the potential growth rate and the actual growth rate (Table 1.).

Table 1.

Year	Rate of NDCF	ROG of GDP at FC	Excess Reserves/ GDP	Potential Growth Rate	Loss of Growth
1991-92	12.7	1.4	-4%	0.98	-0.45
1992-93	13.5	5.4	-2%	4.57	-0.79
1993-94	13.7	5.7	2%	6.51	0.83
1994-95	17.1	6.4	3%	7.51	1.12
1995-96	17.2	7.3	1%	7.71	0.42
1996-97	15.2	8	0%	7.97	-
1997-98	16.9	4.3	1%	4.56	0.25
1998-99	15.3	6.7	2%	7.56	0.87
1999-00	18.3	6.4	2%	7.14	0.7
2000-01	16	4.4	3%	5.17	0.81
2001-02	13.8	5.8	6%	8.34	2.53
2002-03	16.6	3.8	9%	5.92	2.08
2003-04	19	8.5	14%	14.81	6.29
2004-05	22.7	7.5	14%	12.08	4.61
2005-06	25.8	9.5	11%	13.57	4.05
2006-07	27	9.7	14%	14.8	5.05
2007-08	28.9	9	19%	14.94	5.93

Source: Calculated from Reserve Bank of India data

*Figure in parentheses indicate negative values

The loss of GDP growth has been increasing with the increase in reserve holdings. The percentage loss in GDP growth was 5.93% in 2007 – 08 and the loss was highest in the year 2003 – 04 at 6.29%.

The above analysis proves that India is paying a very heavy price to play by the rules of financial globalization. In the year 2003 – 04 India lost out above 6% of GDP due to its policy of accumulating reserves in excess of what is justified by all rules of reserve accumulation. The amount of excess reserves held by the Reserve Bank of India could have been alternatively used to augment the public capital stock of the economy. In a country like India which is characterized by inadequate expenditure on infrastructure and social sector, this is indeed a great loss. The social rate of return would have been much higher if these excess reserves could be invested in infrastructure which is the focus area of the government during the Eleventh Five Year Plan.

A study (Fan, Hazell and Thorat, 1999) carried out by the International Food Policy Research Institute on linkages between government expenditure and poverty in rural India has revealed that an investment of Rs. 1 million in roads lifts 165 poor persons above the poverty line. The number of people who would have moved out of poverty if the entire amount of excess reserves had been invested in roads has been calculated in Table 3.

Table 2. No. of people out of poverty with investment in Roads equivalent to Excess Reserves

Year	Inv. In Roads/Excess reserves	Number of people out of poverty
1991-92	-9,886.25	-16,31,231
1992-93	-6,213.25	-10,25,186
1993-94	4,686.20	7,73,223
1994-95	9,263.90	15,28,544
1995-96	2,325.80	3,83,757
1996-97	130.79	21,581.17
1997-98	3,578.76	5,90,494.6
1998-99	6,908.65	11,39,926
1999-00	9,233.97	15,23,605
2000-01	13,384.78	22,08,488
2001-02	25,654.36	42,32,969
2002-03	40,384.93	66,63,513
2003-04	69,453.45	1,14,59,818
2004-05	78,226.29	1,29,07,337
2005-06	68,343.14	1,12,76,617
2006-07	94,340.38	1,55,66,163
2007-08	140,076.00	2,31,12,539

In 2007 – 08 the amount of excess reserves held with Reserve bank of India was US$ 140,076 mn. According to the Uniform recall period distribution data of NSSO 61st round the number of people living below the poverty line is 3017.20 lakh in 2004 – 05. If the entire excess reserves (US$ 140,076 mn) in 2007 – 08 had been invested in road infrastructure then according to the study by Fan, Hazell and Thorat approximately 231.12 lakh people or 8% of the people living below poverty line would have moved out of poverty.

India has responded to financial globalization in a manner that is far from optimal. By accumulating reserves far in excess of its short term debt obligations India has lost approximately 2% of GDP every year during the period 1991 – 92 to 2007 - 08. Moreover the investment of the excess reserves in social and infrastructure sector would give a higher social rate of return. The sudden reversal of capital flows due the crisis in developed countries reduced the foreign exchange reserves in 2008 – 09 but now India is again accumulating more reserves. Therefore, the loss in GDP growth and the opportunity lost in domestic investment is likely to rise in future.