managing india’s foreign exchange reserves investment (1)

Project ReportON

Managing India’s Foreign Exchange Reserves Investment

EPGDCFM 2011-13

Submitted By:

Payal Baloni (22)

DECLARATION

This is to declare that I, Payal Baloni (22), a student of Executive Post Graduate Diploma in

Capital and Finance Markets (2011-13), IIFT, New Delhi, has given original data and

information and maintained full confidentiality to the best of my knowledge in the project

report, Managing India’s Foreign Exchange Reserves Investment, and that no part of this

information has been used for any other assignment but for the partial fulfillment of the

requirements towards the completion of this project.

(PAYAL BALONI)EPGDCFM 2011-13

IIFT, NEW DELHI

____________________________________________________________________________________________

GUIDE CERTIFICATION

This is to confirm that Payal Baloni (22), EPGDCFM 2011-13, is doing research project on

the topic “Managing India’s Foreign Exchange Reserves Investment” under my guidance

and the work done by the candidate is original and fulfills the requirements of the institute.

(JAYDEEP MUKHERJEE)IIFT, NEW DELHI

03-Feb-2013

Table of ContentsObjectives of the project.........................................................................................................................4

EPGDCFM 2011-13

Research Methodology............................................................................................................................4

Introduction to Forex Reserves...............................................................................................................5

India’s Forex Reserve composition..........................................................................................................7

Estimating the Adequacy of Reserves:.....................................................................................................8

Various indicators of reserve adequacy:..............................................................................................9

Cost of Excess Reserves..............................................................................................................10

Currency composition of foreign exchange reserves.............................................................................12

Mean Variance Theory.......................................................................................................................12

Optimal Portfolio...............................................................................................................................14

Sharpe Ratio line................................................................................................................................15

Empirical studies................................................................................................................................15

References.............................................................................................................................................19

APPENDIX..............................................................................................................................................20

EPGDCFM 2011-13

Objectives of the project

To study the need for FOREX reserves.

To study the India’s FOREX reserve composition.

To estimate the adequacy of FOREX reserves in India.

To calculate the cost of the excess FOREX reserve holdings.

Research Methodology

Research type: This research is exploratory in nature.

Sources of data: This analysis is mainly based on original data picked up from the RBI’s

Handbook of Statistics.

Introduction to Forex Reserves

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The International Monetary Fund defines foreign exchange 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 markets to affect the currency exchange rate, and/or for

other purposes.

According to RBI Act 1934, reserves refer to both foreign reserves held in gold and foreign

currency assets (held by issue department) and domestic reserves in the form of bank

reserves. Monetary authority acts as a custodian for the sovereign government which is a

principal of the foreign reserve.

There are principally three distinct motives of holding reserves. According to BIS

Economic Papers, No. 38 – 1993, these three motives can be applied to the holding of

reserves by central banks.

Transaction needs: It includes financing the foreseeable foreign exchange

demands of public and private sector in the country such as a government wishing

to repay a maturing foreign loan. The transaction need of forex reserve is more

prevalent in the countries where access to international capital market is limited.

Many developing and under developed countries have very restricted access to

External Commercial Borrowing (ECB). In such cases borrowing to finance current

account deficit is more costly than drawing from reserves. Hence transaction needs

are more dominant in the developing countries than developed countries.

Intervention needs: This corresponds to precautionary demand for money

required for effective intervention in the foreign exchange market. It helps the

central banks to intervene i.e. buy or sell foreign exchange in the market to

influence the value of currency. Forex reserves are held for this purpose is

prevalent in the countries which have relatively open market for goods and capital

and/or has fixed exchange rate regime. The intervention needs can be further

divided into very Short term and Medium term. Very Short term ERM: Generally

Central banks of countries with very open capital market apply very short term

ERM. Such interventions typically in Sterilized nature used to offset the effects of

volatile and short term speculative capital movement which does not relate to

underlying economic fundamentals. Typically central banks of developed countries

apply very short term ERM. Medium term ERM: Unsterilized medium term ERM are

used as an instrument with the objective macro-economic macroeconomic

stabilization policy with regard to prices and output. There are basically two ways

of implementing monetary policy response to exchange rate movement. One being

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directly intervening in the domestic monetary system by changing interest rate and

other being indirectly impacting interest rate by intervening in the foreign exchange

rate market. Typically developing countries central banks employ medium term

ERM.

Buffer Needs: A substantial foreign exchange reserve serves as a buffer against

international financial shocks and crises.

Wealth diversification: Most central banks consider safety, liquidity and return as

the major reserve management objectives. Wealth considerations influence

decisions on the compositions of the reserves. It is important to note that countries

usually diversify their currency portfolio into US dollar, EURO, sterling, Japanese

yen etc. Gold is often held for the same reason of diversification only. When the

sovereign government has net foreign currency debt, central bank typically build

forex reserves to maintain or enhance country’s international credit worthiness.

In case of India, broadly the objectives of holding foreign exchange reserves can be

encapsulated as:

Maintaining confidence in monetary and exchange rate policies.

Enhancing capacity to intervene in forex markets.

Limiting external vulnerability by maintaining forex reserve liquidity to absorb trade

or capital shocks.

Maintaining credit worthiness in the international credit markets

Boosting confidence of market participants by demonstrating backing of domestic

assets by external assets.

Source: India’s Foreign Exchange Reserves: Policy, Status and Issues, Y. V. Reddy

According to the literature on the rationale of accumulating forex reserve by developing

countries, there are principally two explanations namely, Competitiveness and Self

Insurance.

Competitiveness: Most of the Asian countries with their pursuit to build export

competitiveness built large current account surplus. Their export driven growth was

instrumental in accumulating large forex reserve. In these countries, benefit of

stable and managed exchange rate regime (currency devaluation) exceeded the cost

of holding excess forex reserve.

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Self Insurance: More dominant rationale of accumulating forex reserve by large

number of developing countries is self insurance against hard landing of capital and

trade accounts. This motive became more relevant after 2008 subprime crises

where trade and capital shock ill effects were contained by the large liquid forex

reserve held by various developing countries including India and China. In the wake

of risks raised our of deep financial integration and exposure to global financial

instability, the self insurance motive of holding foreign exchange reserve has gained

significance in spite of the costs associated with holding the same. These motives in

fact correspond to the precautionary demand money discussed in BIS Economic

paper. It is now well accepted that such precautionary demand should be higher if

the proportion of the short term or volatile capital inflow are higher.

There is an argument regarding the accumulation of forex reserve with self insurance

motive. They argued that why developing countries accumulated forex reserve to shield

themselves from the financial instability instead of reducing the financial integration. He

argued that prudential capital regulation can itself minimize the risk of financial instability.

Hence the key question was whether it is possible to to reduce the risk of financial

instability by reducing financial integration and thus reducing the cost of self insurance.

India’s Forex Reserve compositionForex reserves consists of Gold assets in the banking department, foreign securities held in the issues department, domestic reserves in the form of bank reserves, Special Drawing Rights (SDR) and Reserve Tranche Position (RTP) held with IMF.

Hence, Forex reserves are invested in multi-currency and multi asset portfolio.

FER= FCA+GOLD+SDR+RTP

As of now the forex reserve of India stands at approximately US $ 16,257 billion. (Source: RBI Database; as on 28th December, 2012)

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Foreign Currency Assets

Gold SDRs Reserve Position in the IMF

0.0

50,000.0

100,000.0

150,000.0

200,000.0

250,000.0

300,000.0

Current Foreign Exchange Reserves(As on 28-12-2012)

FX Components

In

USD

M

illio

n

(Source: RBI Database)

Reserve Adequacy

Governments accumulate reserves for a variety of reasons. A small amount of foreign currency reserves may be needed for day-to-day transactions including debt repayments, payments to international organizations, and payments for imports. The latter may be most important for low income countries. Countries with pegged exchange rates need to hold reserves to offset downward pressure on their currencies. Even economies with flexible exchange rates hold some reserves in order to intervene in foreign exchange markets to prevent a disorderly depreciation of their currency. Governments also hold reserves to provide a defense against substantial and rapid capital outflows that could cause a loss of investor confidence and a currency crisis. This self-insurance motive has received the most attention in recent years and is often seen as one reason for the increase in global reserves since the financial crises of the late 1990s.

Estimating the Adequacy of Reserves:1. Benchmarking Adequacy:

a. Reserves to Imports Ratio: The economic crisis of South-East Asia in 1997

reflected several deficiencies involved in keeping R/M ratio as a criterion of

reserves adequacy.

b. Reserves to Short term External Debt (R/STED) Ratio: It has been Short

term external debt accumulation in access is a common feature in all recent

crisis (for example: asian crisis). It gives us the information about how

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quickly a country will adjust the external sector if it is unable to access

external flows. Also it acts as the indicator for losing investor confidence.

c. Reserves to GDP Ratio: This says that reserves should be kept to a level

that is atleast some percentage of the GDP.

d. Reserves to Broad Money Supply: R/STED ratio entirely neglects the

‘internal condition’; Reserve to Broad Money Supply(R/M3) ratio could be

used to compensate this deficiency. R/M3 ratio is not a good indicator of

reserve adequacy where demand of money supply is stable and financial

markets are strong.

e. Reserves to Total External Debt (Used by RBI): This ratio tells us the

possibility of covering the total external debt using the foreign reserves.

Various indicators of reserve adequacy:

3 Months of Import Cover:

The reserves to imports ratio is considered most relevant to low income

countries exposed to current account shocks and lacking significant access to

capital markets.

20% of Money Supply (Rodrik and Velasco Rule)

Reserves in this range are considered adequate to support confidence in the

value of local currency and reduce the risk of capital flight. This benchmark

is most relevant to countries with managed exchange rates.

100% of Short-term Debt (Greenspan and Guidotti rule)

This benchmark is the most preferred measure for measuring risk of a

capital account crisis. During a financial crisis countries have found that they

are unable to rollover short-term debt.

The Guidotti–Greenspan rule states that a country's reserves should equal

short-term external debt (one-year or less maturity), implying a ratio of

reserves-to-short term debt of 1. The rationale is that countries should have

enough reserves to resist a massive withdrawal of short term foreign capital.

10% of GDP (Jeanne and Ranciere Rule)

And additional measures used by the RBI-100% of Total External Debt

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Based on these indicators we have calculated the excess reserves based on the data from

the total foreign reserves and adequate reserves (based on these indicators). Below graph

depicts the excess reserves by these different methods.

1993

-94

1994

-95

1995

-96

1996

-97

1997

-98

1998

-99

1999

-00

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

2009

-10

2009

-11

2009

-12

-100

-50

0

50

100

150

200

250

300Excess Reserves by Various Methods

Months of Imports (USD bn) 20% of money Supply

100% of Short Term Debt 10% of GDP

100% of Total External Debt

Exce

ss R

eser

ves

(USD

Bill

ions

)

Data Source-Handbook of Statistics, RBI & Calculations by the team

Cost of Excess Reserves

Holding cost of the excess reserves will definitely come into picture due to the size of the

reserves. Reserves have a fiscal opportunity cost because they could alternatively be used

to finance public capital expenditure or to pay down external debt and reduce the interest

bill. In addition, they create a benefit or loss through the financial return on reserves, a

lower government interest bill if reserves and interest rate spreads are negatively

correlated, and often a sterilization cost. Combined, these factors can have a substantial

(quasi-)fiscal impact through interest expenditure, central bank profits, and—indirectly—a

lack of funds for public investment.

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Various methods have been suggested in theory:

Hauner1 (2006) measured the Fiscal cost of foreign reserves for 100 countries.

This is a significant technique but due to lack of data on sterilization costs and

composition of various currencies in the reserves this technique has limitations.

Rodrick (2006) measured the social cost as the difference between the return on

the foreign currency assets(FCA) and interest rate on external commercial

borrowing2.

For calculating the Fiscal cost of reserves we taken the spread between weighted average

of interest rate on central government dated securities (as the data on the sterilization

costs is not available) and return on reserves. Below graph shows the cost of holding these

reserves in percentage of GDP terms and in terms of billion US Dollars.

2004-05 2005-06 2006-07 2007-08 2008-19 2009-100.000%

0.250%

0.500%

0.750%

1.000%

0.00

3.00

6.00

9.00

12.00

4.26 5.22 6.55 10.28 7.23 8.57

0.526% 0.570% 0.557%

0.887%

0.585% 0.621%

Cost of Holding Foreign Reserves

Cost in USD Cost as % of GDP

Perc

enta

ge o

f GDP

in b

illio

n US

DFor calculating the Social Cost we require the interest rate on short term external

borrowings for which we don’t have the exact data available. Although we can take an

indicative figure from the interest rates available for long term external borrowings. The

calculations are mentioned in the Appendix.

Currency composition of foreign exchange reserves

Central banks maintain foreign currency reserves to facilitate international trade and

intervene in the open markets to maintain exchange rates. The total demand for foreign

currency reserves depend on multiple factors such as import percentage of trade,

opportunity cost of holding reserves, exchange rate arrangements etc. However the

1 A Study of Adequacy, Cost and Determinants of International Reserves in India, International Research Journal of Finance and Economics - Issue 20(2008)2 http://www.roubini.com/economonitor-monitor/248231/cost_of_indias_burgeoning_foreign_exchange_reserves_what_to_do_with_s

EPGDCFM 2011-13

http://www.roubini.com/economonitor-monitor/248231/cost_of_indias_burgeoning_foreign_exchange_reserves_what_to_do_with_s

composition of foreign currency reserves would depend on real rate of returns and

volatility of the currency.

So, basically once the optimum level of forex reserves are determined, the question

remains as to how to maintain the most efficient portfolio adding up to the optimum

reserve.

Theories on Currency Composition of FX reserves:

1. Mean Variance Theory

2. Transaction Theory

In this report, we will mainly concentrate on the mean variance method and briefly review

available literature on this theory.

Mean Variance Theory

This theory originates from Harry Markowitz work on “Portfolio Selection (1952)”. It

starts with a critique of Williams (1939) that says that an investor will design a portfolio

such that the discounted anticipated or expected returns are maximized.

Markowitz argues that in addition to risk, an investor is also concerned with the risk

associated with the portfolio. “Investors’ portfolio choice problems will involve calculation

of the so called efficient portfolios, which is the combination of assets that would make the

mean return from the portfolio as large as possible for a given level of risk.”

Basically Markowitz suggests that diversification of portfolio helps in reducing the risk.

Mathematically the returns of the portfolio is given as

And the risk is given as

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Hence the risk of the portfolio depends on the variances of the returns of the assets from

the mean. The risk of a two asset based portfolio will be lower than a single asset portfolio

if the covariance of the two assets is negative. Hence the selection of portfolio depends not

only on the number of assets but also on the interaction of the assets such that the

covariance will be negative.

For a two asset portfolio:

Hence for a two asset based portfolio an efficient frontier can be defined and using the

above differentials, asset allocations can be made to achieve the efficient frontier. For

portfolio’s having more than two assets also, lagrangian multipliers can be used to

determine efficient allocations.

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In the context of foreign exchange reserves, the central bank’s objective should be to select

the most appropriate composition of foreign currencies so as to minimize risks at the same

time to be able to facilitate trade and foster growth.

Optimal Portfolio

I1, I2 and I3 represent indifferent curves. The convexity of the indifference curves

represents the risk aversion of the investor. Here a higher indifference curve signifies a

higher utlity. The point at which the indifference curve is tangential to the efficient frontier

(point A) gives the point where the investor should operate.

Sharpe Ratio lineSince the indifference curves are often not known, Sharpe (1964) and Lintner (1965)

suggested that from the intercept on the return axis at the point of risk free returns, a

tangent be drawn on the efficient frontier. The point of tangency represents the optimal

portfolio.

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Empirical studiesEmpirical studies on mean variance theory applicability on foreign exchange reserves

a. Ben-Basset (1980) – conducted a study on Israel’s currency composition of forex

reserves. The basic philosophy behind Ben-Basset’s work was that the motivation or

objective behind holding of forex reserves is different for emerging countries as

compared to the industrialized or developed nations. According to Ben-Basset,

developed countries would want to maintain currency reserves in such a way as to

maintain international monetary stability, while developing nations are interested in

maintaining a portfolio to maximize their earnings.

In this context, he analyzed Israel’s currency composition from an emerging nation’s

perspective and found out that the optimal composition was quite similar to the actual

composition, thus suggesting that his hypothesis was correct. The study was conducted

with data available on 17 most important trading partners for Israel and the US dollar,

Japanese Yen and Pound sterling as the reserve currency.

b. Dellas and Chin (1991) – Taking Ben-Basset’s work forward, Dellas and Chin

conducted similar study on Korea’s holding of forex reserve currencies. The major

differences were

1. In contrast to Ben-Basset, who took into account the country wise imports on the

basis of country of origin, Dellas and Chin took into account currency of

invoicing.

2. They included Deutsche Mark as the fourth reserve currency.

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Results of Dellas and Chin were also encouraging and further strengthened the

applicability of Mean-Variance method.

c. Papaioannou et al (2006) – This study was conducted primarily to gauge the

relevance of the Euro and its possibility as an alternate reserve currency.

Papaioannou also considered other factors such as transaction costs, and the central

banks responsibilities such as

1. Provide liquidity to market

2. Maintain forex in proportion to external debt obligation

3. Facilitate payments of international trade

4. If applicable, engage in open markets to maintain exchange rates.

The study comprised an analysis of forex reserve holdings for each of the BRIC countries

and the result indicated that the holding of the Euro was already higher than those

calculated by the study.

Further study on Ben-Basset’s methodology and applicability on India

Ben-Basset used the following equation to calculate the risk and returns

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The return on currency I is given as

Where E is the rate of change of currency I in relation to the import currency basket.

Using the above equations of risk and return, we can calculate different levels of risks and

returns for a particular portfolio holding and by varying the holdings we can determine the

efficient frontier. Using the sharpe ratio line, we can get the optimum holdings.

We tried to use the above methodology to calculate India’s optimum portfolio and reached

at the following juncture –

a. Correlation between returns on currencies

Correlati

on Dollar Yen Euro

Dollar 1 -0.21 -0.52

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Yen -0.21 1 0.04

Euro -0.52 0.04 1

b. Average risk and return on currencies (based on 10 year bond yields’ historical data

over 10 years)

Return

Varian

ce

Dollar 4.43% 0.63

Yen 1.41% 0.068

Euro 4.34% 0.36

Now, we were constrained by our inability to calculate the fluctuation of Indian rupee in

relation to the Import currency basket and hence were not able to plot the efficient

frontier.

References

1. Handbook of Statistics, RBI.

2. Half Yearly Report on Management of Foreign Exchange Reserves (2009-10), RBI.

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3. IMF, BoP Manual 2001

4. BIS Economic Papers, No. 38 – 1993

5. India’s Foreign Exchange Reserves: Policy, Status and Issues, Y. V. Reddy

6. Foreign Exchange Reserves Management in India: Accumulation and Utilization, M.

Rama Krishna Prasad and G. Raghavender Raju, Department of Economics, Sri

Sathya Sai University.

7. Managing India's Foreign Exchange Reserve: A preliminary exploration of issues

and options, Chaisse, Julien; Chakraborty, Debashis and Mukherjee, Jaydeep,

Chinese University of Hong Kong, Indian Institute of Foreign Trade, Indian Institute

of Foreign Trade, Munich Personal RePEc Archive.

8. THE OPTIMAL COMPOSITION OF FOREIGN EXCHANGE RESERVES, Avraham

BEN-BASSAT, Bank of Israel and The Hebrew University, Jerusalem. Israel.

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APPENDIX

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Money Supply

Handbook of Statistics: Table 43

Year Broad Money (Rs Billion)Broad Money Million USD

20% in Billion USD

1993-94 431084 93713.91304 18.742782611994-95 527596 114694.7826 22.938956521995-96 599191 130258.913 26.051782611996-97 696012 151306.9565 30.26139131997-98 821332 178550.4348 35.710086961998-99 980960 213252.1739 42.650434781999-00 1124174 244385.6522 48.877130432000-01 1313220 285482.6087 57.096521742001-02 1498355 325729.3478 65.145869572002-03 1717960 373469.5652 74.693913042003-04 2005676 436016.5217 87.203304352004-05 2245677 488190.6522 97.638130432005-06 2719519 591199.7826 118.2399565

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2006-07 3310068 719580 143.9162007-08 4017883 873452.8261 174.69056522008-09 4794812 1042350.435 208.4700872009-10 5602698 1217977.826 243.59556522010-11 6504116 1413938.261 282.78765222011-12 7359200 1599826.087 319.9652174

Months of Import

Months of Import Cover Requirement 3

Year Actual ReservesMonths of Imports Reserve Requirement for 3 months

1993-94 19.254 8.6 6.721994-95 25.186 8.4 9.001995-96 21.687 6 10.841996-97 26.423 6.5 12.201997-98 29.367 6.9 12.771998-99 32.49 8.2 11.891999-00 38.036 8.2 13.922000-01 42.281 8.8 14.412001-02 54.106 11.5 14.112002-03 76.1 14.2 16.082003-04 112.959 16.9 20.052004-05 141.514 14.3 29.692005-06 151.622 11.6 39.212006-07 199.179 12.5 47.802007-08 309.723 14.4 64.532008-09 251.985 9.8 77.142009-10 279.057 11.2 74.752010-11 304.82 9.6 95.262011-12 294.4 7.1 124.39

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GDP

http://www.tradingeconomics.com/india/gdp

Year GDP in bn $ 10% of GDP

Cost of holding Reserves in USD Bn

% of GDP

1993-94 276.037 27.6037 1994-95 323.506 32.3506 1995-96 356.299 35.6299 1996-97 388.344 38.8344 1997-98 410.915 41.0915 1998-99 416.252 41.6252 1999-00 450.476 45.0476 2000-01 460.182 46.0182 2001-02 477.849 47.7849 2002-03 507.19 50.719 2003-04 599.461 59.9461 2004-05 700.921 70.0921 4.26 0.61%2005-06 810.151 81.0151 5.22 0.64%2006-07 951.339 95.1339 6.55 0.69%2007-08 1242.426 124.2426 10.28 0.83%2008-09 1213.782 121.3782 7.23 0.60%2009-10 1380.64 138.064 8.57 0.62%2010-11 1729.01 172.901 17.77 1.03%2011-12 1847.982 184.7982 19.96 1.08%

Foreign Reserves

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