Efficient utilization of India s forex reserves

Abstract

This project aims at determining effective utilization of excess FOREX reserves in India. Ever since the South East Asian Crisis of 1997 which saw the currencies of the Asian tigers crashing, the South East Asian economies have tended to amass FOREX reserves in excess of the requisite level in order to insulate their economy from sudden capital shocks. The seven South East Asian economies India, Hong Kong, Indonesia, Korea, Singapore, Taiwan and Thailand collectively hold reserves amounting to $1.375 trillion, which averages out to around $200bn per economy. This is well in excess of the adequate reserves as stipulated by import and external debt requirements. This raises the question of the cost of holding excess reserves and the possibility of using this excess amount to generate higher returns. The issue gains further prominence in today s financial scenario. This project aims at addressing the same for India. This report is structured in the following manner First we analyze the current use of foreign exchange reserves and understand the recent trends that have influenced its movement. This is followed by analyzing estimates of the balance of payment, invisible account and capital account balance to arrive at India s FOREX as on Jan 1st, 2009. Once we predict the FOREX trend, we estimate of adequate reserve holdings based on Import-Cover rule, the Greenspan-Guidotti Rule and the Prais Winstein Regression estimates. From these, we calculate that $200bn is the adequate reserve amount for India with $60 billion excess reserves to be utilized. We further progress to understand how these excess reserves can be used and how the existing reserves can be hedged for translation exposure. In this context, we realize that the returns on current reserves are as low as 5%, and taking into consideration an inflation of 5.4%, the real returns on foreign currency assets in fact, are negative. It is important that a certain amount of reserves are held for contingency. At the same time, by evaluating utilization of excess reserves of several countries, we find that returns can be significantly improved by smart and thoughtful investments. In this regard, we have thought of hedging FOREX risk by fanning out its storage in various currencies. At the same time, we have also evaluated several options for utilizing the excess FOREX reserves to arrive at a segmented plan for the same. We found out that some of the best uses that India s FOREX reserves can be put to include financing infrastructure and developing a Sovereign Wealth Fund. Through this report we hope to have addressed the increasingly pondered upon question of utilizing India s massive FOREX reserves and to have come up with a workable solution for the same.