Description
This doc includes topics like credit risk,market risk,liquidity risk,operational risk and control system.
Macro Economics Project
? Concept: ? Trend (1991- 2008):
The level of foreign exchange reserves, which comprises the Foreign Currency Assets, Special Drawing Rights, Gold and the Reserve Tranche Position in the IMF, had steadily increased from US$ 5.8 billion as at end-March 1991 to US$ 151.6 billion by end-March 2006 and further to US$ 199.2 billion by end-March 2007. It stood at US$ 309.7 billion as at end-March 2008. Although both US dollar and Euro are intervention currencies, the foreign exchange reserves are denominated and expressed in US dollar only.
Table 1: Movement of Reserves
Review of Growth in Reserves since 1991:
India’s foreign exchange reserves have grown significantly since 1991. The reserves, which stood at US$ 5.8 billion at end-March 1991, increased gradually to US$ 25.2 billion by endMarch 1995. The growth continued in the second half of the 1990s with the reserves touching the
level of US$ 38.0 billion by end-March 2000. Subsequently, the reserves rose to US$ 113.0 billion by end-March 2004, US$ 141.5 billion by end-March 2005, US $ 151.6 billion by end March 2006, US$ 199.2 billion by end-March 2007 and further to US$ 309.7 billion by endMarch 2008 (Chart 1). It may be mentioned that foreign exchange reserve data prior to 2002-03 do not include the Reserve Tranche Position (RTP) in the IMF.
Chart 1: Movements in Foreign Exchange Reserves
Sources of Accretion to the Reserves
The details of the major sources of accretion to the foreign exchange reserves during the period from March 1991 to March 2008 are shown below.
Table 2: Sources of Accretion to the Foreign Exchange Reserves since 1991
The details of accretion during April-March 2007-08 and the corresponding period of the previous year are shown below. The increase in the foreign exchange reserves has been on account of capital and other inflows. Major sources of increase in the foreign exchange reserves for the year 2007-08 have been: (a) foreign investment, (b) external commercial borrowings, (c) short-term credit, and (d) banking capital.
Table 3: Sources of Accretion to Foreign Exchange Reserves during April-March 2007-08
An analysis of the sources of reserves accretion during the entire reform period from 1991 onwards reveals that the increase in foreign exchange reserves has been facilitated by an increase in the quantum of cumulative net foreign direct investment (FDI) from US $ 129 million in 1991-92 to US$ 59.2 billion in 2007-08. During 2007-08, net FDI amounted to US$ 15.5 billion. FII investments in the Indian capital market, which commenced in January 1993, have shown significant increase over the subsequent years. Cumulative net FII inflows increased from US $1million at end-March 1993 to US$ 66.6 billion at end- March 2008, net accretion being US $20.3 billion during the year 2007-08. Outstanding NRI deposits increased from US$ 14.0 billion at end-March 1991 to US$ 41.2 billion as at end-March 2007. As at end-March 2008, the outstanding NRI deposit stood at US$ 43.7 billion. Under current account, India’s exports, which were US$ 18.3 billion during 1991-92, increased to US$ 158.5 billion in 2007-08. India’s imports, which were US $ 24.1 billion in 1991-92, increased to US $ 248.5 billion in 2007-08. Invisibles, in particular, private remittances have also contributed significantly to the current account. Net invisibles inflows, comprising mainly private transfer remittances and services, increased from US$ 1.6 billion in 1991-92 to US$ 53.4 billion in 2006-07. During April-March 2007-08, net invisibles were of the order of US$ 72.7 billion. India’s current account balance,
which was in deficit at 3.1 per cent of GDP in 1990-91, turned into a surplus of 0.7 per cent in 2001-02 and 1.3 per cent in 2002-03. A surplus of US $ 14.1 billion (2.3 per cent of GDP) was posted in the current account during the financial year 2003-04, mainly due to surplus in the invisibles account. However, this was not sustained during 2004-05 with the current account posting a deficit of US$ 2.5 billion (0.4 per cent of GDP). During 2005-06, current account deficit widened further and was of the order of US$ 9.9 billion, accounting for 1.2 per cent of GDP, driven mainly by strong import demand, both oil and non-oil. During 2006-07, the current account deficit amounted to US $ 9.8 billion, constituting 1.1 per cent of GDP. During 2007-08, current account deficit increased to US $ 17.4 billion (1.5 per cent of GDP).
External Liabilities vis-à-vis Foreign Exchange Reserves The accretion to the foreign exchange reserves needs to be seen in the light of total external liabilities of the country. India’s International Investment Position (IIP), which is a summary record of the stock of country’s external financial assets and liabilities, is available as of end December 2007.
Table 4: International Investment Position of India
Prepayment of External Debt
The significant increase in foreign exchange reserves enabled prepayment of certain high-cost foreign currency loans of the Government of India from the Asian Development Bank (ADB) and the International Bank for Reconstruction and Development (IBRD) / World Bank amounting to US$ 3.03 billion during February 2003. During 2003-04, prepayment of certain high cost loans to IBRD and ADB amounting to US$ 2.6 billion was carried out by the Government. Additionally, prepayment of bilateral loans amounting to US$ 1.1 million was also made. Thus, the total quantum of prepayments was of the order of US$ 3.7 billion during 200304. During 2004-05, prepayment of bilateral loan to the tune of US$ 30.3 million was made. During 2006-07, there was only one prepayment of US$ 58.7 million in the month of April 2006. There was no pre-payment of any debt during 2007-08.
Financial Transaction Plan (FTP) of the IMF
International Monetary Fund (IMF) designated India as a creditor under its Financial Transaction Plan (FTP) in February 2003. In terms of this arrangement, India participated in the IMF’s financial support to Burundi in March-May 2003 with a contribution of SDR 5 million and to Brazil in June-September 2003 with SDR 350 million. In December 2003, SDR 43 million was made available to Indonesia under the FTP. During 2004-05, SDR 61 million was made available under the FTP to countries like Uruguay, Haiti, Dominican Republic and Sri Lanka. During May-June 2005, SDR 34 million was made available to Turkey and Uruguay. Thereafter, there were two purchase transactions during 2007-08, viz., SDR 32 million by Bangladesh on April 7, 2008 and SDR 55 million by Turkey on May 14, 2008. Thus, the total purchase transactions amounted to 580 million as at end June 2008. India was included in repurchase transactions of the FTP since November 2005. There were 17 repurchase transactions during the period from November 2005 to June 2008 totaling SDR 749 million received from 6 countries, viz., Turkey, Algeria, Brazil, Indonesia, Uruguay and Ukraine.
Adequacy of Reserves
Adequacy of reserves has emerged as an important parameter in gauging the country’s ability to absorb external shocks. With the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. Various suggestions in this regard were made by the High Level Committee on Balance of Payments, chaired by Dr. C Rangarajan, erstwhile Governor of Reserve Bank of India, Committee on Capital Account Convertibility and Committee on Fuller Capital Account Convertibility chaired by Shri. S S Tarapore, former Deputy Governor of RBI. In the recent period, assessment of reserve adequacy has been influenced by the introduction of new measures. One such measure requires that the usable foreign exchange reserves should exceed scheduled amortization of foreign currency debts (assuming no rollovers) during the following year. The other one is based on a "Liquidity at Risk" approach that takes into account the foreseeable risks that a country could face. This approach requires that a country's foreign exchange liquidity position could be calculated under a range of possible outcomes for relevant financial variables, such as, Current Account Balance, capital account flows like FDIs, FII investments, External Commercial Borrowings, Non-Resident Deposits, etc. Reserve Bank of India has been undertaking exercises based on intuition and risk models to estimate "Liquidity at Risk (LAR)" of the reserves. The traditional trade-based indicator of reserve adequacy, viz. import cover of reserves had fallen to a low of 3 weeks of imports at end-December 1990, rose to 11.5 months of imports at end-March 2002 and increased further to 14.2 months of imports. At end-March 2004, the import cover of reserves was 16.9 months and it came down to 14.3 months as at end-March 2005 and further to 11.6 months as at end-March 2006. The import cover for reserves was 12.5 months at end-March 2007 and 12.4 months at end September 2007. The import cover rose to 15 months as at endMarch 2008. The ratio of short-term debt (redefined since 2005-06 by including suppliers’ credit upto 180 days) to the foreign exchange reserves declined from 146.5 per cent at end-March 1991 to 12.5 per cent as at end-March 2005 but increased to 12.9 per cent as at end-March 2006, to 13.2 per cent at end-March 2007 and to 13.9 per cent at end-September 2007. The short term debt to reserves ratio further increased to 14.3 per cent at end-March 2008. The ratio of short term debt and portfolio stocks to reserves declined from 146.6 per cent as at end-March 1991 to 45.3 per cent as at end-March 2007 and to 44.4 per cent as at end-March 2008.
The traditional approach of measuring foreign exchange reserves is by measuring Reserves to Import (R/M) Ratio. Judging India’s reserve on R/M ratio since 1990-91, it looks very healthy except in economic crisis period of 1990-91, after that the reserves is always more than three months import coverage. A comparison of Foreign exchange reserves of different countries and the import coverage from these reserves is shown below.
IMPORT PER ANNUAL IMPORTS COUNTRY (MILLION USD) MONTH (MILLION USD) 33000 29733.33 4400 15479.08 RESERVES IMPORT (MILLION USD)
162,174 212,253 35,425 252,883
COVER (MONTHS) 4.91 7.14 8.05 16.34
SINGAPORE 396000 KOREA ISRAEL INDIA 356800 52800 185749
(Source: www.wikipedia.org)
From the table it can be seen that India has foreign exchange reserves to support 16 months of import bills which is 4-5 times more than the traditional requirement of 3-4 months. A measure of adequacy of foreign exchange reserves can be expressed in terms of Reserves to Short term External Debt (R/STED) 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. Many authors recognized that the excessive accumulation of short-term external debt in comparison with levels of international reserves was a common feature of all recent crises. Furman and Stiglitz (1998) and Radelet and Sachs (1998) analyse the importance of this indicator in details. They conclude that the international reserves/short-term external debt (R/STED) ratio was one of the determining factors of the Asian crises in the second half of the 1990s.
Therefore, a measure comparing reserves and short-term external debt could be a relevant measure of risks associated with adverse developments in international capital markets. Short term debt provides a measure of all debt repayments to non-residents over the coming year and, as such, constitutes useful information of how fast a country would be to adjust the external sector if it were unable to access external flows (IMF, 2000). Moreover, R/STED ratio also provides a useful indicator of the threshold at which the investors lose confidence (Bird and Rajan 2003). It is widely recommended that countries should hold reserves for four to five quarters STED in advance. In India, Short term external debt (STED) hasn’t increased since 1990-91, while foreign currency assets (FCA) have grown around hundred times. This has made R/STED ratio better in last decade. The ratio reveals that minimum chance of occurrence of currency crisis as the reserves are comparatively very high. The figure 2 shows the trend for Reserves and STED in India from 1990 to 2006.
In terms of Total external liabilities India has foreign reserves to meet 100% of its external liabilities, as shown in the figure below. India also has assets in other countries in the form of private as well as public investment. Hence considering the net external liability ie. External liability-external assets, India has enough surplus in its foreign exchange reserves.
EXTERNAL LIABILITIES COVERAGE
300,000 RESERVES, 252,883 250,000 EXTERNAL LIABILITY, 224000
USMILLION $
200,000
150,000
100,000
NET EXTERNAL LIABILITY, 73900
50,000
0 1
Yet another measure of adequacy followed by some countries is the thumb rule followed by these countries to maintain foreign exchange reserves at 10% of their GDP. Considering this measure we can find out that India maintains Foreign exchange reserves at 20% of its GDP.
The table below shows the value of foreign exchange reserves as a percentage of GDP.
FOREX GDP COUNTRY (MILLION USD)
AS
PERCENTAGE OF GDP 100.51 21.88 21.59 22.97
SINGAPORE 161349 KOREA ISRAEL INDIA 969871 164103 1100695
(Source: www.wikipedia.org)
Thus considering the above mentioned measures of determining adequacy of foreign exchange reserves, we deduce that Foreign exchange reserves are adequate in India.
Utilization of Foreign exchange reserves by India Vis-à-vis other countries.
The guiding objectives of foreign exchange reserves management in India are similar to those of any emerging market economies in the world. The demands placed on the foreign exchange reserves may vary widely depending upon a variety of factors including the exchange rate regime adopted by the country, the extent of openness of the country’s economy, the size of the external sector in a country’s GDP and the nature of markets operating in the country. Even within this divergent framework, most countries have adopted the primary objective of reserve management as preservation of the long-term value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns. While safety and liquidity constitute the twin objectives of reserve management in India, return optimization becomes an embedded strategy within this framework.
The essential legal framework for reserves management is provided by the Reserve Bank of India Act, 1934.. Specifically, sub-sections 17(12), 17(12A), 17(13) and 33(1) of the Reserve Bank of India Act, 1934 define the scope of investment of external assets. In brief, the law broadly permits the following investment categories: i. ii. iii. Deposits with other central banks and Bank for International Settlements(BIS). Deposits with foreign commercial banks. Debt instruments representing sovereign/sovereign-guaranteed liability. Residual maturity for debt papers should not exceed 10 years. iv. Other instruments/institutions as approved by the Central Board of RBI
Hence we see from the legal restrictions imposed by RBI that there is no room for investment of foreign exchange reserves in equities. We find that for India majority of its foreign exchange reserves are invested in the central banks of other countries or as securities. Under securities
India generally invests in triple A bonds. For other emerging economies such as korea, china or Singapore we find that these countries have invested most of their foreign exchange reserves in the equity market to achieve higher returns. India on the contradictory is following a very conservative approach in terms of utilization of its foreign exchange reserves. India’s Investment of Foreign exchange reserves vis-à-vis other countries is shown below.
Utilisation of Foreign Exchange Reserves in US million $(Oct 2008) Singapore Korea Official assets Securities Other national reserve
162,173.90 150,245.00 212,253.00 192,119.00 35,425.10 31,375.07 252,883.00 102,107.00
Israel
India
central banks, BIS and IMF Domestic Banks Foreign Banks IMF position SDRs Gold (Source: www.imf.org) reserve
94.1 339.8 211.7 313 82 75 99.49 13.45 0 447 9 8,382.00 298.8 1,174.30 14,118.20 20,213.00 2,332.46 454 195.21 136,728.00 0 5,210.00
%RETURN ON FOREIGN CURRENCY ASSETS AND GOLD
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0
4.6 4.1 2.8 2.1 3.1 3.9
2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007
The percentage distribution of India’s foreign exchange reserves’ investment is shown below. Note: Securities include investment in equities for China, Israel, Korea and Singapore.
PERCENTAGE UTILIZATION AS ON OCTOBER 2008
100 90 80 70 60 50 40 30 20 10 0 Other Domestic Foreign IMF Securities national Banks Banks reserve central position banks, BIS and IMF SDRs Gold
PERCENTAGE
Singapore Korea Israel India
UTILISATION
Risk factors considered by Government of India while investing its foreign exchange reserves.
There are 4 types of risk factors that the government of India considers while deciding the investment of its foreign exchange reserves. 1. Credit risk 2. Market risk 3. Liquidity risk 4. Operational risk and control system
(i) Credit Risk: Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms. RBI has been extremely sensitive to the
credit risk it faces on the investment of foreign currency assets and gold in the international markets. Investments in bonds/treasury bills, which represent debt obligations of Triple-A rated sovereigns and supranational entities do not give rise to any substantial credit risk. Placement of deposit with BIS and other central banks like Bank of England is also considered credit risk-free. However, placement of deposits with commercial banks as also transactions in foreign exchange and bonds/treasury bills with commercial banks/investment banks and other securities firms give rise to credit risk. Stringent credit criteria are, therefore, applied for selection of counterparties. Credit exposure vis-a-vis sanctioned limit in respect of approved counterparties is monitored on line. The basic objective of an on-going tracking exercise is to identify any institution (which is on the RBI’s approved list) whose credit quality is under potential threat and to prune down the credit limits or de-list it altogether, if considered necessary. A quarterly review exercise is also carried in respect of counterparties for possible inclusion/deletion. (ii) Market Risk: Market risk contains two different types of risks as given below: (a) Currency Risk: Currency risk arises due to uncertainty in exchange rates. Foreign exchange reserves are invested in multi-currency, multi-market portfolios. In consultation with Ministry of Finance, decisions are taken regarding the long-term exposure on different currencies depending on the likely currency movements and other considerations in the medium- and long-term (such as, the necessity of maintaining major portion of reserves in the intervention currency and of maintaining the approximate currency profile of the reserves in line with the changing external trade profile of the country as also for diversification benefits). The Top Management of RBI is kept informed of the currency composition of reserves through a weekly Management Information System (MIS) report. (b) Interest Rate Risk: The crucial aspect of the management of interest rate risk is to protect the value of the investments as much as possible from the adverse impact of the interest rate movements. The focus of the investment strategy revolves around the overwhelming need to keep the interest rate risk of the portfolio reasonably low with a view to minimizing losses arising out of adverse interest rate movements, if any. This approach is warranted as reserves are viewed as a market stabilizing force in an uncertain environment.
(iii) Liquidity Risk: The reserves need to maintain a high level of liquidity at all times in order to be able to be able to meet any unforeseen and emergency needs. Any adverse development has to be met with reserves, and hence a highly liquid portfolio is a necessary constraint in the investment strategy. The choice of instruments determines the liquidity of the portfolio. For example, Treasury securities issued by the US government can be liquidated in large volumes without much distortion to the price in the market, and thus can be considered as liquid. Also, most of the investments with BIS can be readily converted into cash. In fact, excepting fixed deposits with foreign commercial banks , almost all other types of investments are in highly liquid instruments which could be converted into cash at short notice. RBI closely monitors the portion of the reserves which could be converted into cash at a very short notice to meet any unforeseen/emergency needs. (iv) Operational Risk and Control System: Internally, there is a total separation of the front office and back office functions and the internal control systems ensure several checks at the stages of deal capture, deal processing and settlement. There is a separate set up responsible for risk measurement and monitoring, performance evaluation and concurrent audit. The deal processing and settlement system is also subject to internal control guidelines based on the principle of one point data entry and powers are delegated to officers at various levels for generation of payment instructions. There is a system of concurrent audit for monitoring compliance in respect of all the internal control guidelines. Further, reconciliation of accounts is done regularly. In addition to annual inspection by the internal machinery of the RBI for this purpose and statutory audit of accounts by external auditors, there is a system of appointing a special external auditor to audit dealing room transactions. The main objective of the special audit is to see that risk management systems and internal control guidelines are adhered to. There exists a comprehensive reporting mechanism covering all significant areas of activity/operations relating to reserve management. These are being provided to the senior management periodically, viz., on daily, weekly, monthly, quarterly, half-yearly and yearly intervals, depending on the type and sensitivity of information.
Utilization of Foreign exchange reserves by other countries:
Countries like Singapore, china and Korea have used their foreign exchange reserves very well by creating sovereign wealth funds. These sovereign wealth funds invest money in equities, real estate investments and other financial instruments.
Singapore: The Government of Singapore Investment Corporation (GIC), established in 1981, invests internationally in equities, fixed income, money market instruments, real estate and special investments. GIC notes that it manages assets owned by the Government of Singapore (GIC's parent) and the Monetary Authority of Singapore. It has extensive retail property investments in Australia. The present value of its assets is around 330 billion US dollars. The government also wholly owns Temasek, an unwieldy conglomerate (with assets estimated at over US$100 billion) with substantial offshore holdings that include a controlling stake in Australia's Optus and Thailand's Shin telecommunications and broadcast group.
Korea: Korea has also established its own sovereign wealth fund in the year 2005. The SWF was named as Korea Investment Corporation and 17 billion US dollar worth of foreign exchange reserves were invested in it.
China: In 2007 china created its SWF known as China Investment Corporation to manage 200 billion USD foreign exchange reserves. Conclusion:
From the above examples we can see that foreign exchange reserves can provide better returns if it is invested accordingly. Considering the examples of these South Asian countries, India can also start its own SWF and to increase the returns it earns on Foreign exchange reserves. Considering the fact that India has Foreign exchange reserves to suffice 16 months of import bills, India can go for investing up to 25% of its foreign reserves in SWF. Even after investing 25% of the existing reserves, India would be left with enough reserves to suffice 12 months of import bills. This is sufficient considering the present FII pullouts from the country on account of
economic turbulence. However India should avoid using its Foreign exchange reserves in Infrastructure as these projects yield low returns on account of political and economic difficulties especially in adjusting the tariff structure. The use of FER to finance infrastructure may lead to more economic difficulties, including problems in monetary management.
References
? www.rbi.org.in
doc_479790781.docx
This doc includes topics like credit risk,market risk,liquidity risk,operational risk and control system.
Macro Economics Project
? Concept: ? Trend (1991- 2008):
The level of foreign exchange reserves, which comprises the Foreign Currency Assets, Special Drawing Rights, Gold and the Reserve Tranche Position in the IMF, had steadily increased from US$ 5.8 billion as at end-March 1991 to US$ 151.6 billion by end-March 2006 and further to US$ 199.2 billion by end-March 2007. It stood at US$ 309.7 billion as at end-March 2008. Although both US dollar and Euro are intervention currencies, the foreign exchange reserves are denominated and expressed in US dollar only.
Table 1: Movement of Reserves
Review of Growth in Reserves since 1991:
India’s foreign exchange reserves have grown significantly since 1991. The reserves, which stood at US$ 5.8 billion at end-March 1991, increased gradually to US$ 25.2 billion by endMarch 1995. The growth continued in the second half of the 1990s with the reserves touching the
level of US$ 38.0 billion by end-March 2000. Subsequently, the reserves rose to US$ 113.0 billion by end-March 2004, US$ 141.5 billion by end-March 2005, US $ 151.6 billion by end March 2006, US$ 199.2 billion by end-March 2007 and further to US$ 309.7 billion by endMarch 2008 (Chart 1). It may be mentioned that foreign exchange reserve data prior to 2002-03 do not include the Reserve Tranche Position (RTP) in the IMF.
Chart 1: Movements in Foreign Exchange Reserves
Sources of Accretion to the Reserves
The details of the major sources of accretion to the foreign exchange reserves during the period from March 1991 to March 2008 are shown below.
Table 2: Sources of Accretion to the Foreign Exchange Reserves since 1991
The details of accretion during April-March 2007-08 and the corresponding period of the previous year are shown below. The increase in the foreign exchange reserves has been on account of capital and other inflows. Major sources of increase in the foreign exchange reserves for the year 2007-08 have been: (a) foreign investment, (b) external commercial borrowings, (c) short-term credit, and (d) banking capital.
Table 3: Sources of Accretion to Foreign Exchange Reserves during April-March 2007-08
An analysis of the sources of reserves accretion during the entire reform period from 1991 onwards reveals that the increase in foreign exchange reserves has been facilitated by an increase in the quantum of cumulative net foreign direct investment (FDI) from US $ 129 million in 1991-92 to US$ 59.2 billion in 2007-08. During 2007-08, net FDI amounted to US$ 15.5 billion. FII investments in the Indian capital market, which commenced in January 1993, have shown significant increase over the subsequent years. Cumulative net FII inflows increased from US $1million at end-March 1993 to US$ 66.6 billion at end- March 2008, net accretion being US $20.3 billion during the year 2007-08. Outstanding NRI deposits increased from US$ 14.0 billion at end-March 1991 to US$ 41.2 billion as at end-March 2007. As at end-March 2008, the outstanding NRI deposit stood at US$ 43.7 billion. Under current account, India’s exports, which were US$ 18.3 billion during 1991-92, increased to US$ 158.5 billion in 2007-08. India’s imports, which were US $ 24.1 billion in 1991-92, increased to US $ 248.5 billion in 2007-08. Invisibles, in particular, private remittances have also contributed significantly to the current account. Net invisibles inflows, comprising mainly private transfer remittances and services, increased from US$ 1.6 billion in 1991-92 to US$ 53.4 billion in 2006-07. During April-March 2007-08, net invisibles were of the order of US$ 72.7 billion. India’s current account balance,
which was in deficit at 3.1 per cent of GDP in 1990-91, turned into a surplus of 0.7 per cent in 2001-02 and 1.3 per cent in 2002-03. A surplus of US $ 14.1 billion (2.3 per cent of GDP) was posted in the current account during the financial year 2003-04, mainly due to surplus in the invisibles account. However, this was not sustained during 2004-05 with the current account posting a deficit of US$ 2.5 billion (0.4 per cent of GDP). During 2005-06, current account deficit widened further and was of the order of US$ 9.9 billion, accounting for 1.2 per cent of GDP, driven mainly by strong import demand, both oil and non-oil. During 2006-07, the current account deficit amounted to US $ 9.8 billion, constituting 1.1 per cent of GDP. During 2007-08, current account deficit increased to US $ 17.4 billion (1.5 per cent of GDP).
External Liabilities vis-à-vis Foreign Exchange Reserves The accretion to the foreign exchange reserves needs to be seen in the light of total external liabilities of the country. India’s International Investment Position (IIP), which is a summary record of the stock of country’s external financial assets and liabilities, is available as of end December 2007.
Table 4: International Investment Position of India
Prepayment of External Debt
The significant increase in foreign exchange reserves enabled prepayment of certain high-cost foreign currency loans of the Government of India from the Asian Development Bank (ADB) and the International Bank for Reconstruction and Development (IBRD) / World Bank amounting to US$ 3.03 billion during February 2003. During 2003-04, prepayment of certain high cost loans to IBRD and ADB amounting to US$ 2.6 billion was carried out by the Government. Additionally, prepayment of bilateral loans amounting to US$ 1.1 million was also made. Thus, the total quantum of prepayments was of the order of US$ 3.7 billion during 200304. During 2004-05, prepayment of bilateral loan to the tune of US$ 30.3 million was made. During 2006-07, there was only one prepayment of US$ 58.7 million in the month of April 2006. There was no pre-payment of any debt during 2007-08.
Financial Transaction Plan (FTP) of the IMF
International Monetary Fund (IMF) designated India as a creditor under its Financial Transaction Plan (FTP) in February 2003. In terms of this arrangement, India participated in the IMF’s financial support to Burundi in March-May 2003 with a contribution of SDR 5 million and to Brazil in June-September 2003 with SDR 350 million. In December 2003, SDR 43 million was made available to Indonesia under the FTP. During 2004-05, SDR 61 million was made available under the FTP to countries like Uruguay, Haiti, Dominican Republic and Sri Lanka. During May-June 2005, SDR 34 million was made available to Turkey and Uruguay. Thereafter, there were two purchase transactions during 2007-08, viz., SDR 32 million by Bangladesh on April 7, 2008 and SDR 55 million by Turkey on May 14, 2008. Thus, the total purchase transactions amounted to 580 million as at end June 2008. India was included in repurchase transactions of the FTP since November 2005. There were 17 repurchase transactions during the period from November 2005 to June 2008 totaling SDR 749 million received from 6 countries, viz., Turkey, Algeria, Brazil, Indonesia, Uruguay and Ukraine.
Adequacy of Reserves
Adequacy of reserves has emerged as an important parameter in gauging the country’s ability to absorb external shocks. With the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. Various suggestions in this regard were made by the High Level Committee on Balance of Payments, chaired by Dr. C Rangarajan, erstwhile Governor of Reserve Bank of India, Committee on Capital Account Convertibility and Committee on Fuller Capital Account Convertibility chaired by Shri. S S Tarapore, former Deputy Governor of RBI. In the recent period, assessment of reserve adequacy has been influenced by the introduction of new measures. One such measure requires that the usable foreign exchange reserves should exceed scheduled amortization of foreign currency debts (assuming no rollovers) during the following year. The other one is based on a "Liquidity at Risk" approach that takes into account the foreseeable risks that a country could face. This approach requires that a country's foreign exchange liquidity position could be calculated under a range of possible outcomes for relevant financial variables, such as, Current Account Balance, capital account flows like FDIs, FII investments, External Commercial Borrowings, Non-Resident Deposits, etc. Reserve Bank of India has been undertaking exercises based on intuition and risk models to estimate "Liquidity at Risk (LAR)" of the reserves. The traditional trade-based indicator of reserve adequacy, viz. import cover of reserves had fallen to a low of 3 weeks of imports at end-December 1990, rose to 11.5 months of imports at end-March 2002 and increased further to 14.2 months of imports. At end-March 2004, the import cover of reserves was 16.9 months and it came down to 14.3 months as at end-March 2005 and further to 11.6 months as at end-March 2006. The import cover for reserves was 12.5 months at end-March 2007 and 12.4 months at end September 2007. The import cover rose to 15 months as at endMarch 2008. The ratio of short-term debt (redefined since 2005-06 by including suppliers’ credit upto 180 days) to the foreign exchange reserves declined from 146.5 per cent at end-March 1991 to 12.5 per cent as at end-March 2005 but increased to 12.9 per cent as at end-March 2006, to 13.2 per cent at end-March 2007 and to 13.9 per cent at end-September 2007. The short term debt to reserves ratio further increased to 14.3 per cent at end-March 2008. The ratio of short term debt and portfolio stocks to reserves declined from 146.6 per cent as at end-March 1991 to 45.3 per cent as at end-March 2007 and to 44.4 per cent as at end-March 2008.
The traditional approach of measuring foreign exchange reserves is by measuring Reserves to Import (R/M) Ratio. Judging India’s reserve on R/M ratio since 1990-91, it looks very healthy except in economic crisis period of 1990-91, after that the reserves is always more than three months import coverage. A comparison of Foreign exchange reserves of different countries and the import coverage from these reserves is shown below.
IMPORT PER ANNUAL IMPORTS COUNTRY (MILLION USD) MONTH (MILLION USD) 33000 29733.33 4400 15479.08 RESERVES IMPORT (MILLION USD)
162,174 212,253 35,425 252,883
COVER (MONTHS) 4.91 7.14 8.05 16.34
SINGAPORE 396000 KOREA ISRAEL INDIA 356800 52800 185749
(Source: www.wikipedia.org)
From the table it can be seen that India has foreign exchange reserves to support 16 months of import bills which is 4-5 times more than the traditional requirement of 3-4 months. A measure of adequacy of foreign exchange reserves can be expressed in terms of Reserves to Short term External Debt (R/STED) 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. Many authors recognized that the excessive accumulation of short-term external debt in comparison with levels of international reserves was a common feature of all recent crises. Furman and Stiglitz (1998) and Radelet and Sachs (1998) analyse the importance of this indicator in details. They conclude that the international reserves/short-term external debt (R/STED) ratio was one of the determining factors of the Asian crises in the second half of the 1990s.
Therefore, a measure comparing reserves and short-term external debt could be a relevant measure of risks associated with adverse developments in international capital markets. Short term debt provides a measure of all debt repayments to non-residents over the coming year and, as such, constitutes useful information of how fast a country would be to adjust the external sector if it were unable to access external flows (IMF, 2000). Moreover, R/STED ratio also provides a useful indicator of the threshold at which the investors lose confidence (Bird and Rajan 2003). It is widely recommended that countries should hold reserves for four to five quarters STED in advance. In India, Short term external debt (STED) hasn’t increased since 1990-91, while foreign currency assets (FCA) have grown around hundred times. This has made R/STED ratio better in last decade. The ratio reveals that minimum chance of occurrence of currency crisis as the reserves are comparatively very high. The figure 2 shows the trend for Reserves and STED in India from 1990 to 2006.
In terms of Total external liabilities India has foreign reserves to meet 100% of its external liabilities, as shown in the figure below. India also has assets in other countries in the form of private as well as public investment. Hence considering the net external liability ie. External liability-external assets, India has enough surplus in its foreign exchange reserves.
EXTERNAL LIABILITIES COVERAGE
300,000 RESERVES, 252,883 250,000 EXTERNAL LIABILITY, 224000
USMILLION $
200,000
150,000
100,000
NET EXTERNAL LIABILITY, 73900
50,000
0 1
Yet another measure of adequacy followed by some countries is the thumb rule followed by these countries to maintain foreign exchange reserves at 10% of their GDP. Considering this measure we can find out that India maintains Foreign exchange reserves at 20% of its GDP.
The table below shows the value of foreign exchange reserves as a percentage of GDP.
FOREX GDP COUNTRY (MILLION USD)
AS
PERCENTAGE OF GDP 100.51 21.88 21.59 22.97
SINGAPORE 161349 KOREA ISRAEL INDIA 969871 164103 1100695
(Source: www.wikipedia.org)
Thus considering the above mentioned measures of determining adequacy of foreign exchange reserves, we deduce that Foreign exchange reserves are adequate in India.
Utilization of Foreign exchange reserves by India Vis-à-vis other countries.
The guiding objectives of foreign exchange reserves management in India are similar to those of any emerging market economies in the world. The demands placed on the foreign exchange reserves may vary widely depending upon a variety of factors including the exchange rate regime adopted by the country, the extent of openness of the country’s economy, the size of the external sector in a country’s GDP and the nature of markets operating in the country. Even within this divergent framework, most countries have adopted the primary objective of reserve management as preservation of the long-term value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns. While safety and liquidity constitute the twin objectives of reserve management in India, return optimization becomes an embedded strategy within this framework.
The essential legal framework for reserves management is provided by the Reserve Bank of India Act, 1934.. Specifically, sub-sections 17(12), 17(12A), 17(13) and 33(1) of the Reserve Bank of India Act, 1934 define the scope of investment of external assets. In brief, the law broadly permits the following investment categories: i. ii. iii. Deposits with other central banks and Bank for International Settlements(BIS). Deposits with foreign commercial banks. Debt instruments representing sovereign/sovereign-guaranteed liability. Residual maturity for debt papers should not exceed 10 years. iv. Other instruments/institutions as approved by the Central Board of RBI
Hence we see from the legal restrictions imposed by RBI that there is no room for investment of foreign exchange reserves in equities. We find that for India majority of its foreign exchange reserves are invested in the central banks of other countries or as securities. Under securities
India generally invests in triple A bonds. For other emerging economies such as korea, china or Singapore we find that these countries have invested most of their foreign exchange reserves in the equity market to achieve higher returns. India on the contradictory is following a very conservative approach in terms of utilization of its foreign exchange reserves. India’s Investment of Foreign exchange reserves vis-à-vis other countries is shown below.
Utilisation of Foreign Exchange Reserves in US million $(Oct 2008) Singapore Korea Official assets Securities Other national reserve
162,173.90 150,245.00 212,253.00 192,119.00 35,425.10 31,375.07 252,883.00 102,107.00
Israel
India
central banks, BIS and IMF Domestic Banks Foreign Banks IMF position SDRs Gold (Source: www.imf.org) reserve
94.1 339.8 211.7 313 82 75 99.49 13.45 0 447 9 8,382.00 298.8 1,174.30 14,118.20 20,213.00 2,332.46 454 195.21 136,728.00 0 5,210.00
%RETURN ON FOREIGN CURRENCY ASSETS AND GOLD
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0
4.6 4.1 2.8 2.1 3.1 3.9
2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007
The percentage distribution of India’s foreign exchange reserves’ investment is shown below. Note: Securities include investment in equities for China, Israel, Korea and Singapore.
PERCENTAGE UTILIZATION AS ON OCTOBER 2008
100 90 80 70 60 50 40 30 20 10 0 Other Domestic Foreign IMF Securities national Banks Banks reserve central position banks, BIS and IMF SDRs Gold
PERCENTAGE
Singapore Korea Israel India
UTILISATION
Risk factors considered by Government of India while investing its foreign exchange reserves.
There are 4 types of risk factors that the government of India considers while deciding the investment of its foreign exchange reserves. 1. Credit risk 2. Market risk 3. Liquidity risk 4. Operational risk and control system
(i) Credit Risk: Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms. RBI has been extremely sensitive to the
credit risk it faces on the investment of foreign currency assets and gold in the international markets. Investments in bonds/treasury bills, which represent debt obligations of Triple-A rated sovereigns and supranational entities do not give rise to any substantial credit risk. Placement of deposit with BIS and other central banks like Bank of England is also considered credit risk-free. However, placement of deposits with commercial banks as also transactions in foreign exchange and bonds/treasury bills with commercial banks/investment banks and other securities firms give rise to credit risk. Stringent credit criteria are, therefore, applied for selection of counterparties. Credit exposure vis-a-vis sanctioned limit in respect of approved counterparties is monitored on line. The basic objective of an on-going tracking exercise is to identify any institution (which is on the RBI’s approved list) whose credit quality is under potential threat and to prune down the credit limits or de-list it altogether, if considered necessary. A quarterly review exercise is also carried in respect of counterparties for possible inclusion/deletion. (ii) Market Risk: Market risk contains two different types of risks as given below: (a) Currency Risk: Currency risk arises due to uncertainty in exchange rates. Foreign exchange reserves are invested in multi-currency, multi-market portfolios. In consultation with Ministry of Finance, decisions are taken regarding the long-term exposure on different currencies depending on the likely currency movements and other considerations in the medium- and long-term (such as, the necessity of maintaining major portion of reserves in the intervention currency and of maintaining the approximate currency profile of the reserves in line with the changing external trade profile of the country as also for diversification benefits). The Top Management of RBI is kept informed of the currency composition of reserves through a weekly Management Information System (MIS) report. (b) Interest Rate Risk: The crucial aspect of the management of interest rate risk is to protect the value of the investments as much as possible from the adverse impact of the interest rate movements. The focus of the investment strategy revolves around the overwhelming need to keep the interest rate risk of the portfolio reasonably low with a view to minimizing losses arising out of adverse interest rate movements, if any. This approach is warranted as reserves are viewed as a market stabilizing force in an uncertain environment.
(iii) Liquidity Risk: The reserves need to maintain a high level of liquidity at all times in order to be able to be able to meet any unforeseen and emergency needs. Any adverse development has to be met with reserves, and hence a highly liquid portfolio is a necessary constraint in the investment strategy. The choice of instruments determines the liquidity of the portfolio. For example, Treasury securities issued by the US government can be liquidated in large volumes without much distortion to the price in the market, and thus can be considered as liquid. Also, most of the investments with BIS can be readily converted into cash. In fact, excepting fixed deposits with foreign commercial banks , almost all other types of investments are in highly liquid instruments which could be converted into cash at short notice. RBI closely monitors the portion of the reserves which could be converted into cash at a very short notice to meet any unforeseen/emergency needs. (iv) Operational Risk and Control System: Internally, there is a total separation of the front office and back office functions and the internal control systems ensure several checks at the stages of deal capture, deal processing and settlement. There is a separate set up responsible for risk measurement and monitoring, performance evaluation and concurrent audit. The deal processing and settlement system is also subject to internal control guidelines based on the principle of one point data entry and powers are delegated to officers at various levels for generation of payment instructions. There is a system of concurrent audit for monitoring compliance in respect of all the internal control guidelines. Further, reconciliation of accounts is done regularly. In addition to annual inspection by the internal machinery of the RBI for this purpose and statutory audit of accounts by external auditors, there is a system of appointing a special external auditor to audit dealing room transactions. The main objective of the special audit is to see that risk management systems and internal control guidelines are adhered to. There exists a comprehensive reporting mechanism covering all significant areas of activity/operations relating to reserve management. These are being provided to the senior management periodically, viz., on daily, weekly, monthly, quarterly, half-yearly and yearly intervals, depending on the type and sensitivity of information.
Utilization of Foreign exchange reserves by other countries:
Countries like Singapore, china and Korea have used their foreign exchange reserves very well by creating sovereign wealth funds. These sovereign wealth funds invest money in equities, real estate investments and other financial instruments.
Singapore: The Government of Singapore Investment Corporation (GIC), established in 1981, invests internationally in equities, fixed income, money market instruments, real estate and special investments. GIC notes that it manages assets owned by the Government of Singapore (GIC's parent) and the Monetary Authority of Singapore. It has extensive retail property investments in Australia. The present value of its assets is around 330 billion US dollars. The government also wholly owns Temasek, an unwieldy conglomerate (with assets estimated at over US$100 billion) with substantial offshore holdings that include a controlling stake in Australia's Optus and Thailand's Shin telecommunications and broadcast group.
Korea: Korea has also established its own sovereign wealth fund in the year 2005. The SWF was named as Korea Investment Corporation and 17 billion US dollar worth of foreign exchange reserves were invested in it.
China: In 2007 china created its SWF known as China Investment Corporation to manage 200 billion USD foreign exchange reserves. Conclusion:
From the above examples we can see that foreign exchange reserves can provide better returns if it is invested accordingly. Considering the examples of these South Asian countries, India can also start its own SWF and to increase the returns it earns on Foreign exchange reserves. Considering the fact that India has Foreign exchange reserves to suffice 16 months of import bills, India can go for investing up to 25% of its foreign reserves in SWF. Even after investing 25% of the existing reserves, India would be left with enough reserves to suffice 12 months of import bills. This is sufficient considering the present FII pullouts from the country on account of
economic turbulence. However India should avoid using its Foreign exchange reserves in Infrastructure as these projects yield low returns on account of political and economic difficulties especially in adjusting the tariff structure. The use of FER to finance infrastructure may lead to more economic difficulties, including problems in monetary management.
References
? www.rbi.org.in
doc_479790781.docx