CAT, XAT Entrance test GDPI Topics : Forex, floating and fixed exchange rates, dollar, rupee rates : MBA GDPI Training
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What is the Appropriate Level of Forex Reserves?

The foreign exchange reserves include three items; gold, SDRs and foreign currency assets. As of November, 2002 India has over US $ 65 billion of total reserves, foreign currency assets account the major share. Gold accounts for about US $ 3 billion. In July 1991, as a part of reserve management policy, and as a means of raising resources, the RBI temporarily pledged gold to raise loans. The gold holdings, thus have played a crucial role of reserve management at a time of external crisis. Since then, Gold has played passive role in reserve management.

The level of foreign exchange reserves has steadily increased from US$ 5.8 billion as at end-March, 1991 to US$ 54.1 billion as at end-March 2002 and further to US$ 65 billion as of November, 2002. The traditional measure of trade based indicator of reserve adequacy, i.e., the import cover (defined as the twelve times the ratio of reserves to merchandise imports ) which shrank to 3 weeks of imports by the end of December 1990, has improved to about 11.5 months as at end-March 2002.

The debt-based indicators of reserve adequacy show remarkable improvement in the 1990s. The proportion of short term debt (i.e., debt obligations with an original maturity up to one year) to foreign exchange reserves has substantially declined from 147 per cent as at end-March 1991 to 8 per cent as at end-March 2001. i.e. most of the foreign exchange reserves that we have right now have a repayment obligation that exceeds three years - which reflects a higher quality of reserves.

Cost and Benefits of Holding Forex

The direct financial cost of holding reserves is the difference between interest paid on external debt and returns on external assets in reserves. I.e. let us say India has borrowed USD 20 billion @ 5% p.a. rate of interest and has reserves of USD 40 bn which is kept in the equivalent of savings account at 3% p.a rate of interest. Then the managers at RBI have the option of either repaying the USD 20 bn loan on which they pay 5% while earning only 3% on the same thereby saving on net interest outflow or continue paying 5% on the loan and get only 3% for their investment for sake of holding reserves.

Such costs have to be treated as insurance premium to assure and maintain confidence in the availability of liquidity. The costs of comfort level in reserves are often met by some benefits, but both are difficult to measure, in financial or economic, and in quantitative terms.

What is convertibility?

Convertibility can be related as the extent to which a country's regulations allow free flow of money into and outside the country.

For instance, in the case of India till 1990, one had to get permission from the Government or RBI as the case may be to procure foreign currency, say US Dollars, for any purpose. Be it import of raw material, travel abroad, procuring books or paying fees for a ward who pursues higher studies abroad. Similarly, any exporter who exports goods or services and brings foreign currency into the country has to surrender the foreign exchange to RBI and get it converted at a rate pre-determined by RBI.

After liberalization began in 1991, the government eased the movement of foreign currency on trade account. I.e. exporters and importers were allowed to buy and sell foreign currency, as long as the items that they are exporting and importing were not in the banned list. They need not get permission on a CASE TO CASE basis as was prevalent in the earlier regime. This was the first concrete step the economy took towards making our currency convertible on trade account.

In the next two to three years, government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purposes like travel abroad, studying abroad, engaging the services of foreign consultants etc. This set the first step towards getting our currency convertible on the current account. What it means is that people are allowed to have access to foreign currency for buying a whole range of consumable products and services. These relaxations coincided with the liberalization on the industry and commerce front - which is why we have Honda City cars, Mars chocolate bars and Bacardi in India.

There was also simultaneous relaxation on the restriction on the funds that foreign investors can bring into India to invest in companies and the stock market in the country. This step led to partial convertibility on the Capital Account.

"Capital Account convertibility in its entirety would mean that any individual, be it Indian or foreigner will be allowed to bring in any amount of foreign currency into the country and take any amount of foreign currency out of the country without any restriction."

Indian companies were allowed to raise funds by way of equities (shares) or debts. The fancy terms like Global Depository Receipts (GDRs), Euro Convertible Bonds (ECBs), Foreign currency syndicated loans became household jargons of Indian investors. Listing in Nasdaq or NYSE became new found status symbols for Indian companies. However, Indian companies or individuals still had to get permission on a case to case basis for investing abroad.

In 2000, the forex policy was further relaxed that allowed companies to acquire other companies abroad without having to go through the rigmarole of getting permission on a case to case basis. Further, Indian debt based mutual funds were also allowed to invest in AAA rated government /corporate bonds abroad. This got further relaxed with Indians being allowed to hold a portion of their foreign exchange earnings as foreign currency, subject to a limit in the recent monetary policy in October 2002.

In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With India's forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts.

The last few steps as and when they happen will allow an individual to invest in Microsoft or Intel shares that are traded on Nasdaq or buy a beach resort on Bahamas without any restrictions.
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