foreign exchange reserve: India

Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations. Large reserves of foreign currency allow a government to manipulate exchange rates – usually to stabilize the foreign exchange rates to provide a more favourable economic environment.                                                                                                                                                                                                           

India’s total foreign exchange reserve have increased from USD 5.8 billion at the end of March 1991 to USD  313 billion plus  at the end of April 2008. The spectacular rise in reserves has drawn attention to the issue of what is an adequate level of reserve for the country.  Several factors may explain how much foreign exchange reserves a country wants to hold.  

One factor is related to the size of international financial transactions that occur there; that is, reserves holdings are likely to increase both with the size of the country’s population and with its standard of living.  

Volatility of international receipts and payments, insofar as reserves are intended to help cushion the economy; that is, reserve holdings are likely to increase with more volatility in a country’s export receipts.  

A third factor is vulnerability to external shocks; reserve holdings are likely to increase with a country’s average propensity to import, which is a measure of the economy’s openness and vulnerability to external shocks.  

Finally, a country’s tolerance for greater exchange rate flexibility should reduce its demand for reserves, because its central bank would not need a large reserve stockpile to manage a fixed exchange rate; therefore, reserve holdings are likely to be lower the more variable the country’s exchange rate is.

There is a growing debate about the need to hold so many reserves. Those who support holding large reserve balances argue that the cost of doing so is small compared to the economic consequences of a sharp depreciation in the value of the currency that is often associated with financial crises in emerging markets.  

With a large stockpile of foreign exchange reserves, a country’s monetary authority can buy up its currency in the foreign capital markets, which helps to uphold its value.