BIS Review 30/2002 1
Y V Reddy: India’s foreign exchange reserves - policy, status and issues
Special Lecture by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the National
Council of Applied Economic Research, New Delhi, 10 May 2002. Dr Reddy is thankful to
Dr R K Pattnaik for his assistance
* * *
Mr. Chairman and friends,
I am thankful to the National Council of Applied Economic Research, (NCAER) and in particular, to
Dr. Suman Bery, for giving me this opportunity to make a presentation on the foreign exchange
reserves. There are several reasons for speaking on this subject before this august gathering in the
First, the subject is receiving renewed global interest among policy makers and academicians against
the backdrop of increasing globalization of emerging economies, acceleration of capital flows, and
integration of financial markets domestically as well as globally. The debt crisis in some of the
developing countries in the early nineties, the East Asian crisis in 1997 and more recently the currency
crisis of Argentina have posed several dilemmas to policy makers on forex reserves.
Second, multilateral bodies, especially, the Bank for International Settlements (BIS) and International
Monetary Fund (IMF) are attempting several initiatives in regard to international financial architecture
in the context of the debt-banking-financial crisis in several countries, and matters relating to forex
reserves have become an important component of this initiative, encompassing issues on policy,
management and transparency.
Third, there is some interest within India on our level of forex reserves, as evidenced by several
articles in financial dailies, economic journals and research papers. There are also some differences
among academics on the direct as well as indirect costs and benefits of the level of forex reserves,
from the point of view of macro-economic policy, financial stability and fiscal or quasi-fiscal impact.
Fourth, Reserve Bank of India (RBI) has been adopting a proactive communication policy, particularly
under the leadership of Governor Bimal Jalan, and accordingly it is appropriate that the relevant issues
are also presented from the perspective of RBI.
Finally, there is some personal involvement and excitement for me in this subject. The period
1990-2002 has been a journey from agony to comfort in matters relating to forex reserves; for in
1990-91, sitting in North Block in Ministry of Finance in Delhi, I was one of those who had to ensure
that given the very low level of forex reserves and the manner in which they happened to be deployed,
there was enough cash balance to permit day-to-day forex payments of even a million U.S. dollars. In
such a predicament, the threat of national humiliation as well as discomforting relations with foreign
agencies obviously touched on personal pride. Furthermore, in crafting a liberalized forex regime in
the last decade, those of us involved in the process of reform have been acutely aware of the
judgements and risks involved at every step in forex reserves policy and management. Over the
period, without adding much to the stock of external debt, there has been a quantum jump in forex
reserves. This position needs to be contrasted with the 1980s, when external debt, especially short
term debt, mounted while the forex reserves got depleted. In fact, it is often held that, between 1956
and 1992, India faced balance of payments constraints in all but six years, while during the last ten
years, there has never been a feeling of constraint on this account, eventhough the period coincided
with liberalization of external account, global currency crisis and domestic political uncertainties.
This presentation attempts to capture the basic concepts, theory and practice with orientation on
issues relevant to India. The questions addressed are; What are forex reserves? Why hold forex
reserves and how did the policy evolve? What is the appropriate level of reserves? How does the
current status appear in terms of indicators of adequacy of reserves? The presentation proceeds
further to focus on several aspects of forex management, such as the implications for quasi fiscal
deficit and communication policy of the RBI. The issues in regard to policy and management of forex
reserves in India are posed in some detail while the concluding part contains my random thoughts
from a futuristic perspective. Given the broad canvass and well recognized complexity, the
presentation, for most part, touches on the broad contours without going into abstruse technical and
2 BIS Review 30/2002
The subject of forex reserves may be broadly classified into two inter-linked areas, namely, the theory
of reserves, and the management of reserves. The theory of reserves encompasses issues relating to
institutional and legal arrangements for holding reserve assets, conceptual and definitional aspects,
objectives for holding reserve assets, exchange rate regimes, and conceptualization of the appropriate
level of foreign reserves. In essence, a theoretical framework for reserves provides the rationale for
holding forex reserves. Reserve management is mainly guided by the portfolio management
consideration i.e., how best to deploy foreign reserve assets? The portfolio considerations take into
account inter alia, safety, liquidity and yield on reserves as the principal objectives of reserve
management. The institutional and legal arrangements are largely country specific and these
difference should be recognised in approaching the critical issues relating to both reserve
management practices and policy making.
What are Forex Reserves?
Conceptually, a unique definition of forex reserves is not available as there have been divergence of
views in terms of coverage of items, ownership of assets, liquidity aspects and need for a distinction
between owned and non-owned reserves Nevertheless, for policy and operational purposes, most
countries have adopted the definition suggested by the International Monetary Fund (Balance of
Payments Manual, and Guidelines on Foreign Exchange Reserve Management, 2001); which defines
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
The standard approach for measuring international reserves takes into account the unencumbered
international reserve assets of the monetary authority; however, the foreign currency and the
securities held by the public including the banks and corporate bodies are not accounted for in the
definition of official holdings of international reserves.
In India, the Reserve Bank of India Act 1934 contains the enabling provisions for the RBI to act as the
custodian of foreign reserves, and manage reserves with defined objectives. The powers of being the
custodian of foreign reserves is enshrined, in the first instance, in the preamble of the Act. The
‘reserves’ refer to both foreign reserves in the form of gold assets in the Banking Department and
foreign securities held by the Issue Department, and domestic reserves in the form of ‘bank reserves’.
The composition of foreign reserves is indicated, a minimum reserve system is set out, and the
instruments and securities in which the country’s reserves could be deployed are spelt out in the
relevant Sections of the RBI Act.
In brief, in India, what constitutes forex reserves; who is the custodian and how it should be deployed
are laid out clearly in the Statute, and in an extremely conservative fashion as far as management of
reserves is concerned. In substantive terms, RBI functions as the custodian and manager of forex
reserves, and operates within the overall policy framework agreed upon with Government of India.
Why Hold Forex Reserves?
Technically, it is possible to consider three motives i.e., transaction, speculative and precautionary
motives for holding reserves. International trade gives rise to currency flows, which are assumed to be
handled by private banks driven by the transaction motive. Similarly, speculative motive is left to
individual or corporates. Central bank reserves, however, are characterized primarily as a last resort
stock of foreign currency for unpredictable flows, which is consistent with precautionary motive for
holding foreign assets. Precautionary motive for holding foreign currency, like the demand for money,
can be positively related to wealth and the cost of covering unplanned deficit, and negatively related to
the return from alternative assets.
From a policy perspective, it is clear that the country benefits through economies of scale by pooling
the transaction reserves, while subserving the precautionary motive of keeping official reserves as a
‘war chest’. Furthermore, forex reserves are instruments to maintain or manage the exchange rate,
while enabling orderly absorption of international money and capital flows. In brief, official reserves are
held for precautionary and transaction motives keeping in view the aggregate of national interests, to
achieve balance between demand for and supply of foreign currencies, for intervention, and to
preserve confidence in the country’s ability to carry out external transactions.