India’s foreign exchange reserves stand at an all-time high of more than $ 77 billion. Concerns are, however, being expressed not only about the desirability of a high level of reserves but also about the risks in investing them in securities of countries, such as the United States of America, whose currencies are depreciating. The value of reserves will naturally decline if the currencies in which the reserves are invested decline over time. This is what some people fear is happening to India’s reserves.
The US dollar has declined over the last year by nearly 21 per cent against the euro and 14 per cent against a basket of other currencies. Assuming for the sake of argument that India’s foreign exchange reserves had been invested in the euro and not in the dollar, there would have been a corresponding gain through exchange appreciation of nearly 21 per cent. The dollar is, however, the effective transaction currency for most exporters in India as also for importers. The exports and imports of India are mostly denominated in dollars. More important, India’s central bank intervenes in exchange markets through the dollar. It has, therefore, been convenient and practical if the Reserve Bank of India were to invest its reserves in dollars. It is, however, a fact that there is lack of transparency about the currency composition of reserves — how much of our nation’s stockpile of reserves is invested in specific currencies.
Concern about the danger of erosion in value of our foreign exchange reserves has been widely expressed. Recently, a concerned Mumbai citizen, R.P. Abrol, who is involved in small-scale industries, rang me up and expressed his concern over the effects of a declining dollar on India’s reserves. Not being sure of how the reserves are invested, he wanted to assure himself that the RBI is doing the right thing in its investment policy. He felt that the RBI should diversify its investment policy into currencies other than the dollar, such as the euro, which are strengthening. He has followed up with a letter to the governor of the RBI, in which he was more direct in pointing out the dangers of a run on the dollar. Abrol recalled experiences with cooperative banks in India when the value of deposits fell to literally nothing following the fall of confidence. He wanted the governor to assure him and the public at large that the RBI was following the right policies in regard to safeguarding the value of the invested reserves.
Much turns on the future prospect of the greenback. The dollar has been declining over the last year or so. This fall has been caused partly by the declining strength of the US’s balance of payments. The US’s current account — which represents the difference between its exports of goods and services and its imports — has been running at an annual level of $ 500 billion or 5 per cent of the US’s gross domestic product. There is no sign of this gap diminishing. When there is such an unsustainable current account deficit, it is inevitable that the currency of the country, which runs the deficit, faces a decline with reference to other currencies of the world. The surprise is rather that this has not happened sooner and in a larger measure than was visible last year. This phenomenon is generally explained by the confidence of the rest of the world in the “strength” of the American economy notwithstanding the current decline in the dollar.
The Indian central bank’s policy of investing its reserves in securities of countries like the US is part of the general tradition of investing in strong securities. In spite of the current account deficit, the US’s credit rating is at present unchallenged. But the danger of a further decline in the dollar cannot be ruled out. Given this state of affairs, it is only fair that the RBI responds to concerns about the currency composition of its reserves and comes out with a paper indicating the deployment of its reserves and how it ensures that its composition is optimum.
It is conceded that it is part of the central banking orthodoxy not to disclose the currency composition of its reserve management. There is a fear that this disclosure might itself affect the valuation of the currencies of the countries in which the reserves are invested. But, given the tendency of the dollar to decline, the RBI needs to assure the Indian public that its policies are sensibly designed. The best way this can be done is to have a peer review by established experts in foreign currency management and have their report published. While it is true that the RBI’s statutory auditors do audit its reserve management policy, the audit is more from the point of view of accounting standards and not from the point of optimality of the composition of reserves with reference to the strength or weakness of currencies.
The current concern is heightened by the recent statements of the secretary of the US treasury about the dollar. While he declared himself at times to be in favour of a strong dollar, he has also made a confusing statement that a weak dollar will not hurt the US economy. The markets went into a tizzy over this messy “exposition”. Playing with exchange markets with such obtuse statements is equivalent to playing with fire. The dollar went in for a free fall, much to the discomfort of the competing nations, like Germany, France and Japan. It is obvious the stronger a currency becomes, the weaker the country’s competitive strength in the export market.
Taking into account the risks a further decline in the greenback portends, there are various ways in which the RBI can react. It can put more of its reserves in the currencies, like the euro and the yen. It can also adopt hedging tactics, although hedges of such a large order may not be quite available in the markets. Nor is it clear that the “hedges” will come cheaper. Hedging is justified because it is a price to be paid for security. The RBI will do well to explore various methods it adopts for ensuring that the reserves are protected against exchange variations with respect to its principal currency of investment.
All this is relevant particularly because there is a climate of increasing transparency. The RBI is particularly a strong adherent of transparency. It would appear reasonable to require that the RBI details the measures it has taken so as to assure the public at large that its investments are sufficiently diversified and that they are protected against further erosion of the greenback. I concede that the RBI may very well turn to its critics and explain that facts prove that it has indeed been quite prudent. The last review of the accretion of reserves had taken credit for an increase of nearly $ 2 billion as a result of “valuation change” — which was the result of exchange-rate variation. This happened over a period of nearly eight months — April to November 2002 — and that too on a base of reserves of roughly $ 60 billion, which is the level of our reserves if we exclude gold and special drawing rights.
The RBI may very well argue that this order of revaluation “gains” is itself the result of a prudent policy of investment. If all the reserves had been invested in dollars, there would have been “no gain” on account of exchange valuation with reference to the dollar. This goes to show that the RBI has been quite successful in implementing its reserve management policy. That the RBI has been in touch with established foreign exchange management experts of the world is yet another factor to be borne in mind.
In these circumstances, there should be no cause for hesitation on the part of the RBI to disclose what may have turned out to be a successful exercise for optimal reserve management. The least the country expects from an efficient and transparent RBI is an assurance that all necessary steps are being taken to protect the nation’s nest-egg from unexpected or even expected decline of value of the currency or currencies of investment. The RBI will do well to respond appropriately to concerns such of those expressed by Abrol. Such concerns should not be spurned aside just because they have come from unimportant or politically insignificant quarters. However arcane the subject of foreign exchange management may be, the common man’s fears have a signalling role in keeping the RBI on its toes. We should not have reason to feel later that timely warning signals went unheeded. To be forewarned is to be forearmed.