How does a country's foreign exchange reserves affect businesses, with a special focus on India and China
Foreign exchange reserves in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions held by central banks and monetary authorities.
They are something like family ornaments—not in regular use, but in case of an emergency (like a currency crisis, for example), they are an extremely good fallback to have. Again, like with ornaments, some countries like China, India, Japan and Korea keep on accumulating lots of it, while others like the US and UK maintain a steady state, while yet others like Germany have actually seen a decline in forex reserve levels.
How are forex reserves built up?
Building up of forex reserves is actually a complicated picture, but can be simplified as follows. Foreign exchange comes into a country in the form of investments, payments for exports, loans and bilateral aid among other things. It goes out as payments for imports, payment of interest, repayment of loans and repatriation of investments and profits. The difference stays on to build up the reserves.
Who maintains forex reserves?
The monetary authority and central bank of each country, like the Reserve Bank of India (RBI), the Federal Reserve of the US and the People’s Bank of China, maintain the forex reserves of the country. Then there are other big investment funds that some countries like Abu Dhabi and Singapore maintain. Many argue that these should be included in the forex reserve count. India has also been speaking about setting up such an investment fund.
Why forex reserves?
These are maintained primarily to protect a country’s domestic currency from losing its value or, in other words, to avoid a currency crisis. Just like other goods, a country’s currency can lose its value when demand for it falls or when there is excess supply of it. Such a situation may arise when investors do not want to stay invested in that country and want to transfer their funds out of that country or from the currency of that country. For example, suppose due to any reason a foreign investor wants to sell out his equity holdings in Indian companies and want to transfer these funds to the USA. In this case, he or she would convert the Indian rupees received by selling the equities into US dollars. If a large number of investors do this simultaneously while the reverse (fresh investments by foreign investors into Indian equities) is not happening, it will lead to a fall in the value of the rupee. Which is to say, it would lead to the depreciation of the Indian rupee against the dollar and there is a net outflow of dollars. Sometimes this depreciation (or need for devaluation) could be large in magnitude. Such instability in exchange rates and loss of confidence in the currency have an effect on the economy. So to avoid such sudden changes and to maintain confidence in the currency, reserves are maintained.
Forex reserves are also maintained to achieve some level of exchange rates. These levels are determined based on the policies and objectives of the country. Generally, developing economies, in order to increase exports and decrease imports, try to keep their exchange rates low (so that a given sum of foreign currency can buy more goods from them) and the value of their currency low and in order to do so build up reserves.
Forex reserves are generally deployed in low-risk liquid assets having sovereign guarantee. Reserves are often advanced as loans to other countries, other central banks, Bank for International Settlements and highly rated foreign commercial banks. Foreign exchange reserves are also used to manage liquidity in the system.
Developing nations
Emerging and developing economies are racing to attract foreign flows as they are limited. It is done primarily on the belief that this will lead to increase in investments and their ability to import, which would overcome domestic supply constraints in their economy and will insure them against crisis.
China has the largest forex reserves in the world. India, Korea and Brazil are also building up huge forex reserves. India’s foreign exchange reserves have increased from a mere $19,553 million in March 1994 to $309,723 million in March 2008, and then fell to $253,000 million in March 2009. One of the reasons for such a trend is India’s fundamentals, which made its corporate sector highly profitable and new investment opportunities kept coming up. This attracted foreign capital into the country.
The general build-up of forex reserves is also due to the large inflow of foreign investors. These investors come into developing or emerging economies as a result of the increase in availability of finance and credit for investments. The best opportunities were often found in these economies characterized by high interest rate regimes and large profitable/returns. For example, fundamentals and returns in the Indian economy is still far better than many others.
The recent dip happened because of the selling of US dollars by the RBI to contain depreciation or fall in value of the Indian rupee. Primarily, the RBI has to do so because of the increasing (negative) gap in the balance of trade. That is, to balance the increase in import costs (mainly because of burgeoning price of petroleum, which peeked in July 2008) given dismal growth in exports. Selling of equities by foreign institutional investors (FII) also contributed to it. Also, there were outflows because foreign investors who invested in India were required to clear their liabilities or payments and losses abroad made during the ongoing slowdown. In order to clear their losses, funds were arranged from other economies.
Capital flight and hence reduction in reserves happen not only due to the needs or policies of the host, but also take into account the supply side, the interest of the foreign investors and their position.
Another reason for fall in reserves is the appreciation of the US dollar vis-a-vis other currencies. This can be explained with the help of the following example. Suppose India has reserves worth $100, half in $ and half in euro. Lets assume for simplicity that $1 = 1. Now suppose there is appreciation of the dollar vis-a-vis the euro and new rate is $1 = 2. Now the reserves that India has will have reduced and would be worth only $75.
Developed countries
Developed countries in comparison tend to have lower forex reserves. The reason for not accumulating large reserves is that their currencies are often reserve currencies themselves and, therefore, are highly liquid, so there does not exist that high a precautionary motive for them. Also these economies have export sectors that are not driven by exchange rates. So they do not have to manage their exchange rates in order to support their domestic industry.
However, Japan is an exception to this trend. Compared to the other developed nations, Japan’s dependence on exports is very high. The reason why it accumulates forex and has the second highest reserves in the world after China is to prevent the yen from appreciating, thereby incentivizing its export sector. Also, Japan’s history of having lost two World Wars and having to live with the limitations (particularly on militarization) imposed by its eventual victors may have an important role in this Japanese mentality.
Cost of reserves
There are costs associated with maintaining these reserves. Investments made by foreign funds in a country tend to earn much higher returns than what a central bank gets by investing its reserves. For example, an FII coming in earns much higher rates of return by investing in equities, but the government earns only a nominal (or very low) rate of return by investing in debt instruments of other central banks.
Forex reserves are kept in highly liquid assets in order to fulfill needs of foreign exchange when it arises. The government cannot invest these reserves in projects or physical infrastructure. So there is an opportunity cost of holding the reserves. The reserves also impact government policy negatively in the sense that it has to consider the effects of policy changes on its reserves. For example, in October 2007, Securities and Exchange Board of India (SEBI) came up with a new ruling regarding participatory notes and FIIs, but were forced to make necessary amendments because of the threat of FIIs pulling out.
There is also another significant management activity, which is referred to in economic terms as sterilization. Suppose an investor wants to invest in India and brings in US dollars. However, in order to buy assets in India, they need to make payments in rupees. So they exchange their dollars with RBI for rupees, which they then put into the Indian economy and purchase assets. In this whole transaction, the quantity of Indian currency (money supply) has increased in the Indian economy. To negate this increase in money supply, the RBI can issue debt or bonds to mop up that amount of currency from the system. This method of reducing the increased money supply in market is called sterilization. However, generally interest rates are relatively higher on such bonds and debt relative to what the RBI earns by investing reserves. Also, partial or incomplete sterilization could lead to inflation.
Impact of reserves on businesses
As far as businesses are concerned, in the short run they definitely benefit from larger forex reserves as they can access more liquidity if there is ineffective, partial or no sterilization. Increased liquidity also creates demand in the economy. Due to build-up of such reserves, volatility in exchange rates is often checked, which provides a conducive environment to businesses. Stable exchange rates allow exporters and importers to engage in futures contracts. Also, the expectation of the currency and the economy being crisis-proof raises confidence among investors.
However, this can have repercussions as well. Often businesses are badly hurt when there is a bursting of bubbles in asset markets. Inflation is also not good for businesses in the medium to long run. The government may not also be able to provide adequate support to businesses due to net loss of earnings. There may be cuts in subsidies, investments and other expenditure, which may have an effect too.
China versus India
The large reserve position of China could effect Indian businesses in two ways. It may put pressure on the Chinese yuan to appreciate. This may allow an opportunity for the Indian export sector to expand as Indian businesses can tap into the share of Chinese export businesses. Also, in such a situation India could increase its exports to China. However, at the same time Indian importers who are importing from China may be on the losing side.
On the other side, such large reserves held by China make it more investment friendly and the Indian economy may not see that much foreign direct investment. Indian businesses in that case may not enjoy linkages that might have come through those investments.
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