Academic journal article South Asian Journal of Management

Demand for Foreign Exchange Reserves in India: A Cointegration Approach¿

Academic journal article South Asian Journal of Management

Demand for Foreign Exchange Reserves in India: A Cointegration Approach¿

Article excerpt

Using cointegration and vector error correction approach, we estimate India's demand for foreign exchange reserves over the period 1983-2005. Our results establish that the ratio imports to GDP, the ratio of broad money to GDP, exchange rate flexibility and interest rate differential determine India's long run reserves demand function. Our empirical results show that reserve accumulation in India is highly sensitive to capital account vulnerability and less sensitive to its opportunity cost. The speed of adjustment coefficient of vector error correction model suggests that Reserve Bank of India has to engage in more active reserve management practices.

INTRODUCTION

Over the past few years, there has been a tremendous increase in foreign exchange reserves with the central banks of developing economies around the world, especially in the aftermath of East Asian crisis 1997-98. Foreign exchange reserves held by developing countries have risen from 30% of global reserves to almost 60% by 2005 (Figure 1). The management of these huge reserves and the associated cost of holding are the major issues faced by the central banks of developing countries now.

Foreign exchange reserves are defined as external stock of assets, which is avauable to the country's monetary authorities to cover external payment imbalances or to influence the exchange rate of the domestic currency through intervention in exchange market, or for other purposes (IMF, 2000). A country's reserve consists of gold, foreign currencies, Special Drawing Rights (SDR) and the reserve position with the International Monetary Fund (IMF), Historically under the Bretton-Woods system, the foreign exchange reserves were used by the central banks across the world to maintain the external value of their respective currencies at a fixed level. With the break down of Bretton-Woods system in the early 1970s, countries started adopting a relatively flexible exchange rate system, under which the reserves play only a less important role. Yet, the global exchange reserves have increased from 1.75 to 7.8% of world GDP between 1960 and 2002 (Flood and Marion, 2002).

The present paper analyzes the demand for foreign exchange reserves in the Indian context. As an emerging economy, India has been accumulating a high level of foreign exchange reserves in the past few years and occupies the sixth position among the high reserve countries in the world (IMF Survey, 2005). However, a significant increase was observed only after 1990-91, the year of wide opening up of the Indian economy. The reserves, which touched an all time low of US$5 bn at the end-March 1991, increased to $ 1 4 1 bn in 2004-05 . The ratio of reserves to GDP has increased from 3.5% in 1991-02 to 20% in 2004-05 (Figure 2) . This will drive us to investigate the factors, which induce the Reserve Bank of India (RBI) to hold high level of reserves.

DEMAND FOR RESERVES: THEORYAND EMPIRICAL EVIDENCE

There has been a spurt in research in demand for reserves since 1960s (Grubel, 1971). The demand for reserves is explained broadly using two approaches. The first approach postulates that the movements of reserves respond to discrepancies between the desired reserves and actual reserves held by a country (Clark, 1970; and Edwards, 1983). The alternate approach explains the reserve holdings in terms of the monetary approach to balance of payments. According to this approach a change in reserve holdings is related to the disequilibrium in the domestic money market. Foreign exchange reserves will increase when there is an excess demand for money, given that domestic credit is constant; and conversely foreign exchange reserves will decrease if there is an excess supply of money. Thus, according to the monetary approach, foreign exchange reserves are a residual holding by a country (Edwards, 1984). The empirical studies following this approach hypothesized that the monetary market disequilibrium affects the demand for reserves only in the short run and found supported empirical evidence (Ford and Huang, 1994; and Badinger, 2004). …

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