Academic journal article IUP Journal of Applied Finance

Trade Dynamics and Foreign Exchange Reserves Management in India: An Empirical Study

Academic journal article IUP Journal of Applied Finance

Trade Dynamics and Foreign Exchange Reserves Management in India: An Empirical Study

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Unlike foreign exchange reserves (henceforth reserves) emanating from capital account surplus, net exports are the permanent sources of 'owned reserves' for a country. In a closed-economy framework, with or without negligible cross-border capital mobility, the level of net exports is the core target variable from Balance of Payments (BOP) point of view. According to orthodox two-gap models, when the foreign exchange gap is binding, a country faces severe contractionary effects on investment and trade (particularly imports), generating a downward protracted external adjustment. In that perspective, the external adjustment typically takes the form of either export promotion, given a certain level of import propensity, or import substitution (or compression) in order to avoid a run on country's reserve stock. In view of the rising trade integration, predictability over trade flows (export proceeds and import payments in values) over a medium term enables prudent management of the available reserves. In particular, for developing countries facing binding foreign exchange constraints, export coverage of imports1 assumes more weight, compared to the overall reserves management, primarily because of uncertainty over credible international response during crisis periods. Many commodity-exporting countries in Africa implicitly follow these trade-based external adjustment policies even in a benign environment of capital inflows. Systematic temporal assessment of import propensity in the home country and trends in the world export demand, therefore, help identify the short-run BOP vulnerabilities and allow the policymakers to initiate appropriate adjustment measures.

The introduction of commodity futures and options complicates the pricing of tradable goods due to uncertainty over actual trade flows and the timing of realization of final settlements, giving scope for destabilizing speculation and unwarranted variability in reserve requirements.2 Further, the effects of leads and lags in foreign currency (trade) payments and exchange rate fluctuations against major invoicing currencies could be potentially dangerous in view of the sudden capital flight and chronic currency mismatch. When foreign portfolio investments dominate the reserve accretion process, short-run reserve management takes cognizance of the current magnitude of trade commitments as well as the trade dynamics observed over a period in the past. In other words, as sudden pull-out by foreign institutional investors could lead to an instantaneous (proportionate) drain of reserves, reserve management, in the short run, emphasizes more on trade flows than on any other considerations.3 In that light, a comprehensive examination of India's trade flows in the post-1991 reform period is important for evaluating the relevance of traditional 'thumb rules' of reserve adequacy, such as import cover, export-to-import ratio, and current receipts-to-current payments.

Against this backdrop, this study explores the possible long-run co-movements among trade, demand and exchange rate and the underlying short-run feedback mechanism to 'equilibrium trade'4 broadly in congruence with a target-oriented reserve management policy.5

Review of Literature

The literature on trade-based reserve management dates back to the 1960s, during which a few key models of optimal reserves were theorized in a closed economy setup. Trade-based approaches broadly address two important issues, viz., home-country foreign exchange constraints and potential vulnerability to external trade shocks. Countries with less diversified export baskets and low access to international capital flows face severe foreign currency shortages to finance imports of capital goods and other essential manufacturing goods. The absence of capital flows (limited access or highly volatile flows) gets reflected in the import-rationing and output loss in developing countries. …

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