eToro – Forex Trading Forum

[forester]

The foreign reserves holdings of oil and some emerging economies including the BRIC countries are reaching stratospheric levels. This external surplus is largely a result of the run-up of the oil and commodity prices. Should these nations be complacent with their high levels of forex holdings or should they worry about the opportunity costs of holding high levels of foreign reserves? This savings glut of oil and emerging economies has been largely channelled to the US, cheaply financing its large current account imbalance. The US current account deficit is estimated to absorb about 75% of the global external surpluses. Increasing liquidity of the oil and newly industrialised economies are being funnelled into financial instruments issued by advanced countries yielding negative real rates of return.

[forester]

Holding adequate levels of foreign reserves is essential to meet the liquidity on account of imports and external debt service. Holding of foreign reserves balance in cash or low-yielding liquid instruments such as the US Fed securities is akin to holding cash and bank balance in current accounts by the corporate/household sector to meet the necessary liquidity in carrying out day-to-day transactions. But there is a trade off involved with increasing returns when funds are locked up in higher yielding but longer-term instruments.

[forester]

India's foreign reserves holdings has been around $300 billion for quite some time, forming almost 35% of our national GDP. The surge in reserves causes a mismatch between the opportunity costs of holding the reserves with macro-economic adjustment costs incurred when they fall short. There are several global benchmarks to determine the optimal level of foreign reserves holdings providing adequate liquidity for current account transactions such as imports and debt servicing. One rule of thumb is based on imports. It predicts that reserves should be enough to cover three months of imports.

[forester]

The current level of foreign reserves holdings in India covers 15 months of imports, making current foreign reserves holdings overvalued by five times. Another oft-used benchmark is the Guidotti-Greenspan rule. As per this rule, the reserves should be enough to cover the short-term debt, that is, the ratio of average reserves holdings to short-term debt payable during the year should be one. This ratio of reserves to short-term debt for India is seven as on end March, 2008. The reserves holding by this measure is seven times more than the requirement. The average reserves to GDP ratio is 35% in India as compared to 10% on average in advanced countries. All this means that our reserves are too high for comfort.

[forester]

The bulk of our reserves are invested in US Fed securities. The interest rates in both US and euro areas have yielded negative real rates of return of between 2% and 3% in the last 4-5 years. At this negative real yield on investments in US government securities, India's loss on its foreign reserves holdings is anything between $6 billion and $9 billion per annum at current reserves level. This is the high cost paid by the country for maintaining excessive liquidity, besides the opportunity costs foregone by not investing in longer maturing, higher yielding bonds and equities. By either measure of present level of short-term foreign debt of $44 billion or three-months import cover of $60 billion, a reserve level of $80 billion should provide comfortable liquidity. This reserve level is also 10% of GDP, the level maintained by most advanced countries. Thus by all measures, our foreign reserves holdings are over-liquid by $200-220 billion. A part of the excess reserves holdings can be gainfully employed by the RBI to intervene in the forex market to restore the value of a grossly undervalued rupee.

[forester]

By the approximate measure of McIndex Purchasing Power Parity (equivalent price of a McDonald's hamburger across countries), the Indian rupee is undervalued by 30-40%. A correctly valued rupee would reduce the import bill on oil and other commodities, sobering the spiralling inflationary effect due to over-valued imports on domestic prices. Central bank intervention in the forex markets by offloading a part of its current reserves holdings would help in sucking out excessive monetary liquidity in the domestic economy. The actual growth rate in broad money supply is in excess of 20% and exceeds the targeted growth rate by almost 6-7%.

[forester]

The balance of available foreign reserves holdings ought to be gainfully deployed in foreign assets which maximise returns. The imperative of earning higher and market-based returns on foreign assets should not be lost track of. India is experiencing global financial integration with its gross foreign assets and liabilities exceeding 60% of GDP. Assets held by sovereigns currently stand at $7 trillion in international reserves of which sovereign wealth funds constitute between $2-3 trillion. (See the accompanying table for the major global sovereign wealth funds).

[forester]

The US has enjoyed much better performance on foreign assets than other countries. The sum total of capital gains and income yields on US foreign assets during the period 2001-06 has been as high as 12-15% while the return on its foreign liabilities is only 5-6%, giving US a net return of 7-8% on its foreign portfolio. To appreciate the returns on FII investments in India, consider the following data as on end 2007. As per SEBI records, while the cumulative purchases by FIIs were to the tune of $501.75 billion, cumulative sales amounted to $435.41 billion and net purchases were worth $66.33 billion. The market value was $255.4 billion. A rough calculation shows that the returns on average on the FII investments in India yielded a fabulous cumulative annual rate of 351 5% on average till end 2007.

[forester]

A substantial part of the current foreign reserves holdings could thus be set aside to create a sovereign wealth fund run by global professional managers rewarded with performance-based salaries and independent of bureaucratic and political meddling. It is not wise - when you permit foreign capital, which earns high returns in the domestic equity and commodity markets - to constrain the foreign capital held domestically from exploring higher returns in high yielding equities, corporate bonds and commodities markets abroad. But this calls for a paradigmatic shift in thinking - freedom from a licence raj constraining domestic capital from freely flowing in and out. We have to overcome the present mindset and show more faith and respect for the Indian talent and entrepreneurial spirit.