Jun 27, 2013

Optimum foreign currency reserves and India

Rupee crossed 60/USD yeterday. It splashed across newspapers. RBI, the central bank of India, gave up any efforts to intervene during the slide, giving up meekly. India has a forex reserves of around 290 Billion USD currently, which is around 15% of the GDP. RBI could have deployed the war chest but it chose not to, logically so. The size of the INR forex market is around 50 to 70 Billion USD per day and to influence it significantly, the player must enter with a quiver of around 4 to 5 Billion USD and if RBI decides to deploy its forex reserves to this effect, it might run out of reserves in around 2 months. And the speculators will have an exponential run sooner than later, as the reserves dwindle, hastening the process of currency crisis. A breach of psychological benchmark of Rs 60/USD is better than a currency crisis. 

A floating exchange regime need not have any forex reserves, theoretically. But a forex reserve is required nevertheless. The reserves can be used to influence exchange rate, can be used to contain volatility, or to insure against loss of liquidity/capital market access.  Indian currency, INR, is not yet fully convertible, and India maintains a forex reserve. India maintains the 10th biggest reserve in the world. RBI's stated motive to maintain such reserve is to contain volatility. It has no stated intentions of maintaining forex rates at any particular level. That explains the non interventionist approach of RBI. It's not that RBI is not bothered as you can see in this news item. It's just that RBI finds it impractical to intervene at this point of time. 

A question arises as to how much reserves is adequate. If RBI doesn't use the reserve in times of crisis like this, is it judicious to keep a reserve? If yes, what should be the size of such a reserve? The answer is not simple. The cost of keeping a huge reserve is enormous, in terms of giving up on the earning potential of the reserves thus maintained. A huge reserve gives a psychological advantage if the central bank decides to intervene in the markets, but at the cost of wasted opportunity to earn. Indian reserves are decent, but not enormous. The power of RBI to intervene in the forex market is very limited. 

The blogger has a strong opinion that the reserve size is a function of the sensitivity of the forex market to intervention. It must be a function of the size of the market, and the size of the intervention required to bring about a required change in forex rate. The latter, that is the size of the intervention required to bring about an intended change in forex rate, is a function of order flows (the micro-structure approach) at any given moment, and the existing liquidity at that instant, and nothing else. For example, if the size of liquidity of the market at the given instant is around 50 Billion USD, and the order flows in one particular direction changes from one billion USD to say, five billion USD, it might influence the market enormously, whereas a directional imbalance of a hundred million dollars is not enormous. However, if the liquidity of the market dries up and becomes small due to lack of trade, then even a directional change of a hundred million dollars can bring about a bigger change in exchange rate. This is when the reserves come in handy. In a situation when the liquidity is low and the smaller volumes play a significant role. How frequent is such a situation? This is the moot point. 

I wish there was a good mathematical model to predict an ideal forex reserves size. I am yet to find one. If you know of any such model, please point it out. 

Meanwhile, the rupee bears the brunt of weak fundamentals. It just reflects the inherent flaws in the macro indicators, mainly the gap in current account and high inflation that has persisted over the last few years. This high inflation is chiefly due to mindless spending by the Govt on welfare programs such as NREGA, and the blogger has no qualms calling the kettle black, when it is indeed black. The situation about current account is elaborated here by the blogger. 

And the optimum size of forex reserves, for a country like India, remains a question unsolved.