Foreign Exchange reserves are basically held to achieve a balance between demand for and supply of foreign currencies.
The reserves also help in maintaining confidence in monetary and exchange rate policies and enhancing the capacity of the central bank to intervene in forex markets.
They help build a capacity to absorb shocks in times of crisis and provide the confidence that the economy is well placed to meet all external obligations. Also, reserves provide the security of backing domestic currency through external assets.
Further, it helps the country maintain the investor confidence required to attract the much-needed FDI in crucial sectors of the economy. The country also benefits by using the excess reserves to repay its liabilities.
India's foreign exchange reserves hit a record high in recent years and are currently placed at $137.55 billion as on the week ending March 4, 2005. Since the inception of economic reforms, forex reserves have risen continuously. However, the forex reserves in the past two years have been rising exponentially.
The swelling of forex reserves has become a macroeconomic issue. Policymakers, independent analysts and politicians have expressed some worry regarding the deluge of dollars into our economy over the past two years.
Nearly 50 per cent of our current forex reserves have been built up in the past 2 years. The question being asked is how have the reserves been built up, and whether they would start dwindling.
Some experts seem to suggest that the quantum of dollar flows is not explained by normal economic activity such as foreign direct investment, portfolio investment in stock markets, money sent by Indian workers abroad and bank deposits made by non-resident Indians.
So where is the forex coming from?
Analysis of components forming the inflows suggest that the upswing is mainly attributable to the resurgence in exports, increase in capital inflows (including foreign investment), stronger rupee and the reduction in the current account deficit.
It is possible that the substantial part of the forex inflows could be funds that have been held abroad over the years by the Indian business class.
Historically, Indian businesses, with some help from public lending institutions, have been known to over-invoice project imports and use it as an instrument to keep some money out of the country. Some of these funds may be coming back into the country, as confidence in the domestic economy, in the medium term has grown stronger.
The persisting weakness in the western economies, primarily the United States, has added to this reverse flow of funds.
Private transfers -- inward remittances by a large number of Indians who live abroad -- to families, into Foreign Currency Non-Resident (FCNR) accounts, and real estate, also represent a large portion of the inflows.
Furthermore, Indian companies today are able to raise debt and equity in foreign markets, and do so far more effectively than they could in the past. This again explains a part of the increasing forex reserves.
All this indicates that a good part of the increased dollar inflows are here to stay. The assessment by some analysts that these dollar inflows are merely in search of the interest rate differential that prevails between the US and India and can exit anytime is not entirely correct.
Although fund managers are parking their money in India due to the advantage they get from the positive interest rate differential, a lot of these funds, just as in other Asian economies, have come seeking a more permanent parking space.
The high reserves have certainly provided the much-required boost to investor confidence and given India a good image abroad.
India's forex reserves have been at a comfortable level for quite some time now, even after the traditional approach of assessing adequacy of foreign exchange reserves in terms of import cover has been broadened to include some important parameters, such as size, composition, risk of capital flows and international uncertainty.
With high reserves, high exports, and increasing foreign direct investment inflows, the economy is all set to ride the trajectory of higher growth. Thus, instead of worrying about the cost of holding such high reserves, the government would be better off capitalising on them to improve the country's image.
Intentions seem to be good. Prime Minister Manmohan Singh and Finance Minister P Chidambaram both send out the right signals about their commitment to development and providing the right environment for development. But, sadly, action seems to be missing.
So, what are the ways in which resources can be utilised in the most effective manner?
For one, there is definitely a case for revisiting and resetting the timetable for capital account convertibility. It is rather unfortunate that the debate has been put on the backburner.
It is time for the Reserve Bank of India to take a stand on whether it wants to follow the example of China and move towards a controlled exchange rate regime or is it ready to let the rupee float and dump its policy of buying the dollars to check the rupee from appreciating.
Being a developing economy with a large and growing manufacturing sector, our import demand is going to be continuously high in the coming years and we will need large forex reserves to meet this demand, especially when export growth may not be able to keep pace with import demand.
Further, if the economy grows at 8 per cent, and there is a revival in investment leading to an increase in import demand, all the excess reserves will stop accumulating.
The high foreign exchange reserves can be used to allow higher import of capital goods and technology to support the growing economy and for development purposes. Another alternative use of the reserves could be to use part of the inflows to replace external commercial borrowings.
Thus, the contradictory situation, where there is more commercial borrowing (large forex inflows) and lack of demand for domestic rupee resources, can be avoided.
A sizeable proportion of resources, taking the stock of forex reserves available, can be used for domestic investment in both the medium and long term.
A great debate on this issue seems to be going on these days and the present government seems to be more than inclined towards this proposal.
The government should also allow Indian residents to open foreign exchange -- say, dollar-denominated -- deposits in domestic banks. At present this is allowed with a lot of restrictions.
Another way to utilise these huge forex reserves would be to follow an aggressive policy in investing overseas, and outward FDI. Recent announcements are definitely steps in the right direction in this regard.
A lot of restrictions on investing in foreign markets have been relaxed. However, further steps need to be taken to further facilitate Indian companies to acquire foreign companies and brands by signing more bilateral investment and double taxation treaties.
While on the one hand so much can be done with the reserves, on the other hand the costs of reserve accumulation are rising, especially when accompanied by sterilisation.
Reserve accumulation means a poor country is lending money very cheaply to the United States and Europe. If the same resources were harnessed for investment, economic growth would accelerate, inflation would diminish, and the welfare gains would increase.
Unfortunately there is not enough happening to create sufficient demand for dollars. This has resulted in an appreciating rupee, which the country does not exactly want.
The reserves may not really be of that much concern if we are aiming for 8 per cent growth. In such a scenario, imports will also increase and we may not be looking at such a big import cover after all.
Therefore, the time has come to think up policy measures that would create greater import demand and widen the current account deficit. The policies must ensure that the piled up reserves are used to attain greater economic growth.
The debate on capital account convertibility should be restarted without any further delay. The government must also initiate aggressive FDI and trade policy reforms, promote exports aggressively and use the India Brand Equity Fund to create the India brand to boost export growth.
All this should be done with various components of the forex reserves in view. Devising an appropriate strategy to make productive use of reserves is as important as providing incentives for larger inflow of forex.
Nupur Hetamsaria is Research Scholar, ICFAI University and currently a Visiting Research Scholar at Syracuse University, NY. Vivek Kaul is Research Scholar, ICFAI University.