Monday, October 23, 2006

How is excessive foreign exchange reserve a problem?

India has currently about $166 bn foreign exchange reserves as against China’s $987.9 bn.

A large stock of foreign exchange reserves is not an unmitigated blessing. Larget than required foreign exchange reserves entail huge cost. Normally, higher capital inflows put upward pressure on the country’s currency. Currency appreciation leads to lower exports and higher imports, which means that the level of economic activity gets severely affected. The final outcome is recession and unemployment. To prevent such a predicament, central banks intervene in the forex market, something the RBI normally does. It buys up dollars, to prevent the rupee from appreciating, in exchange for rupees. But this creates the possibility of inflationary pressures, resulting from excess liquidity in the system. To prevent this, again, is unwarranted. The return from bonds far exceeds the returns from US Treasury Bills – 10 year benchmark government bond provides a return in excess of 8% as against about 3% return from US Treasury Bills – in which the reserves are invested. Thus, the attempt to keep the rupee undervalued, entails a huge loss worth billions of dollars.