The Reserve Bank of India (RBI) governor, Y V Reddy, today warned that the current level of capital flows from industrialised nations into India and other emerging market economies (EMEs) might not be maintained. | |
| In this backdrop, the whole debate over excess foreign exchange reserves cannot be based on the situation prevailing now, Reddy said at a seminar in Singapore. |
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| Defending India's accumulation of large amount of reserves, Reddy said the global economy has not been tested on the eventuality of a not-so-orderly correction of the current global imbalances. |
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| In such an eventuality, disruption in financial markets in the form of large cross-currency volatility and sharp rise in interest rates are likely in the global economy. |
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| He also pointed out that the management of reserves has been changing and there has been a quest for higher returns within these traditional objectives. |
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| According to him, reserve managers have already been shifting into higher-yielding instruments with a higher risk-returns equation, presumably as a result of progressively higher rising level of reserves. |
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| Consequently, the financial returns on free reserves at the margin could be far higher than the average return. |
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| Citing the example of China, he said a new development in reserve management is to hold a part of the reserves which could be used by the public sector. |
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| Such foreign exchange reserves could be termed as quasi reserves. China has utilised its foreign exchange reserves to strengthen the banking system without foreign securities being sold. |
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| Investment funds are sometimes created by the public sector out of 'windfall revenue' accruing to a country owing to a rise in export price of, say, oil or other commodities. |
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| Such reserves arise owing to positive external shocks which can cause a surge in government revenues and, at times, could be challenging as some governments may have to deal with an appreciating exchange rate, undermining export competitiveness. |
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| Reserves are built out of the current account, capital account or both. In countries such as India, reserves accretion was driven more by capital account surplus. |
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| The reserve accumulation has been five times higher than the level in the early 1990s and the emerging markets have accumulated reserves at an annual rate of $250 billion as reported by the Bank for International Settlements (BIS). |
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| In 1990s, India had a very low level of reserves but with rising level of reserves, the comfort has increased. The level of comfort and discomfort could be linked to the problem of plenty and the problem of paucity "" with a continuum representing different levels of comfort at various levels of reserves. |
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| The relevant factors on which the comfort could be based would not only depend on the domestic factors but also hinges on the exchange rate regime and external factors like the confidence the country has in the international financial architecture. |
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| While assessing the comfort level, it would be necessary to take a medium term view of domestic factors such as growth prospects, possible real sector shocks, the external sector developments, current account balance, the changing composition of capital flows, the external assets and liabilities through a national balance sheet approach, as well as international financial architecture, he said. |
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