$22-31bn Forex Reserve Adequate To Absorb Shocks

The Tarapore Committee has reiterated the need for adequate level of foreign exchange reserves in a band of $22 billion to $31 billion to withstand cyclical changes in the balance of payments as well as unanticipated shocks which may lead to reversals of capital flows.

In a scenario where there would be no curbs on capital flows, the committee felt that an indicator of adequacy of reserves should be a combination of import cover, debt servicing and leads and lags. The committee has suggested the following four indicators:

To take care of volatility and uncertainty that could arise from a move to capital account convertibility, reserves should cover at least six months of imports. Under this formula, the foreign exchange reserves would, at present, need to be about $22 billion.

 

Reserves should not be less than three months of imports plus 50 per cent of annual debt service payments plus one months exports and imports to take into account the possibilities of leads and lag. On this basis, the present requirement would be $24 billion.

The short-term debt and portfolio stock, which is equivalent to 70 per cent of the level of reserves, should be lowered to 60 per cent by using a formula that incremental short-term debt and portfolio liabilities should be accompanied by equivalent increases in reserves which would ensure that this ratio would decline to the desired extent. On this basis, the reserves would need to rise from the present $26 billion to $31 billion.

The net foreign exchange assets (NFA) to currency ratio (NFA/currency ratio) should be prescribed by law at not less than 40 per cent .The present ratio is 70 per cent, and the objective should be to maintain it around the present ratio. Under the proposed ratio of a minimum of 40 per cent, it would be around $15 billion whereas under the desired ratio of 70 per cent, the requirement would be a little over $26 billion.

The advantage of alternative indicators would be that the authorities would have enough safeguards to ensure against any contingency. The committee therefore recommends that the RBI should use the four alternative measures for ensuring adequacy of reserves, and in particular it recommends that a minimum NFA/currency ratio of 40 per cent be stipulated in the RBI Act to ensure against an unbridled increase in currency without adequate backing of foreign exchange reserves.