During the last fiscal year, India added more than $105 billion to its stockpile of international reserves. These reserves are largely held in the form of US government securities or other deposits, which are characterized by very low yields. Consequently, the latest figures indicate that the return on foreign currency assets, after accounting for depreciation, was only 4.6% in 2006-07. With an annual inflation rate of 5.42% during the same period, the real rate of return on these assets was -0.82%.
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The trend was similar over the past few years also, with the rates of return on foreign currency assets being consistently lower than the inflation rate.
Such low rates of return have led many to question the rationale of accumulating a massive volume of reserves. Traditionally, reserve adequacy, that is, how much reserves the central bank should hold, has been measured by using several standard benchmarks, and reserves in excess of such benchmarks have been deemed excess reserves. The most common benchmark used to determine reserve adequacy is in terms of months of import cover, that is, the number of months of imports that can be financed by the existing volume of reserves. Generally, three to four months of import cover has been suggested as being adequate. Another often-used benchmark is the Greenspan-Guidotti rule, which states that sufficient liquid reserves should be maintained to meet external obligations arising within a year without any external assistance.
However, recent research undertaken by the author (Icrier Working Paper 206) illustrates that using a single benchmark of reserve adequacy in isolation to calculate the volume of excess reserves may not be appropriate. The import cover rule as a measure of reserve adequacy fitted in a world where financial markets were not integrated and trade openness reflected a country’s vulnerability to external shocks—the Bretton Woods period.
In today’s world, countries hold reserves for a number of reasons other than immediate current account financing and meeting short-term obligations. For example, the kind of exchange rate arrangement a country follows is a key determinant of the reserves it should hold. Countries whose exchange rate is constant vis-à-vis another country are more likely to hold more reserves to maintain that arrangement than a country that allows the exchange rate to fluctuate. Other factors influencing the amount of reserves include the strength of the financial sector, freedom of foreign capital to move in and out of the country and quality of political institutions.