Economy
Forex reserves war-chest: how much is enough?
Summary
- Deciding how much a country must hold in forex reserves to get sufficient hedge against external risks is complicated. But beyond a point, more is certainly not better since holding the dollars has costs.
Raghuram Rajan, former governor of Reserve Bank of India (RBI), recently called upon emerging market economies, including India, to build up foreign exchange reserves as protection against the “populist and extreme" policies in advanced countries. As of 26 January, the central bank boasted $616.7 billion in reserves, a figure that has impressively doubled over the last decade, positioning India among the world's top 10 countries in terms of reserve holdings. How much more does it need to accumulate? Is there a level that is enough to insure against external crises?
Understanding the optimal level of reserves begins with recognizing their significance. Historically, reserves were primarily accumulated to finance imports. The "import cover" ratio, which compares reserves against monthly imports to gauge how many months of imports can be sustained solely on reserves if other foreign exchange inflows cease, has traditionally served as a key macroeconomic benchmark. Although the International Monetary Fund (IMF) suggests a three-month import cover as a baseline, most countries aim to maintain reserves well beyond this minimum.
Over the years, however, the import cover measure has become less relevant with greater access to alternative forms of international capital beyond forex reserves. For instance, Germany imported twice as much as India in 2022, but held half the reserves, confident that imports would be comfortably financed through forex flowing in from exports and foreign capital investment.
‘Debt + imports’ rule
The Asian financial crisis in the late 1990s highlighted that import cover alone is not sufficient to assess whether reserves are adequate. In the years preceding the crisis, import covers for Thailand and Indonesia were above the three-month accepted threshold, but short-term external debt ballooned to exceed reserves. The resulting panic about repayment capacity led to large capital outflows and culminated in a currency crisis. To counter this problem, the Greenspan-Guidotti rule recommends that a nation’s reserves should at least equal its short-term external debt.
For emerging markets, an expanded version of the rule, which requires reserves to cover the total of short-term debt and current account deficit, is more suitable. In other words, forex reserves should be enough to meet a country’s foreign exchange financing needs for the year. This metric is reasonably good at predicting currency crises: note how its gap with actual reserves dipped in 2012-13, when a surging current account deficit pushed India to the brink of an external crisis.
Cover all BoP drains
Given the limitations of these thumb rules, the IMF goes one step ahead and adds two more indicators that impact balance of payments (BoP): non-debt external liabilities and broad money. These, too, dictate how much of reserves an economy needs to protect itself: a decline in non-debt liabilities (such as foreign portfolio inflows) calls for more reserves to compensate for low dollar inflows on the capital account; more of broad money needs more reserves to cover the increased risk of outflows of residents’ deposits. Combining the four metrics (the other two being exports and short-term debt), the IMF calculates a threshold ratio. The more the actual reserves exceed that threshold (ideally by 1-1.5 times), the better-insured that economy is. Reserves of most Brics and the once-called “Fragile Five" countries exceed this range. India’s have improved since 2013, but China’s have worsened despite holding over $3 trillion in reserves: the reason is its large domestic deposit base that increases broad money.
Cost-benefit analysis
The fact that countries hold reserves in excess of these thresholds shows a clear preference for precautionary buffers. Unfortunately, holding surplus reserves has costs. There are opportunity costs, as reserves are usually parked in relatively safe and lower-yielding assets. There may also be sterilization costs if the purchase of dollars for reserve accumulation releases excessive rupee liquidity.
Yet nations prefer to insure themselves against forex drains experienced in past currency crises. India’s recent external stress episodes were caused by demand shock (2008), fuel price shock (2013, 2022) and US rate hikes (2018, 2022). A simple scenario analysis suggests that reserves are fairly adequate, with a cushion of around $150-275 billion. For central banks, that’s not small change, but it’s not big bucks either. While accumulating a large "war-chest" of reserves may seem prudent given economic uncertainties, the benefits must be weighed against the costs, particularly when reserves exceed certain levels.
The author is an independent writer in economics and finance.
