Relation between Exchange Rate and Foreign Exchange Reserves

Abstract: Using time series data of the variables in the year 1980 – 2010 the present study tries to establish a causal relationship between exchange rate and foreign exchange reserves in the Indian context. Emphasis has been laid on understanding the impact of foreign exchange reserves on the exchange rate. India has accumulated unprecedented foreign exchange reserves and synchronously has been experiencing a large depreciation in its Rupee vies avis US dollar. This trend prompted us to undertake this study to establish some association between the two trends.

Introduction

Exchange rate fluctuation over a wide range bi-directionally (ceiling and floor) or in a unidirectional way tends to have a debilitating effect on the overall trade. Nations following the policy of import-linked export promotions will have a deep impact by currency depreciation on production costs thereby triggering inflation. The appreciation of currency creates a dampening environment for exporters. The exchange rate fluctuation can be intuitively governed by umpteen parameters which may include economic and non-economic factors like the capital inflows, interest rates prevailing in the economy, the rate of inflation, volume of foreign exchange reserves, current account balances, GDP growth rate, fiscal deficit, import to GDP ratios, export to GDP ratios, political stability, development indices, the corruption index, the health of the global economy, etc. The present study tries to understand the association between the foreign exchange reserves and the exchange rate in the Indian economy between 1980 and 2010. India has experienced an unprecedented increase in foreign exchange reserves (currency assets considered) which stands at 122.48 billion dollars in the year 2010-11 which is consistent with the Asian trend of accumulating excessive foreign exchange reserves. On the current account balance front India has always faced a current account balance deficit except between 2001 and 2003 when the current account balance was in surplus which was largely attributed to enhancement in the export of services. In the year 2010, the current account deficit stood at - 42.807 billion dollars. The exchange rate vies a US dollar is consistently in a depreciating mode.

What is the exchange rate?

An exchange rate is a rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in relation to another currency.[1] For example, an interbank exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥114. In this case, it is said that the price of a dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.The government has the authority to change the exchange rate when needed.

Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers, and where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date

What are Foreign exchange reserves?

Foreign exchange reserves (also called forex reserves or FX reserves) are money or other assets held by a central bank or other monetary authority so that it can pay its liabilities, if needed, such as the currency issued by the central bank, as well as the various bank reserves deposited with the central bank by the government and other financial institution. Reserves are held in one or more reserve currencies, mostly the United State Dollar and to a lesser extent the Euro.

India's central bank which holds the foreign exchange reserve is RBI (Reserve bank of India) the currency is usually in form of “The US DOLLAR” because our dollar is dominating currency and is also used as the” primary currency for International trade”.

How central bank does have a large number of foreign reserves?

To know the working of foreign reserves we need to first know what is” foreign exchange market”

For example: imagine you are an exporter, you have certain goods which you export to the USA, and your trading partner will pay money to inform for dollars then you take the dollar which is usually a foreign currency. You deposit this currency into to commercial bank and exchange them into Indian currency to pay for your work as well as suppliers. So the commercial bank where you exchange the currencies will go to the foreign exchange market for the conversion

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Foreign exchange market: A foreign exchange market is a market where the currencies of one country are traded to the currency of another country, but remember there is no physical marketplace where currencies are changing with other currencies. Because there is a huge network of commercial banks, investment banks, and Forex brokers which is spread across the globe and interconnected through telephones and computers.

For example: consider two countries India and USA and between there is a foreign exchange market both countries have commercial, investment banks, and forex brokers then there is the central bank in India which is RBI and in the USA there is a federal reserve. And now both countries have importers and exporters who do international business, then come individuals who are employees, students who are tourists, etc. Basically doing money transfers, currencies exchange while visiting foreign countries then comes large multinational cooperation which are engage in foreign economic activity so consider all these base level players who uses the commercial bank services investment banks and forex companies because they don’t have direct access to foreign exchange market so if you are individual who are employees, students who are tourist, importer and exporter you will be need the American dollar if you want to do business with the united states so in order to do that you need Indian currency per dollar then you will approach to the desk of commercial bank services investment banks and forex companies and then enquirer about the exchange rate now let’s assume that whatever the exchange rate was you had accepted it, then the dollars are immediately given to you now this financial entities haven’t open their short position they have to find a customer whose order will match this order to find the customer the foreign entity will approach foreign exchange market and the main goal of financial entity is to make profit

How is this central bank useful?

India has RBI as its central bank the role of RBI is to facilitate monetary policies otherwise these financial entities (commercial bank services investment banks and forex companies) keep looking for profits and will do so much currency conversion which may de-stabilized the economy now imagine if huge Indian currency is traded for a dollar and then all of the sudden the dollar value goes down just to keep a check on this the central bank comes into the picture

The functions of the central bank are:

• To control the money supply and exchange rate
• Control the release of national currency notes
• Control commercial banks lending and accept a limit
• Manages the country’s debt
• Maintain gold and foreign currency reserve
• Interacts with another central bank of the world

RBI collects some amount of foreign currency as a reserve and keeps them aside which may be useful in proper stock during a challenging time for example if there is a food shortage in the country should have enough reserves to pay for it which may last for 5-6 months regardless of all the country carries some amount of foreign exchange this reserve also include government securities, treasury bills, and government bonds.

Reserve accumulation can be an instrument to interfere with the exchange rate. From the first General agreement on tariff and trade (GATT) of 1948 to the foundation of the world trade organization (WTO) in 1995, the regulation of trade is a major concern for most countries throughout the world. Hence, commercial distortions such as subsidies and taxes are strongly discouraged. However, there is no global framework to regulate financial flows. As an example of the regional framework, members of the European Union are prohibited from introducing capital control, except in an extraordinary situation. The dynamics of china’s trade balance and reserve accumulation during the first decade of 2000 was one of the main reasons for the interest in this topic. Some economists are trying to explain this behavior. Usually, the explanation is based on a sophisticated variation of mercantilism, such as to protect the take-off in the tradable sector of an economy, by avoiding the real exchange rate appreciation that would naturally arise from this process. One attempt uses a standard model of open economy intertemporal consumption to show that it is possible to replicate a tariff on imports or a subsidy on exports by closing the current account and accumulating reserves. Another is more related to the economic growth literature. The argument is that the tradable sector of an economy is more capital intense than the non-tradable sector. The private sector invests too little in the capital since it fails to understand the social gains of a higher capital ratio given by externalities (like improvements in human capital, higher competition, technological spillovers, and increasing returns to scale). The government could improve the equilibrium by imposing subsidies and tariffs, but the hypothesis is that the government is unable to distinguish between good investment opportunities and rent-seeking schemes. Thus, reserve accumulation would correspond to a loan to foreigners to purchase a number of tradable goods from the economy. In this case, the real exchange rate would depreciate and the growth rate would increase. In some cases, this could improve welfare, since the higher growth rate would compensate for the loss of the tradable goods that could be consumed or invested. In this context, foreigners have the role to choose only the useful tradable goods sectors.

A currency reserve is a currency that is held in large amounts by governments and other institutions as part of their foreign exchange reserves. These reserve currencies usually become the international pricing mechanisms for commodities traded on the global market such as oil, natural gas, gold, and silver, causing other countries to hold this currency to pay for these goods. Currently, the U.S. dollar is the primary reserve currency in the world, kept not only by American banks but by other countries. Manipulating and adjusting the reserve levels can enable a central bank to prevent volatile fluctuations in currency by affecting the exchange rate and increasing the demand for and value of the country's own currency.

Periodically, the board of governors of a central bank meets and decides on the reserve requirements as a part of monetary policy. The amount that a bank is required to hold in reserve fluctuates depending on the state of the economy and what the governing board determines as the optimal level.

Examples: In the past, reserve currencies have come about in a de facto manner: They simply were the currency that belonged to the most powerful nations or the ones that dominated trade. The Bretton Woods Agreement (see below) essentially appointed the U.S. dollar as the world's leading currency reserve in 1944. But there are other popular currencies held in reserves.

The closest thing to an official list of reserve currencies comes from the International Monetary Fund (IMF), whose special drawing rights (SDR) basket determines currencies that countries can receive as part of IMF loans. The euro, introduced in 1999, is the second most commonly held reserve currency. Others in the basket include the Japanese yen and the British pound sterling. The latest addition, introduced in October 2016, is China's yuan or renminbi.