Foreign Exchange Reserves: What They Cover and Why They Are Held

Foreign exchange reserves are holdings of other countries' money, and of claims that turn into it quickly. Nobody set them aside as a fund: they are what the external account left behind, period after period. The job is narrow. Reserves meet obligations in a currency the country cannot print, on a day the usual suppliers of that currency have stopped.

Two ideas already established do all the work here. The first is that a country's dealings with the rest of the world produce a leftover each period, a residue after everything earned and everything handed over has been settled. The second is that whoever put foreign money into a country can take it out again without asking anyone, so some of that money can leave at very short notice. The reserve stock is what the first of those built up, and the second is the thing it exists to meet. Set those two ideas against a single arithmetic operation, a division, and the unit that comes out of it decides what the answer means.

Every rupee figure below belongs to the Republic of Sankhya, an invented country, and to its invented trading partner Marut. Under the current account the Sankhya figures were worked on just two traded products, and the lines for income earned across the border and for transfers were held at nil there so one comparison would land cleanly. The figures below run the whole economy with both of those lines switched on. The figures therefore differ by construction, and not because either set is wrong.

What are foreign exchange reserves, and where does the stock come from?

Where they came from answers half the question about what they are. Start there. In the period covered here the Sankhya current accountA period's tally of what a country earned abroad and what it spent there, across goods, services, income and transfers. How it is put together is covered separately. came out at a deficit of Rs 14,000 crore, while the capital accountThe record of claims crossing the border in a period: money coming in to buy assets, money going out to buy them, and borrowing on either side. Covered separately. came out at a surplus of Rs 19,000 crore. Put the two together and Rs 5,000 crore is what remains. The Rs 5,000 crore is an identity rather than a finding. The two accounts and the change in reserves are defined so that they must come to the same thing, with any residue booked as errors and omissions, so the sum can never disagree and is never a cross-check on anything. The identity does show one thing worth holding: the reserve stock is not a pot somebody funded, it is the residue of a period, and the level today is simply every past residue added up.

Think about a household that keeps whatever is left in the account on the last day of the month. Nobody in that household ever decided the balance should be Rs 84,000/-. Some months left Rs 9,000/- behind, one month took Rs 3,000/- back out because the scooter needed work, and the balance is just the running sum. Asked why the balance is what it is, the household's honest answer is that no one chose it. Foreign exchange reserves work exactly like that, in Rs crore instead of Rs thousands, and with the whole country's dealings abroad producing the monthly leftover.

Here is the Sankhya run. Five periods back the stock stood at Rs 3,52,000 crore. The five leftovers since then were plus Rs 11,000 crore, then a fall of Rs 4,000 crore, then plus Rs 9,000 crore, then plus Rs 12,000 crore, and finally the published plus Rs 5,000 crore. The five leftovers come to Rs 33,000 crore, and Rs 3,52,000 crore plus Rs 33,000 crore is Rs 3,85,000 crore. Notice the second period. A leftover can be negative. In such a period the country handed over more foreign money than it took in, and the stock goes down. The opening stockThe level a running balance starts a period at, before that period's additions and subtractions. The closing stock of one period becomes the opening stock of the next. of the published period was Rs 3,80,000 crore, and the plus Rs 5,000 crore carried it to Rs 3,85,000 crore.

What is actually held inside the reserve stock?

A reserve stock is not a room full of banknotes. The stock is a portfolio, and the things in it were chosen against one test. Sankhya holds Rs 3,08,000 crore, or 80.00 per cent, as balances in Marut units and other foreign currencies, sitting as deposits and as short paper issued by the countries whose money it is. Sankhya holds Rs 46,200 crore, or 12.00 per cent, in gold, held for this purpose rather than as a position anyone intends to trade. The last Rs 30,800 crore, or 8.00 per cent, is a position with an international body, drawn on by procedure rather than by selling something. The three holdings come to Rs 3,85,000 crore exactly.

Now the test itself, and it is not the one most readers expect. What decides whether a holding belongs in the reserve stock is not the return it earns but how quickly it turns into usable foreign money under pressure. A holding that would fetch an excellent price in six months is worthless for this job if the obligation falls due on Thursday. The speed test is why the stock leans so heavily on deposits and short paper: they settle in a day or two, at a price nobody is going to argue about, on the worst day of the year as readily as on the best.

Gold fails the speed test partially rather than completely, and that makes it the interesting case. Gold can be sold, and there is always somebody to sell it to, but the price moves while the sale is under way and the settlement takes days rather than hours. The position with an international body is slower again in a different way: it is drawn on through a procedure, so there is paperwork and a sequence to follow. Both belong in the stock. Neither is the part a treasurer would reach for first.

What does import cover mean, and in what unit is it measured?

Import cover asks a single question: if every source of foreign money stopped tomorrow, how long could the country keep paying for the goods it buys from abroad using only the stock it already has? The answer is a length of time, and the unit of that length is the whole lesson in this guide. Cover is the reserve stock divided by one month of goods imports, so the answer comes out in months, and a cover figure quoted without its unit is not a figure at all.

Work it on Sankhya. The stock is Rs 3,85,000 crore. Goods imports are Rs 3,85,000 crore across a year. One month of that bill is Rs 3,85,000 crore shared over twelve, or Rs 32,083 crore, rounded to the nearest crore. Now divide: Rs 3,85,000 crore over Rs 32,083 crore is 12.00, and because the denominatorThe number being divided by, the lower half of a fraction. Whatever unit it carries decides the unit of the answer. Swap the denominator and the result means something else. was one month, the 12.00 is 12.00 months.

Here is the wrong turn, and it is worth walking into on purpose. The stock and the annual import bill are both Rs 3,85,000 crore, so a reader who divides the stock by the annual figure gets 1.00. The 1.00 is arithmetically fine, but it is not months. The denominator was a full year of imports, so the answer is one year of cover. One year of cover is the same statement as 12.00 months wearing a different unit. The reason this matters is that 1.00 and 12.00 look nothing like each other, and a reader who copies one into a sentence expecting the other has changed the claim by a factor of twelve. The Sankhya stock equals exactly one year of imports, so here the wrong method produces a visibly wrong-looking number rather than a plausible one.

What are reserves actually for?

The purpose is narrower than most readers assume, and it is worth stating narrowly. Reserves exist to meet obligations in a currency the country cannot print, on a day the people who normally supply that currency have stopped supplying it. That is the job. Reserves are an insurance function against a timing problem, not a store of national wealth and not a fund for buying things.

Unpack the two halves. First, a currency the country cannot print. Sankhya can create Sankhya rupees. Sankhya cannot create Marut units, and the seller of an imported machine wants Marut units. So there is a class of obligation that domestic money cannot settle at any quantity, and that is exactly the class reserves are for. Second, a day the usual suppliers have stopped. On an ordinary day, Marut units arrive in Sankhya from exporters being paid, from foreign investors putting money in, and from lenders abroad rolling over what falls due. The three sources between them handle the whole bill and the reserve stock never moves. The problem is the month when all three go quiet at once. The same news that stops one stops the others, so they tend to go quiet together rather than one at a time.

Use a household picture. A picture lands faster here than any account will. A household keeps two months of expenses in a savings account. The savings balance is not there to be invested well. It is there so that if the salary is late and the relatives who might have helped are also short, the rent still gets paid on the day it is due. Nobody judges that balance by what it earned. The household judges it by whether it was there on the one morning it was needed. A reserve stock is the same instrument at country scale, and the currency it has to be in is the only thing that makes it complicated. The currency requirement is also why foreign portfolio moneyMoney from abroad that buys shares and bonds in a market and can be sold and taken out again quickly, without the owner needing anyone's agreement. What separates it from direct investment is covered separately. matters so much here: it is the part of the inflow most able to reverse in the same week it decides to.

Why is a large reserve stock not free to hold?

Everything in the stock had to pass the speed test, and the things that pass it pay very little. Deposits and short paper in a strong foreign currency are held precisely because they settle instantly and hold their value, and that is the same reason they earn near the bottom of what anything earns. Meanwhile the country itself borrows, and it borrows at its own rate. Holding a large stock therefore carries a cost. The cost is the gap between the little the stock earns and the more the country pays on what it owes, and that gap is the price of being able to pay on a day nobody will lend.

Put numbers on it for Sankhya, all of them illustrative. Suppose the reserve assets earn 2.00 per cent, the rate on safe short holdings in Marut units, while Sankhya pays 6.00 per cent on what it has borrowed, where its own policy rateThe rate a central bank sets to steer the cost of short term money in its own economy. How it is set and what it moves is covered separately. sits. On Rs 3,85,000 crore, the stock earns Rs 7,700 crore in a year and the borrowing costs Rs 23,100 crore. The difference is Rs 15,400 crore, the same as applying the 4.00 percentage pointThe plain difference between two percentages. Six per cent less two per cent is four percentage points. Saying it is three times larger only invites confusion. gap directly to the stock. Set that against the Sankhya output figure of Rs 17,47,200 crore and the annual carry works out at 0.88 per cent of output.

Now for the important part: how to hold that figure. The carry is a trade-off and not a criticism. Rs 15,400 crore a year is what Sankhya spends to be certain it can settle Marut obligations in a month when nothing is arriving from anywhere. Whether that is worth paying is a judgement about how likely such a month is and how bad it would be. The cost is real and countable. Anyone talking about the size of a reserve stock is therefore talking about two things at once rather than one.

What does a cover figure leave out?

Go back to what cover is made of. Its denominator is one month of goods imports, and nothing else went into it. So the figure answers one question completely and every other question not at all. Cover counts imports and says nothing whatever about claims, so two countries reporting exactly the same cover can be in completely different positions.

Three things fall straight out of that. Cover is silent about obligations that are not imports, so debt falling due, dividends going out and services being bought are all outside it. Cover is silent about how fast money could leave. Nothing in the calculation asks who could withdraw what and when. And cover is silent about who the claims are owed to, so a stock facing a handful of large holders and a stock facing thousands of small ones look identical to it.

Take Sankhya beside Vritta, an invented neighbour. Vritta holds Rs 2,40,000 crore and imports Rs 2,40,000 crore of goods a year, so one month of its imports is Rs 20,000 crore and its cover is 12.00 months, exactly matching Sankhya. Now look at the short term external debtMoney a country has borrowed from abroad that has to be repaid within the next twelve months. Short term external debt has to be either repaid or rolled over, and rolling over is not always available. and portfolio money that could move quickly against each stock. In Sankhya those claims come to Rs 96,250 crore, or 25.00 per cent of the stock, so the reserves stand at 4.00 times the claims. In Vritta the claims come to Rs 1,20,000 crore, or 50.00 per cent of the stock, so the reserves stand at 2.00 times. Same cover. Twice the fast-moving claims relative to the stock. The cover figure cannot see any of it.

What sits outside the reserve stock?