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Suppose a country follows a fixed exchange rate regime. If the demand for FE is high and the exchange rate cannot be increased to induce a reduction in demand, then the central bank needs to have adequate reserves so that it can supply FE and meet the excess demand. In contrast, under a flexible exchange rate regime, the price of FE can adjust to bring about a balance between demand and supply. In this context, FE reserves are not required. A rough but useful rule of thumb used is that in the long run the exchange rate between currencies of two countries needs to change at a rate equal to the difference in the inflation rates in the two countries.
So, there is a glaring imbalance if a country follows fixed exchange rates despite persistent higher inflation Krugman The imbalance can be sustained with large FE reserves but eventually there is a crisis. This can be avoided if flexible exchange rate regime is adopted, obviating the need for large FE reserves.
Foreign Exchange Reserves by Country Comparison
It is true that under a flexible exchange rate regime, the flexibility can give way to considerable volatility in the FE market. In this case, it helps to have FE reserves with the central bank so that it can intervene and reduce the volatility. In the latter case, there is less uncertainty for currency markets. The price mechanism works better in the currency market and the need for central bank intervention is less. Accordingly, the central bank does not need to hold large FE reserves, if it has adopted inflation targeting.
• Currency distribution in the FX market | Statista
The RBI has been operating under flexible exchange rate regime since the early s; prior to that it followed a fixed exchange rate regime which is, in fact, an important reason why there was a balance of payments crisis in Given the two important changes in policy regimes, there is no compelling need for the RBI to maintain very large reserves now. This is true not just of India but most other emerging economies. They are mostly going through a hangover of the currency crisis that they had experienced.
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It is usually forgotten that the context then was different; most emerging economies now have flexible exchange rates and formal or informal inflation targeting. The proposal here to cut down FE reserves is not new. It had been put forward earlier by the erstwhile Planning Commission in but it was criticised.
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However, the criticism of the proposed policy was not always valid. For example, the critique in Panagariya was actually about the short-run adjustment process involved in shifting from FE reserves to investments in infrastructure projects rather than about the issue of what is an optimal level of reserves in the long run.
These arguments, to a great extent, missed the wood for the trees. It is worth revisiting the basic proposal again.
Currency and gold reserves worldwide
Often there is a tendency to keep reserves equal to the value of six months of imports. Around two decades back, the forex reserve which could finance the imports of three to six months was considered adequate but the change in global trade and finance patterns have changed the adequacy norms for forex reserves. Now the adequacy norms not only covers import bill but also factors in percentage of reserves to short-term debt, as a proportion of external debt, ratio of reserves to GDP, as percentage of current account deficit CAD and inflow and outflow variations from the capital account.
Judging by any factor, the forex reserves in India are currently more than sufficient.
Because of the aforesaid reasons, almost all countries particularly developed hold high level of foreign exchange reserves despite the high cost of holding it. Forex Reserves and Their Benefits.
Read General Awareness Topic: Forex Reserves and Their Benefits For anything to qualify as money, it must possess three important characteristics - the store of value, medium of exchange and general acceptability. It helps in boosting the confidence of the market in the ability of a country to meet its external obligations.
It acts as cushion for unforeseen external shocks. It was due the adequate forex reserve level that India was able to bear the global meltdown of
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