Mfs Project on Forex

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A

PROJECT REPORT ON

THE STUDY OF FOREIGN EXCHANGE

RESERVE IN A COUNTRY

Submitted By:

DIVYA NAIR (B-30)

GOKUL SOOD (B-)

MBA PROGRAMME 2010-2012 (SEMESTER II)

In partial fulfilment of the requirements of the project for the

subject- MANAGEMENT OF FINANCIAL SERVICES

for the

award of the degree of

MASTER OF BUSINESS ADMINISTRATION

SHRI JAIRAMBHAI PATEL INSTITUTE OF BUSINESS

MANAGEMENT

AND COMPUTER APPLICATIONS (NICM-MBA)

Submitted to:-

PROFESSOR URVI AMIN


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Table of contentsSR.N

O

PARTICULAR

S

PAG

E NO.1. INTRODUCTION 3

2. HISTORY 3

3. LIST OF COUNTRIES 4

4. HOW FOREX ARE BUILTUP?

5

5. WHO MAINTAINS FOREXRESERVES?

5

6. NEED OF FOREXRESERVES INDEVELOPED NATIONDEVELOPING NATION

6

7. COST OF RESERVES 10

8. IMPACT ON BUSINESS 11

9. INDIA V/S CHINA 12

10. BIBLIOGRAPHY 13


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INTRODUCTION A foreign exchange reserve in popular usage commonly

includes foreign exchange and gold, Special Drawing Rightsand International Monetary Fund reserve positions held bycentral banks and monetary authorities.

They are something like family ornament not in regular use,but in case of an emergency (like a currency crisis, forexample), they are an extremely good fallback to have.

Again, like with ornaments, some countries like China,India, Japan and Korea keep on accumulating lots of it,while others like the US and UK maintain a steady state,

while yet others like Germany have actually seen a declinein forex reserve levels.

HISTORYOfficial international reserves, the means of official

international payments, formerly consisted only of gold, andoccasionally silver.

But under the Bretton Woods system, the US dollarfunctioned as a reserve currency, so it too became part of anation's official international reserve assets.

From 1944-1968, the US dollar was convertible into goldthrough the Federal Reserve System.

But after 1968 only central banks could convert dollars intogold from official gold reserves.

After 1973 no individual or institution could convert USdollars into gold from official gold reserves.Since 1973, no major currencies have been convertible into

gold from official gold reserves. Individuals and institutions must now buy gold in private

markets, just like other commodities.Even though US dollars and other currencies are no longer

convertible into gold from official gold reserves, they still canfunction as official international reserves.
http://en.wikipedia.org/wiki/Bretton_Woods_systemhttp://en.wikipedia.org/wiki/Bretton_Woods_system


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list of the top 20 largestcoun tries by foreignexchange reserves:

Rank Country Billion USD

1 People's Republic of China $ 3,201

2 Japan $ 1,1383 Russia $ 516

4 Saudi Arabia $ 484

5 Republic of China (Taiwan) $ 400

6 Brazil $ 352

7 India $ 320.39

8 South Korea $ 311

9 Switzerland $ 289

10 Hong Kong $ 277

11 Singapore $ 249

12 Germany $ 231

13 Thailand $ 186

14 France $ 182

15 Algeria $ 175

16 Italy $ 170

17 United States $ 143

18 Mexico $ 139

19 Malaysia $ 134

20 Indonesia $ 122
http://en.wikipedia.org/wiki/People%27s_Republic_of_Chinahttp://en.wikipedia.org/wiki/People%27s_Republic_of_Chinahttp://en.wikipedia.org/wiki/Japanhttp://en.wikipedia.org/wiki/Japanhttp://en.wikipedia.org/wiki/Russiahttp://en.wikipedia.org/wiki/Russiahttp://en.wikipedia.org/wiki/Saudi_Arabiahttp://en.wikipedia.org/wiki/Saudi_Arabiahttp://en.wikipedia.org/wiki/Republic_of_Chinahttp://en.wikipedia.org/wiki/Republic_of_Chinahttp://en.wikipedia.org/wiki/Brazilhttp://en.wikipedia.org/wiki/Brazilhttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/South_Koreahttp://en.wikipedia.org/wiki/South_Koreahttp://en.wikipedia.org/wiki/Switzerlandhttp://en.wikipedia.org/wiki/Switzerlandhttp://en.wikipedia.org/wiki/Hong_Konghttp://en.wikipedia.org/wiki/Hong_Konghttp://en.wikipedia.org/wiki/Singaporehttp://en.wikipedia.org/wiki/Germanyhttp://en.wikipedia.org/wiki/Germanyhttp://en.wikipedia.org/wiki/Thailandhttp://en.wikipedia.org/wiki/Thailandhttp://en.wikipedia.org/wiki/Francehttp://en.wikipedia.org/wiki/Francehttp://en.wikipedia.org/wiki/Algeriahttp://en.wikipedia.org/wiki/Algeriahttp://en.wikipedia.org/wiki/Italyhttp://en.wikipedia.org/wiki/Italyhttp://en.wikipedia.org/wiki/United_Stateshttp://en.wikipedia.org/wiki/United_Stateshttp://en.wikipedia.org/wiki/Mexicohttp://en.wikipedia.org/wiki/Malaysiahttp://en.wikipedia.org/wiki/Malaysiahttp://en.wikipedia.org/wiki/Indonesiahttp://en.wikipedia.org/wiki/Indonesiahttp://en.wikipedia.org/wiki/Indonesiahttp://en.wikipedia.org/wiki/Malaysiahttp://en.wikipedia.org/wiki/Mexicohttp://en.wikipedia.org/wiki/United_Stateshttp://en.wikipedia.org/wiki/Italyhttp://en.wikipedia.org/wiki/Algeriahttp://en.wikipedia.org/wiki/Francehttp://en.wikipedia.org/wiki/Thailandhttp://en.wikipedia.org/wiki/Germanyhttp://en.wikipedia.org/wiki/Singaporehttp://en.wikipedia.org/wiki/Hong_Konghttp://en.wikipedia.org/wiki/Switzerlandhttp://en.wikipedia.org/wiki/South_Koreahttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Brazilhttp://en.wikipedia.org/wiki/Republic_of_Chinahttp://en.wikipedia.org/wiki/Saudi_Arabiahttp://en.wikipedia.org/wiki/Russiahttp://en.wikipedia.org/wiki/Japanhttp://en.wikipedia.org/wiki/People%27s_Republic_of_China


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H ow are forex reserves builtup?

Building up of forex reserves is actually a complicatedpicture, but can be simplified as follows.

Foreign exchange comes into a country in the form ofinvestments, payments for exports, loans and bilateral aidamong other things.

It goes out as payments for imports, payment of interest,repayment of loans and repatriation of investments andprofits.

The difference stays on to build up the reserves.

W ho m aintains forexreserves?

The monetary authority and central bank of each country,like the Reserve Bank of India (RBI), the Federal Reserve ofthe US and the Peoples Bank of China, maintain the forex

reserves of the country.

Then there are other big investment funds that somecountries like Abu Dhabi and Singapore maintain.

Many argue that these should be included in the forexreserve count.

India has also been speaking about setting up such aninvestment fund.


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W hy forex reserves?These are maintained primarily to protect a country

domestic currency from losing its value or, in other words,to avoid a currency crisis.

Just like other goods, a country currency can lose its valuewhen demand for it falls or when there is excess supply ofit.

Such a situation may arise when investors do not want tostay invested in that country and want to transfer theirfunds out of that country or from the currency of thatcountry.

For example, suppose due to any reason a foreign investorwants to sell out his equity holdings in Indian companiesand want to transfer these funds to the USA.

In this case, he or she would convert the Indian rupeesreceived by selling the equities into US dollars.

If a large number of investors do this simultaneously whilethe reverse is not happening, it will lead to a fall in the valueof the rupee.

It would lead to the depreciation of the Indian rupee againstthe dollar and there is a net outflow of dollars.

Sometimes this depreciation (or need for devaluation) couldbe large in magnitude.

Such instability in exchange rates and loss of confidence inthe currency have an effect on the economy.

So to avoid such sudden changes and to maintainconfidence in the currency, reserves are maintained.

Forex reserves are also maintained to achieve some level ofexchange rates.

These levels are determined based on the policies andobjectives of the country.

Generally, developing economies, in order to increaseexports and decrease imports, try to keep their exchangerates low.

Forex reserves are generally deployed in low-risk liquidassets having sovereign guarantee.


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Reserves are often advanced as loans to other countries,other central banks, Bank for International Settlements andhighly rated foreign commercial banks.

Foreign exchange reserves are also used to manage liquidityin the system.

D eveloping nationsEmerging and developing economies are racing to attract

foreign flows as they are limited.

It is done primarily on the belief that this will lead toincrease in investments and their ability to import, which

would overcome domestic supply constraints in theireconomy and will insure them against crisis.

China has the largest forex reserves in the world. India,Korea and Brazil are also building up huge forex reserves.

Indias foreign exchange reserves have increased from amere $19,553 million in March 1994 to $309,723 million inMarch 2008, and then fell to $253,000 million in March

2010.

One of the reasons for such a trend is Indias fundamentals,which made its corporate sector highly profitable and newinvestment opportunities kept coming up.

This attracted foreign capital into the country.The general build-up of forex reserves is also due to the

large inflow of foreign investors.

These investors come into developing or emerging economiesas a result of the increase in availability of finance andcredit for investments.

The best opportunities were often found in these economiescharacterized by high interest rate regimes and largeprofitable/return.


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For example, fundamentals and returns in the Indianeconomy is still far better than many others.

The recent dip happened because of the selling of US dollarsby the RBI to contain depreciation or fall in value of theIndian rupee.

Primarily, the RBI has to do so because of the increasing(negative) gap in the balance of trade.

That is, to balance the increase in import costs (mainlybecause of burgeoning price of petroleum, which peeked in

July 2008) given dismal growth in exports.

Selling of equities by foreign institutional investors (FII) alsocontributed to it.

Also, there were outflows because foreign investors whoinvested in India were required to clear their liabilities orpayments and losses abroad made during the ongoingslowdown.

In order to clear their losses, funds were arranged fromother economies.

Reduction in reserves happen not only due to the needs orpolicies of the host, but also take into account the supplyside, the interest of the foreign investors and their position.

Another reason for fall in reserves is the appreciation of theUS dollar vis-a-vis other currencies.

This can be explained with the help of the followingexample.

o Suppose India has reserves worth $100, half in $ andhalf in euro.

o Lets assume for simplicity that $1 = 1.o Now suppose there is appreciation of the dollar vis-a-

vis the euro and new rate is $1 = 2.o Now the reserves that India has will have reduced and

would be worth only $75.


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D eveloped countriesDeveloped countries in comparison tend to have lower forex

reserves.The reason for not accumulating large reserves is that their

currencies are often reserve currencies themselves and,therefore, are highly liquid, so there does not exist that high

a precautionary motive for them.Also these economies have export sectors that are not driven

by exchange rates.So they do not have to manage their exchange rates in order

to support their domestic industry.However, Japan is an exception to this trend. Compared to

the other developed nations, Japans dependence on exportsis very high.

The reason why it accumulates forex and has the secondhighest reserves in the world after China is to prevent theyen from appreciating, thereby incentivizing its exportsector.

Also, Japans history of having lost two World Wars andhaving to live with the limitations (particularly onmilitarization) imposed by its eventual victors may have animportant role in this Japanese mentality.


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Cost of reservesThere are costs associated with maintaining these reserves.

Investments made by foreign funds in a country tend toearn much higher returns than what a central bank gets byinvesting its reserves.

For example, an FII coming in earns much higher rates ofreturn by investing in equities, but the government earnsonly a nominal (or very low) rate of return by investing indebt instruments of other central banks.

Forex reserves are kept in highly liquid assets in order tofulfill needs of foreign exchange when it arises.

The government cannot invest these reserves in projects orphysical infrastructure.

So there is an opportunity cost of holding the reserves.The reserves also impact government policy negatively in thesense that it has to consider the effects of policy changes on

its reserves.For example, in October 2007, Securities and Exchange

Board of India (SEBI) came up with a new ruling regardingparticipatory notes and FIIs, but were forced to makenecessary amendments because of the threat of FIIs pullingout.

There is also another significant management activity,which is referred to in economic terms as sterilization.

Suppose an investor wants to invest in India and brings inUS dollars.

However, in order to buy assets in India, they need to makepayments in rupees.

So they exchange their dollars with RBI for rupees, whichthey then put into the Indian economy and purchase assets.

In this whole transaction, the quantity of Indian currency(money supply) has increased in the Indian economy.


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To negate this increase in money supply, the RBI can issuedebt or bonds to mop up that amount of currency from thesystem.

This method of reducing the increased money supply inmarket is called sterilization.

However, generally interest rates are relatively higher onsuch bonds and debt relative to what the RBI earns byinvesting reserves.

Im pact of reserves onbusinesses

As far as businesses are concerned, in the short run theydefinitely benefit from larger forex reserves as they canaccess more liquidity if there is ineffective, partial or nosterilization.

Increased liquidity also creates demand in the economy.Due to build-up of such reserves, volatility in exchange

rates is often checked, which provides a conduciveenvironment to businesses.

Stable exchange rates allow exporters and importers toengage in futures contracts.Also, the expectation of the currency and the economy beingcrisis-proof raises confidence among investors.

However, this can have repercussions as well.Often businesses are badly hurt when there is a bursting of

bubbles in asset markets. Inflation is also not good for businesses in the medium to

long run.The government may not also be able to provide adequate

support to businesses due to net loss of earnings.There may be cuts in subsidies, investments and otherexpenditure, which may have an effect too.


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Ch ina versus IndiaThe large reserve position of China could effect Indianbusinesses in two ways. It may put pressure on the Chinese yuan to appreciate.This may allow an opportunity for the Indian export sector

to expand as Indian businesses can tap into the share ofChinese export businesses.

Also, in such a situation India could increase its exports toChina.

However, at the same time Indian importers who areimporting from China may be on the losing side.

On the other side, such large reserves held by China makeit more investment friendly and the Indian economy may notsee that much foreign direct investment.

Indian businesses in that case may not enjoy linkages thatmight have come through those investments.


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Bibliography

www.google.com

www.wiwkipedia.com

www.investopedia.com

www.rbi.com

www.investmentservices/china.com

www.imf.com
http://www.google.com/http://www.google.com/http://www.wiwkipedia.com/http://www.wiwkipedia.com/http://www.investopedia.com/http://www.investopedia.com/http://www.rbi.com/http://www.rbi.com/http://www.investmentservices/china.comhttp://www.investmentservices/china.comhttp://www.imf.com/http://www.imf.com/http://www.imf.com/http://www.investmentservices/china.comhttp://www.rbi.com/http://www.investopedia.com/http://www.wiwkipedia.com/http://www.google.com/

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