Comments on The Cost of Holding Reserves: Evidence from India by Abhijit Sen Gupta Kenneth Kletzer India Policy Forum New Delhi, July 15, 2008

Summary As of December 2007, India’s international reserves were $270 billion. This is about 18% of GDP compared to an advanced country average of 4%. The paper considers two questions: Are emerging market central banks hoarding excess reserves? What is the opportunity cost of India’s foreign reserve stock?

For the first question, Sen Gupta begins by summarizing a simple theoretical model of reserve demand from Jeanne and Ranciere (2008). He then estimates reserve holdings for a panel of 167 countries over He finds that several major emerging economies are holding reserves well in excess of those predicted by his model. For India, his estimate of the excess is $22 billion. For the second question, he calculates the cost of holding these additional reserves to be between 0.3% and 2% of India’s GDP.

Why should central banks hold foreign reserves? Traditional answers: i)countries face uncertain export revenues and reserves allow a country to sustain imports in the presence of limited capacity to run a trade deficit ii)foreign credit may be withdrawn suddenly resulting in a net demand for foreign exchange. Both of these entail a decision to avoid currency depreciation. Both are raised by Keynes (1930), for example, notably the relationship of reserves to short-term foreign debt.

These have led, respectively, to rules of thumb expressed in terms of months of import cover and short-term amortization to GDP ratios (Greenspan-Guidotti (1999) following an IMF proposal (1997)). They are reflected in regressions by the inclusion of the import share and short-term indebtedness, controlling for per capita GDP. Sen Gupta adds some variables to measure the role of the exchange rate regime, domestic financial depth and international financial integration.

Why add financial variables? The typical answer is that these reflect the exposure of the economy to external crises. Henry Thornton (1802) raised this issue but articulated it in terms of external and internal drains (as emphasized by Obstfeld, Shambaugh and Taylor (2008)). With an open capital account, domestic currency deposits can be withdrawn to purchase foreign deposits or currency. A run on the banking system (an internal drain) coupled with an external drain leads to a depreciation unless the lender of last resort already holds sufficient foreign assets to exchange for domestic public liabilities in defense of the currency.

The ratio of M2 to GDP measures the deposit base at risk in a domestic financial crisis. Domestic demand deposits are not a proxy – they are what matters. The exposure of the lender of last resort to an external drain in the event of a domestic financial crisis depends on the openness of the capital account and, perhaps, variables that capture domestic confidence. The exchange rate regime may matter because it informs us of the central bank’s exchange rate objective. However, it can be a poor measure of the weight the central bank places on countering exchange rate movements.

Why go on about this? 1.The panel regression is a hybrid based on some loose arguments about external crisis exposure, political instability and exchange rate policies: If the objective of reserve holding is insurance against export revenue fluctuations with limited balance of payments financing, then import share should be in the regression. If the objective is maintaining domestic financial stability, then financial openness, M2/GDP and trade openness should be in the regression.

2. Sen Gupta’s regression results tell us that reserve holdings for India and China, among a few others, exceed those predicted by a model that includes variables to measure the domestic financial stability objective of the central bank. The central banks of these countries may anticipate further liberalization of the capital account or perceive greater risks (costs) of domestic financial crises than other emerging market economy central banks. Reserve holding should be forward looking if the central bank expects further international integration of domestic financial markets.

Specific comments 1. The exchange rate regime and political instability variables are not significant for the emerging market sample. Perhaps, the political stability story is unsuccessful. It may be worthwhile separating floating regimes with very low exchange rate volatility from actual pegs. 2. Per capita GDP and M2/GDP are highly correlated. I suggest comparing regressions with each and not the other. Also, consider the alternative of a model with trade share and the money to output ratio. 3. The theoretical model has little to do with the empirical model of reserves or the estimation of the opportunity cost of reserve hoarding.

In the theoretical model, the government offers consumption insurance to households against export revenue shocks. The household pays a premium xR for a contingent indemnity R. A maximum with respect to R (but not x) is found. The calculation of the steady state reserve level reveals that this is repeated insurance. However, reserves are (non- contingent) interest-bearing assets subject to exhaustion. This is an incomplete model of self-insurance by the government. It lacks the government’s budget constraint and does not account for its liquidity constraint (stock outs). The approach differs from buffer stock models (eg. Frankel and Jovanovic (1981) and Flood and Marion (2003)) that acknowledge the downward constraint and cost of holding reserves.

Opportunity cost of reserves Three measures of the marginal cost of reserves are given. The opportunity cost of sterilizing capital inflows is usually measured by the real interest differential between domestic public debt and international reserve assets corrected for default risk. If the central bank sells reserves to purchase government debt, it reverses its original sterilization and the currency appreciates.

Concluding comments Modeling the insurance motive for reserve hoarding by the emerging markets requires an objective for the central bank that includes the risk and costs of financial crises, a monetary policy objective and constraints on the central bank’s actions. The reserve demand estimates do not account for out of sample policy changes that affect the openness variables. The estimates give an upper bound on the costs of holding reserves in a liberalizing policy environment (conversely, lower bound).