Guest Contribution: “Forex reserves: why following China won’t work for India”

Today we are fortunate to have a contribution by Joshua Aizenman, Dockson Chair in Economics and International Relations at the University of Southern California. This post was originally published at East Asia Forum.

Reserve Bank of India Governor Raghuram Rajan recently stated that India’s economy cannot be said to be insulated from external shocks unless the country’s foreign exchange reserves rise to the levels of China’s. ‘I think, if you focus only on reserves, there is really no point at which you feel safe … 400, 500, 600 … any level of reserves, until you get to Chinese level, it is probably not enough’, he said.

Recent research, however, suggests that the myth of a ‘comfortable level of reserves’ is, at best, doubtful, at worst, misleading.

The elusive comfortable level of reserves depends on the level of reserves of your reference group (the ‘keeping up with the Joneses’ effect). Having deeper reserves than your neighbour may signal that your neighbour is the better target for foreign-currency speculative runs. Alternatively, this may be the outcome of hoarding in attempts to delay real appreciations that may hurt relative competitiveness, leading to ‘hoarding wars’ between exporters, attempting to keep their export market shares in overseas countries.

South Korea presumed prior to the global financial crisis that having international reserves at about 35 per cent of GDP was ‘comfortable’. Yet, they found in 2008–09 that it was not enough to abate financial panic — it took the unprecedented US Federal Reserve swap extended to South Korea to mitigate the panic. The lesson: South Korea overlooked the key importance of balance sheet exposures. At times of panic and flight to quality, the provision of (preferably elastic) swap lines by the supplier of global liquidity acting as the ‘buffer of last resort’ is the ultimate stabiliser. The outcome was that South Korea adopted prudential regulations (in line with economists Valentina Bruno and Hyun Song Shin’s recommendations).

Chances are that international reserves covering short-term hard-currency debt, reaching around 15–20 per cent of GDP, may provide a ‘precautionary buffer’ dealing with a typical exposure of an emerging market. Yet, this may not suffice to cover tail risks of the type exposed by the global financial crisis, a crisis with uncertain duration, and would not suffice to cover a run on the domestic banking system at times of internal instability.

Commodity-exporting countries have found that adding sovereign wealth funds above a ‘precautionary buffer’ of international reserves is advantageous. In the case of India, however, this recommendation will likely not fit.

Reserve Bank of India (RBI) Governor Rajan’s reference to China is intriguing — Chinese hoarding took off in 2001, more than tripling its ratio of international reserves to GDP by 2010. This took place during a prolonged spell of running current account surpluses and GDP growth reaching about 10 per cent a year. Chances are that this unprecedented reserve accumulation was the outcome of mercantilist motive (delaying the on-set of real appreciation, prolonging export led growth of manufacturing), as well as sporadic massive inflows of capital. These developments led to the growing concerns regarding the unintended consequences of global imbalances.

The global crisis put an abrupt end to these imbalances, and one doubts the feasibility and desirability of a strategy of massive hoarding foreign exchange reserves at times of global deflationary pressure and underemployment in numerous OECD countries. Also doubtful is the degree to which such a strategy fits India — underinvestment in infrastructure and labour-market rigidities have prevented India from exploiting its manufacturing potential. These bottlenecks would not be resolved by accumulating reserves.

Furthermore, the much lower saving rate in India and its tendency to run current account deficits does not support massive hoarding of the Chinese type. For sure, Rajan is aware of these factors — he noted that, instead of building just reserves, there is a need to focus on creating a policy environment that boosts investor confidence. Chances are that dealing with the infrastructure deficit of India needs much more than upgrading the RBI’s policies, or upgrading India’s reserves. Exploiting fully India’s manufacturing comparative advantage requires trimming costly labor market regulations, where high costs of firing reduce labor hiring. Access to reliable electricity and transportation networks are also necessary conditions for thriving manufacturing. India needs investment in efficient railway, highway, and air-cargo systems, integrated smoothly with navel ports and airports, with minimal red-tapes associated with export/import clearings.

The challenges associated with massive hoarding of international reserves are well known: sterilisation is needed to mitigate inflationary pressure, leading to quasi fiscal costs and potential monetary instability. China’s history suggests that there are ways to manage it, but none offers a panacea, and it’s too early to judge the degree to which dealing with past credit expansions in China will end with a soft landing. One also doubts whether China’s experience can or should be replicated by India — their fundamentals and institutions differ.

Yet, Indian households follow a decentralised version of Rajan’s comments, hoarding massive levels of gold (with an estimated market value of US$1.16 trillion in November 2012). The gold position of the private sector reflects both tradition and possible under-banking in India. Chances are that better provisions of accessible, stable and secured banking services should allow substituting these large and probably wasteful private gold positions with higher hoarding of international reserves by the RBI. Better provisions of banking services in India is indeed a worthwhile goal for the country, and the Reserve Bank should facilitate such a process. Yet, this should be done not to match the reserves of China but to improve the provision of safer and cheaper banking services.

This post written by Joshua Aizenman.

21 thoughts on “Guest Contribution: “Forex reserves: why following China won’t work for India”

  1. PeakTrader

    India’s government should work with foreign businesses to build production plants and infrastructure.

    However, India shouldn’t follow China’s economic model, which includes exchanging goods for foreign currencies (rather than for foreign goods), to further raise output and employment.

    China’s “growth-at-any-cost” policy is most inefficient. It sells its goods too cheaply and lends its foreign currencies too cheaply to generate foreign demand and raise domestic output and employment.

    Consequently, foreigners capture huge “gains-in-trade,” whle China’s receives small gains-in-trade, particularly when negative externalities are included.

  2. Ricardo

    Governor Rajan is actually in a battle over control of the rupee. Traders love his approach to monetary stability but business interests follow a mercantilist attitude that more money and lower interest rates are needed. While low interest rates and more money may generate a short-term boom the US experience in 2008 proves that such a policy is disastrous for an economy.

    Rajan’s comment was totally taken out of context. The Economic Times reported it correctly. “MUMBAI: Reserve Bank Governor Raghuram Rajan has said though the country has enough foreign exchange reserves, no nation can fully insulate itself from external vulnerabilities.”

    “We are well-buffered with substantial reserves, though no country can be de-coupled from the international system,” Rajan said at a conference organised by the Brookings Institution in Washington yesterday.”

    The ET recognized his comment on China was a throw-away line, not a policy statement. That should be clear from his comment that India “has enough foreign exchange reserves.”

    As in most countries when the mercantilists gain power there is an increase in government extortion of business payments and a decline in the productivity of the economy. It happened (is happening) to the US and the narrow business interests want the same for India. They are graspiing at any statement by Rajan to discredit him rather than actually working toward what is for the greater good of India.

    The WSJ stated it well, “Mr. Rajan, a former chief economist of the International Monetary Fund, was appointed RBI governor by the ruling Congress government in September. He is now loved by many market players but loathed by some business leaders.

    Mr. Rajan has shown his resolve to fight inflation by raising India’s benchmark interest rate three times in his eight-month tenure. He seems to have helped make some headway in reining in India’s inflation as well as the country’s chronic current account deficit. That has helped allow the rupee and Indian stocks to rebound from last year’s lows.

    His tightening bias has also earned him the ire of some trade associations and businesses who want lower interest rates so that they can borrow money more cheaply.

  3. PeakTrader

    In the link “The global crisis put an abrupt end to these imbalances,” there were at least three major factors that caused the financial crisis, recession, and current depression:

    1. The massive moral hazard created by Congress in the housing market. It was a giant social program Congress believed it didn’t have to pay for. If lending standards in the housing market began to tighten when the Fed began the tightening cycle in 2004, the financial crisis may have been averted.

    2. U.S. consumers bought foreign goods and foreigners bought U.S. Treasury bonds. The federal government didn’t “refund” enough dollars, in the form of tax cuts, to U.S. consumers to allow the spending to go on. Instead, the government spent those dollars, creating a mountain of federal debt to add to the mountain of household debt. A large tax cut, e.g. $5,000 per worker or $700 billion in 2009, rather than the small and slow tax cuts, would’ve reduced household debt substantially, strengthened the banking industry, raised discretionary income, generated a consumption-employment cycle, and created more employment and tax revenue.

    3. Peak Oil is a constraint on U.S. and global growth, since oil prices began the rise to $150 a barrel in 2007 & 2008.

    1. baffling

      “1. The massive moral hazard created by Congress in the housing market. It was a giant social program Congress believed it didn’t have to pay for. If lending standards in the housing market began to tighten when the Fed began the tightening cycle in 2004, the financial crisis may have been averted.”

      you can’t be taken seriously when you make inaccurate statement such as this. the financial crisis was not the fault of Congress. a major cause was greedy financial groups who conducted fraud as a means to acquire profit. i find it baffling how many people want to find blame with the government so that they can let the private sector off the hook for the financial crisis. if was the private sector who levered up, and they did it via fraudulent documentation. perhaps congress could have passed regulations requiring jail time for executives of fraudulent companies-something i certainly support-but then you would have heard the chorus of too much regulation is stifling innovation from the far right.

      1. PeakTrader

        Baffling, an important part of a politician’s job is blaming others, e.g. “the private sector,” which explains why you’re baffled.

        Why would banks lend money to people with no income and no downpayment without the encouragment and support of government?

        Borrowers were able to to buy houses they couldn’t really afford, and lenders were able to make lots more money on more loans.

        Lenders knew they’d be bailed-out, by “too-big-to-fail,” which they were, with TARP, and knew the music would eventually stop.

        Politicians like Dodd and Frank facilitated and accelerated the housing boom, creating massive moral hazard, and then when the economy crashed, went to the other extreme over-regulating the financial industry and creating uncertainty.

        Bush Administration Tried to Reform Freddie and Fannie Five Years Ago
        February 19, 2009

        “Fannie Mae and Freddie Mac “accelerated their imprudent behavior after we attempted to regulate them. They bought almost as much mortgage debt from 2005 through 2008” as they bought in their first 30 years of their existence.

        In 2003, when we sent our first members of the Cabinet up to talk about this on Capitol Hill, Barney Frank had a hearing in which they basically beat up everybody we sent up there in pretty vociferous language.

        In fact, we moved aggressively in 2004 to regulate Fannie and Freddie, actually got a bill through the Senate Banking and Finance Committee only to have it filibustered by [Sen.] Chris Dodd.”


        Michael Bloomberg, former Mayor of New York City:

        “It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp.

        Now, I’m not saying I’m sure that was terrible policy, because a lot of those people who got homes still have them and they wouldn’t have gotten them without that.

        But they were the ones who pushed Fannie and Freddie to make a bunch of loans that were imprudent, if you will. They were the ones that pushed the banks to loan to everybody. And now we want to go vilify the banks because it’s one target, it’s easy to blame them and Congress certainly isn’t going to blame themselves.”


        “By 2007, 55 percent of all loans made by Fannie and Freddie had to be “affordable.” By June 2008, there were 27 million subprime housing loans outstanding (19.2 million of them directly owed by government or government-sponsored agencies), with an unpaid principal amount of $4.6 trillion.

        Almost 50 percent of all mortgages outstanding in the United States in 2008 were subprime or otherwise deficient and high-risk loans.

        Two-thirds of these mortgages were on the balance sheets of government agencies, or firms required to buy them by government regulations.”

        1. baffling

          you conveniently ignore the issue that banks were conducting fraud during this whole process. softening lending standards is not a green light to commit fraud. banks signed up people they knew could not pay off the mortgage by FRAUD. they did not believe they would be bailed out by tarp-that was not even in their imagination at the time-they believed they could sell off the mortgages before they went bad. they sold them as quality mortgages because the committed FRAUD during the underwriting of the loans-hoping somebody else in the private sector would be left holding the bag later in time.

          people are rewriting history by saying fannie and freddie required these subprime mortgages. this is not true. standards for the mortgages existed, but were not met due to FRAUD by the mortgage companies.

          government policies were not developed which created the subprime crisis. the crisis developed because of criminal activity, on a large scale, was conducted against the housing agencies and the us government, as well as the free market capitalist system. i am not sure why people want to overlook this criminal activity which led to the fallout of a financial crisis.

          ignoring fannie and freddie, the private banking sector was still making loans and securitizing them outside of the government agencies. and these were some of the worst of the security products-think of the abacus product. this still would have occurred had fannie and freddie not been involved in the mortgage business.

          1. PeakTrader

            Baffling, “you conveniently ignore” the fact Congress created the conditions for people to commit fraud, including borrowers.

            And, it was rational to diversify risk. For a time, investors made a lot of money.

            It’s people like you “rewriting history,” including dismissing “too-big-to-fail.”

            Of course, many people took advantage of the conditions Congress created, including many homeowners, who also benefited enormously.

            What Caused the Financial Crisis
            November 16, 2010

            “Starting in the late 1990s, the government, as a social policy to boost homeownership, required Fannie Mae and Freddie Mac to acquire increasing numbers of “affordable” housing loans. (An “affordable loan” is made to people who normally would not qualify.)”


            “As long as the music is playing, you’ve got to get up and dance.”
            – Charles O. Prince, July 2007, CEO of Citigroup

            Citigroup avoided the dance, because it knew it would end in disaster. Eventually, it was forced to dance to compete, was late to the dance, and lost the most. Government throws very expensive dances.

          2. baffling

            the number of “affordable” loans generated was a fraction of the overall mortgage volume. this was not the cause of the problem. people have tried to pin the crises on the community reinvestment act for years, but the accusations have no credibility. unethical and fraudulent behavior was a far greater contributor to the financial crisis, not policy.

            congress did not create conditions for people to commit fraud. people committed fraud, period. rules existed and were not followed. the government cannot keep people from breaking the laws if they so desire, unless you want a nanny state. the laws were not fraudulent, only the behavior of the mortgage lenders and some homebuyers.

            your quote of chuck prince
            “As long as the music is playing, you’ve got to get up and dance.”
            chuck is using the excuse, since everybody else is cheating i needed to cheat as well. the end justifies the means i suppose…chuck deserves to be in jail for fraud. it is simply baffling that people will give old chuck an excuse for criminal behavior by blaming the government for his company’s fraudulent behavior!

          3. PeakTrader

            Baffling, you’re hopelessly in denial.

            Millions of people behaving rationally was not the cause of the crisis.

            And, the government didn’t seem to mind financing fraud for millions of “affordable” loans.

            The real fraud was politicians believing they could create a giant social program without paying for it.

          4. baffling

            peak, according to your logic since we have laws against murder, and yet thousands of people are murdered every year, it is the government’s fault. this is simply faulty logic. people are responsible for their own behavior, and people know when they are acting fraudulently. they either choose to act that way, or they choose not to act that way. it is absurd to blame the government for such behavior!

          5. PeakTrader

            Baffling says: “peak, according to your logic since we have laws against murder, and yet thousands of people are murdered every year, it is the government’s fault. this is simply faulty logic. people are responsible for their own behavior, and people know when they are acting fraudulently. they either choose to act that way, or they choose not to act that way. it is absurd to blame the government for such behavior!”

            So, according to your logic, since we have laws against speeding, and yet thousands of people drive too fast every year, it is the police’s fault. This is simply faulty logic. People are responsible for their own behavior, and people know when they are driving too fast. They either choose to drive fast or they choose not to drive fast. It is absurd to blame the police for such behavior!

            (And, according to your logic, when there are no cops giving out speeding tickets, more people won’t drive faster).

          6. baffling

            peak, you need to think about what you are writing rather than respond simply to be a contrarian. you do not blame government for fraudulent mortgage behavior for the same reason you do not blame the police for speeding. it is the people who are choosing to conduct such behavior, and it has nothing to do with government policies. the government, and police, need to enforce the rules when possible, but you need to be careful of becoming a nanny state with too much enforcement.

  4. PeakTrader

    A self-sustaining consumption-employment cycle (where consumption generates employment and employment generates consumption, etc.), which has failed to take hold over the past few years, would’ve raised tax revenue and reduced spending on the unemployed.

    We not only added $5 trillion of additional federal debt to achieve this deep depression, we also destroyed substantial potential output (which is one way to close the output gap).

    What’s sad is Americans were willing to work longer, and harder, to pay down debt, which would’ve added to future economic growth, including over the past few years, if they could find employment. Instead, they were forced into early retirement, collected (endless) unemployment benefits, collected disability, etc..

    The economy continues to shrink and Americans are poorer.

  5. Ricardo


    “A self-sustaining consumption-employment cycle (where consumption generates employment and employment generates consumption, etc.), which has failed to take hold over the past few years, would’ve raised tax revenue and reduced spending on the unemployed.”

    So the amount of goods available to sell is of no concern. To paraphrase Marie, “Let them eat currency.”

  6. PeakTrader

    Ricardo, why would sellers build-up inventories, and hire workers, when there are no customers? The U.S. economy is underproducing by about $1 trillion a year. There are over 20 million unemployed and underemployed Americans, which adds to income inequality Chart:

    UCLA Anderson Forecast: U.S. economy falls short of true recovery
    June 05, 2013

    “U.S. real GDP is now 15.4 percent below the normal 3 percent trend. To get back to that 3 percent trend, we would need 4 percent growth for 15 years, 5 percent growth for eight years, or 6 percent growth for five years, not the disappointing twos and threes we have been racking up recently, which are moving us farther from trend, not closer to it. It’s not a recovery. It’s not even normal growth. It’s bad.”

  7. PeakTrader

    India shouldn’t follow China, because what the Chinese do best is corruption, crony capitalism, misallocate resources, cause negative externalities, prevent creativity, create inefficiency, and export much of its GDP.

  8. Ricardo


    Did you miss Hayek’s point? Keynes was ignorant of the body of economic thought and his General Theory proved it by relying of refuted mercantilist arguments. Keynesinaism was embraced by government because it gave them a justification for crony capitalism and confiscation, but since the General Theory, experience has proven that Hayek was right and Keynes wrong. But the governments control the media and the educational institutions and so they perpetuate fallacious economic principles for their own gain.

  9. PeakTrader

    Ricardo, I don’t know what you’re talking about. Keynesian economics is supported mathematically and empirically.

    You’re confusing Keynesian economics with the misuse of Keynesian economics by politicians.

    From Commanding Heights:

    “Keynes intended government to play a much larger role in the economy. His vision was one of reformed capitalism, managed capitalism — capitalism saved both from socialism and from itself.

    Fiscal policy would enable wise managers to stabilize the economy without resorting to actual controls. The bulk of decision making would remain with the decentralized market rather than with the central planner.

    …fiscal policy — spending, deficits, and tax. These tools could be used to manage aggregate demand and thus ensure full employment.

    As a corollary, the government would cut back its spending during times of recovery and expansion. This last precept, however, was all too often forgotten or overlooked.”

Comments are closed.