Fx reserves, need for insurance and Guidotti-Greenspan rule

Every Friday the RBI publishes a report called the WSS short form Weekly Statistical Supplement. The report contains all the important data about the money supply, credit creation etc. From the Fx market perspective the important number to watch out for in the report is the Fx reserves of the RBI. For the week ending November 13^th the Fx reserves of the RBI stand at USD 572.77 billion. The total reserves comprise foreign currency assets, gold, SDRs and the reserve position with the IMF. The latter two are negligible in the overall scheme of things with a total value of USD 6.4 billion. FCA and gold form USD 530.2 billion and USD 36.35 billion respectively.

Now lets see this number in a bit more detail. The variation over end March 2020 is USD 94.96 billion and over the past year is USD 124.52 billion. That is saying that close to 20% of the total reserves have been built up in the last year. Now this is a far cry from 1991 when India’s reserves had run down to just USD 1 billion and was forced by the IMF to devalue the rupee by 20% in a matter of 2 days.

Now having swung to the other side on the reserve position, readers would do well to ask the question how much reserves are enough ? And does this question have a unique answer across economies and different countries? IMF Economist Eeswar Prasad, in his book The Dollar Trap, tackles this question at length. Firstly he recognizes the Asian Crisis in the late 1990s as the tipping point when countries across the world became acutely aware of the problem associated with global free flow of money. It became clear to the CB’s in the crisis hit countries as well as the bystanders that they need to create an insurance cover in form of foreign currency reserves. They realized that if they approach some multilateral agency in times of crisis it results in ominous conditions.   

The first crude criterion which was in vogue in the 90s was that the country should have reserves to pay for 6 months of its import requirements. The second criterion which emerged in the late 90s based on empirical evidence was known as the Guidotti Greenspan rule named after the deputy finance minister of Argentina, Pablo Guidotti, and Fed Chief, Alan Greenspan. A simplified version of the rule says that at any point a country should have enough reserves to cover all of its short term external debt (maturity with one year or less). As the discussion is broad and there are multiple threads to address, we will stop in this note because of the paucity of space and will come back to discuss the cost of such reserves, the basic tenet on the choice of reserve currency and alternatives available in later notes.

In other news, the US government has indicated that mass vaccinations will start in the US in two to three weeks’ time and they plan to vaccinate 70% of the population by May 2021. The daily number in the US reached close to 200,000 last week Friday. The daily number of deaths also peaked at 2000 on the same day. The Dollar Index trades at 92.26 and the US 10 year treasury stands at 0.82. On the Brexit front, as the UK and EU negotiators reach their final (yet again!) week of negotiations, the UK’s Chancellor of the Exchequer Rishi Sunak said that UK should not accept a deal with the EU at any price.