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Gold & India's forex reserves

How gold could minimize risk and volatility for India's foreign exchange reserves...

INDIA'S ACCUMMULATION of foreign exchange reserves has been increasing in recent years, writes R.Pattabiraman for Commodity Online. The country's primary sources of foreign exchange reserves have been capital flows and portfolio inflows.

   While the share of gold in total foreign exchange reserves is very high in the United States and European countries, the share is comparatively lower in Asian countries. Given this scenario, the question arises whether India should add more gold to its composition of foreign exchange reserves.

   In the present scenario, we find that emerging-market economies have started accumulating foreign exchange reserves on an unprecedented scale, an annual rate of $250 billion during the period 2000-2005. High foreign exchange reserves are often seen as a strength indicating the backing a currency has. On the other side of the coin, however, holding of huge foreign exchange reserves also indicates the lack of confidence on the global financial architecture.

   Gold does not earn any interest, other than the return that it fetches if lent. This is in fact the primary reason why central banks in many countries have decided to reduce their gold holdings, but gold's share of global reserves was above 10% in 2006, mainly because of the sharp rise in the Price of Gold.

   For a country that follows a fixed exchange rate regime, foreign exchange reserves have an important function. In order to keep the currency at its fixed exchange rate, the central bank of the country has to trade in the currency market to balance demand and supply.

   But for countries that follow floating exchange rate, the need for maintaining foreign exchange reserves is a question that has remained unanswered. If the foreign exchange reserves are not adequate, then investors may turn speculative on the currency and affect its pricing.

   The three components of India's foreign exchange reserves are gold, special drawing rights issued by the International Monetary Fund, and foreign currency assets. India is constantly growing its foreign exchange reserves to meet the requirements of its increasing current account deficit and to protect against volatile capital flows.

   Thanks to this process, India today seems to hold foreign exchange reserves very much in excess. But with the growth of domestic industry and higher oil prices in international markets, the current account deficit is expected to widen in the coming years. This implies that India would require more foreign exchange reserves to manage the foreign exchange demand that will arise from current account transactions.

   The objectives of reserve management in India are preservation of long-term value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns. Hence, gold being highly liquid can serve this purpose.

Commodity Online is a leading online, print and content provider of news, information and research reports on the commodities sector. With offices in Mumbai, New Delhi, Ahmedabad, Cochin, Bangalore and Dubai, it also powers content in the SME sector, as well as the insurance and banking industries.

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