Christian Vallence of RBA has this nice article on the topic. Hope to get something from RBI econs as well on similar lines.
The Reserve Bank of Australia holds and manages the nation’s foreign exchange reserve assets in order to meet its policy objectives. While Australia’s foreign exchange reserves are relatively modest by international standards, they nonetheless constitute a sizeable portion of the Bank’s balance sheet, and variations in the Australian dollar value of these reserves are usually the most volatile component of the Bank’s profit and loss statement. This article discusses some of the key decisions faced by the Bank in holding and managing Australia’s foreign exchange reserves, including the appropriate size of reserve holdings, the way in which they are acquired, and risk management strategies. Each of these decisions involves a trade-off between policy capacity, and financial costs and risks to the Bank’s balance sheet.
How does RBA acquire Forex assets?
There are three methods through which a central bank can acquire reserves (either singularly or in combination): by borrowing foreign currency directly, for example, by issuing foreign currency securities (either in the name of the central bank or with the central government acting as an intermediary); borrowing foreign currency through the foreign exchange swap or cross-currency swap markets; or purchasing reserves outright, by selling the domestic currency in exchange for foreign currency. Borrowing foreign currency generates a hedged foreign exchange position, while outright holdings leave a central bank unhedged. The different methods have different implications for the capacity of the central bank to intervene and manage its balance sheet risk.
RBI buys/sells via both the ways – purchasing reserves outright and through swap markets. In 2005-08, it was mostly buying forex reserves via outright purchase (extract data from RBI’s DBIE site. It is there in Monthly Bulletin data in Time Series Publications).
In 2011-12 and 212-13, as rupee was depreciating it first sold forex reserves in outright spot market. That led to tight liquidity. Then RBI shifted position in swap market and has been slowly unwinding the swap position. From $14.5 bn in Jul-12, the swap position has come to $13.5 bn.
Coming back to the note. Each of the three have their costs and benefits.
The Reserve Bank of Australia accrues (and replenishes) the majority of its reserves by selling Australian dollars over time, and by reinvesting the earnings on its foreign assets. This generates a net ‘long’ or unhedged position in foreign currency.
The Bank considers the insurance characteristics of unhedged holdings to be superior to those of borrowed reserves as unhedged reserves carry little or no refinancing risk, as many of the Bank’s liabilities – most notably banknotes – are effectively perpetual. Conversely, foreign currency liabilities that fund borrowed reserves must be rolled over or repaid when they mature. A central bank that has intervened with borrowed reserves has entered into a ‘short’ foreign currency position, and may find rolling over or repaying its liabilities more costly if the depreciation of the domestic currency persists beyond the central bank’s refinancing horizon. If a central bank instead holds unhedged reserves then it may be able to wait for the exchange rate to move higher before replenishing reserves that had previously been drawn down. A central bank that borrows to fund reserves may also need to maintain a higher level of (gross) reserves to guard against this refinancing risk.
Superb. Helps connect the dots.
The author talks about carrying cost of reserves, impact on B/S and so on.
Though for RBA, one can apply the same ideas to RBI as well..