Macroeconomic Determinants of India's Foreign Exchange Reserves : An Empirical Analysis

The study of foreign exchange (forex) reserves has assumed importance due to increasing globalization of emerging market and developing economies. The journey of India from abysmally low reserves in 1991 to today's comfortable position has made the study of forex reserves very relevant in Indian context. This study, covering the period from 1996-97:Q1 to 2014-15:Q4, attempts to identify various macroeconomic determinants of India's forex reserves. While the ratio of India's forex reserves to its GDP is considered as the dependent variable, the ratio of M3 to GDP of India, trade openness of India, and volatility of US dollar-INR bilateral nominal exchange rate are considered as the explanatory variables. The study performs stationarity tests, Johansen's cointegration test, Johansen's Vector Error Correction Model (VECM) in VAR, impulse response function and variance decomposition analysis. With all the variables in log terms being I(1), Johansen's cointegration test confirms one long-run relationship among the variables. Forex reserves are found to be varying positively with money supply and trade openness, and negatively with exchange rate volatility. Deviations in forex reserves adjust towards the equilibrium level in the long run, but at a low speed. Therefore, RBI may be engaged in active reserve management