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How Gold Contains Market Volatility in IndiaViews: 780
Jul 18, 2007 5:53 pmHow Gold Contains Market Volatility in India#

How Gold Contains Market Volatility in India
By R. Pattabiraman
17 Jul 2007 at 10:04 AM GMT-04:00

MUMBAI (CommodityOnline.com) -- India’s accumulation of foreign exchange reserves has been increasing in recent years. 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 United States and European countries, the share is comparatively lower in Asian countries. Given this scenario, the question that arises is 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.

These economies have accumulated reserves at 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, 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 decided to reduce their gold holdings. The gold’s share of reserves was above 10% in 2006. This is mainly because of the sharp rise in the price of gold.

For a country that follows a fixed exchange rate regime, foreign exchange reserve has an important function. In order to keep the currency exchange rate fixed, 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 maintained by a country is not adequate, then investors may get speculative on the currency and affect its pricing.

The three components of India’s foreign exchange reserves are gold, special drawing rights and foreign currency assets. India is constantly accumulating its foreign exchange reserves to meet the requirements of its increasing current account deficit and to protect against volatile capital flows.

In this process it is felt that today India seems to hold foreign exchange reserves very much in excess. With the growth of the domestic industry and higher oil prices in international markets, the current account deficit is expected to widen in the coming years.

This implies that the country 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 minimise risk and volatility in returns. Hence, gold being highly liquid can serve this purpose.

By arrangement with www.commodityonline.com.

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