There is some confusion in the minds of the Central Bank regarding the issue of Foreign Exchange Reserves or is it an attempt to build a defense for the accumulation of Foreign Reserves through borrowing in foreign exchange- building castles in the sand. Or that the Central Bank is genuinely interested in building up a backing for the currency in Foreign Reserves since the Rupee is more or less now pegged to the US dollar?

During the colonial period when the Currency Board was in operation instead of the Central bank. The Currency Issue was fully backed by Foreign Exchange Reserves- 100%. Since the Currency was a component of Reserve Money in fact the only Reserve Money, the Money Supply could not increase unless Foreign Exchange Reserves increased by an equivalent amount. If the Foreign Exchange Reserve declined then the Currency Board would have to reduce the Currency in Circulation which constituted the Reserve Money. Banks decided how much Reserve Money to hold to ensure liquidity to cover any drain on their deposits. So the Money Supply would be automatically reduced. There was no question of printing money to fund fiscal deficits.

In India up to 1956 a foreign securities to Currency ratio of 40% was prescribed by law. But it was abrogated. This opened the flood gates for automatic monetization of the fiscal deficits. But Dr Man Mohan Singh through the Supplemental Agreements with the RBI gave up the government’s claim to demand the Central Bank to fund the fiscal deficit through money printing.

If the Central Bank wants to go back to the Currency Board days it has to consider Reserve backing not in terms of Gross Foreign Reserves but Net Foreign Reserves after deducting short-term Inter-bank liabilities in foreign currency and short term liabilities on debt as well as portfolio balances in shares held by foreigners for they can flow out in a twinkle. It must also deduct foreign currency deposits and foreigners holdings of Treasury Bills. A backing of Net Foreign Reserves to Currency of 40% was recommended by the Capital Account Convertibility Committee in India. S.S. Tarapore in his book "Capital Account Convertibility- Monetary Policy and Reforms says "had the earlier stipulation ( 40% ratio) not been abrogated, an unbridled expansion of currency relative o the reserves would not have been possible in 1990-91 and remedial measures would necessarily have had to be put in place long before the balance of payments situation reached crisis levels ( in July 19991 the ratio fell critically to 14% and we had a totally un manageable situation).