Adequacy of foreign exchange reserves of a country is captured by which of the following indicators? 1. Reserves to import ratio 2. Reserves to external debt ratio 3. Reserves to GDP ratio 4. Reserves to monetary aggregates Select the correct answer using the code below:

Correct — D, 1, 2 and 4 only. Reserve adequacy asks a single question — are the reserves large enough to meet the claims that could fall on them? So every genuine adequacy indicator divides reserves by a potential claim. Imports are the claim in a trade shock, which gives the reserves-to-import ratio and its familiar 'months of import cover'. External debt, especially the short-term part falling due within a year, is the claim in a rollover crisis, which gives the reserves-to-external-debt ratio. Broad money is the claim if residents flee the domestic currency, which gives reserves to monetary aggregates. GDP is not a claim on reserves at all — it is the size of the economy — so the reserves-to-GDP ratio is a scaling measure, not an adequacy test, and statement 3 is the one that drops out.

• (a)1 and 3 only — Keeps import cover but throws away the two claim-based tests that matter most in a modern crisis — external debt and broad money — while retaining the one ratio that measures nothing anyone can demand from the reserves.
• (b)1, 2, 3 and 4 — The all-of-the-above option. It only works if you treat reserves-to-GDP as an adequacy measure, but GDP is a flow of output, not a liability that can be presented for payment in foreign currency.
• (c)2, 3 and 4 only — Drops import cover, which is the oldest and most quoted adequacy yardstick of all — the IMF's rule of thumb of at least three months of imports is stated in exactly those terms.

Foreign exchange reserves are held for safety and liquidity rather than return, so 'how much is enough' is judged against the obligations that could be presented in foreign currency. Three families of indicators do this. A trade-based one compares reserves with the import bill. A debt-based one compares reserves with external debt, in its strictest form with short-term debt on residual maturity. A money-based one compares reserves with broad money, capturing the risk that domestic deposit holders convert into foreign currency.

The examiner has built the item around one plausible-looking impostor. Reserves as a percentage of GDP is published, quoted and compared across countries — but it answers 'how big are the reserves relative to the economy', not 'can the reserves meet what may be demanded of them'. A small open economy can hold reserves worth 40% of GDP and still be short of its short-term debt; a large economy can hold 15% of GDP and be comfortable. This is also why the IMF's composite Assessing Reserve Adequacy metric is built from short-term debt, other portfolio liabilities, broad money and exports, and does not use GDP as a denominator. For India the numbers as of the December before this paper's period were comfortable on every claim-based test: reserves covered roughly nine months of imports and about 90% of total external debt.

• Import cover, the reserves-to-import ratio, is expressed in months; the IMF's conventional minimum is about three months of imports.
• The debt-based test in its strictest form is the Greenspan-Guidotti rule — reserves should at least equal external debt falling due within the next twelve months.
• The money-based test compares reserves with broad money, capturing the risk of residents converting domestic deposits into foreign currency.
• The IMF's Assessing Reserve Adequacy metric weights short-term debt, other portfolio liabilities, broad money and exports; GDP is not one of its components.
• India's reserves comprise foreign currency assets, gold, SDRs and the reserve tranche position in the IMF, with foreign currency assets much the largest part; import cover stood at 10.9 months at end-December 2024.

• Assuming that any published ratio involving reserves is an adequacy indicator.
• Choosing the all-of-the-above option in a four-statement item because each line sounds technical.
• Confusing total external debt with short-term external debt when applying the debt-based rule.

Asked as a four-statement code item where three lines are textbook adequacy ratios and the fourth is a real but differently-purposed ratio.

• practice — not a real PYQ

  The Greenspan-Guidotti rule on foreign exchange reserves says that a country's reserves should at least cover

  • (a)three months of imports
  • (b)external debt maturing within one year
  • (c)twenty per cent of broad money
  • (d)ten per cent of GDP

  Answer(b) external debt maturing within one year — the rule targets rollover risk on short-term external debt.

• practice — not a real PYQ

  Which one of the following is the largest component of India's foreign exchange reserves?

  • (a)Gold
  • (b)Special Drawing Rights
  • (c)Foreign currency assets
  • (d)Reserve tranche position in the IMF

  Answer(c) Foreign currency assets — they make up close to nine-tenths of the total, with gold a distant second.