Which of the following statements is/are correct?

1. Most of India's reserves is held in the form of foreign currency.

2. There is no cost of holding foreign currency as reserves by a nation.

Select the correct answer using the code given below. 

The correct answer is 1 only.

Key PointsAnalysis of Statements

• Most of India's reserves being held in the form of foreign currency is a reflection of the country's strategy to manage its international trade and foreign exchange rates effectively. Foreign currency reserves are crucial for a country's economic stability, allowing it to pay off international debts, influence exchange rates, and maintain confidence in its financial markets.
  • These reserves are typically held in major global currencies like the US dollar, Euro, and British Pound, among others. Hence, statement 1 is correct.
• Contrary to the second statement, there is indeed a cost of holding foreign currency as reserves. This cost comes in various forms such as the opportunity cost of not investing these funds in potentially higher-yielding assets or domestic development projects. Additionally, there are actual costs associated with the management and security of these reserves.
  • Moreover, holding large amounts of a foreign currency can expose a country to currency risk if the value of that currency depreciates significantly. Hence, statement 2 is incorrect.

Additional Information

• The composition of a country's reserves is a strategic decision influenced by factors like trade patterns, currency stability, and economic policy goals. Foreign currency reserves play a pivotal role in ensuring a country's economic security and are a key indicator of its ability to engage in international trade.
• Opportunity cost is a critical concept in economics and finance, referring to the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. In the context of holding foreign currency reserves, the opportunity cost could be significant, especially for developing countries that could have otherwise used these funds for infrastructure, education, or healthcare.
• Currency risk, also known as exchange rate risk, arises from the change in the price of one currency against another. Countries managing large foreign currency reserves must carefully navigate this risk to protect the value of their assets.
• Understanding the dynamics of foreign exchange reserves is crucial for policy-making, especially in developing economies that are more vulnerable to external shocks. These reserves serve as a buffer against economic crises, allowing countries to support their national currencies when needed.