“Macroeconomic Dynamics of Forex Reserves and

Currency-Index Relationships: Evidence from VAR,

ARIMA, and Granger Causality Analysis.”

Capstone Project

B.Sc. Finance Semester VI

Mentor: Dr. Ketan Mulchandani

Submitted by:

Name Roll Number

Harshit Nagpal A017

Esha Vora B015

Rishika Bisani B039

Swarangee Patel B048

Yashvi Shah B057

SVKM’s NMIMS Anil Surendra Modi School of Commerce 2023

 Acknowledgement

We express our sincere gratitude to Mrs. Sangita Kher, Dean, ASMSOC, NMIMS, Mumbai
for providing this opportunity to work on such an extensive project. We also could not have
undertaken this journey without our mentor Dr. Ketan Mulchandani, who guided us to
prepare the project with his valuable knowledge, expertise, time, and kind supervision at
every step of the way. We are also grateful to the other faculty, classmates, and our friends
for their invaluable patience and feedback. Their belief in us has kept our spirits and
motivation high during this process.

I
 Declaration

We, Group. 26 of TYBSc. Finance, declare that this report for our Capstone Project, titled
“Macroeconomic Dynamics of Forex Reserves and Currency-Index Relationships: Evidence
from VAR, ARIMA, and Granger Causality Analysis.” Submitted to Narsee Monjee Institute
of Management Studies, is a record of original work and research conducted by us under the
guidance of our mentor Dr. Ketan Mulchandani. All information included in this report, to
the best of our knowledge, is authentic. This report has not been submitted to any other
institution for the award of a published before. The information derived from the literature
has been duly acknowledged in the text and a list of references provided.

II
Index of Contents
1. Introduction......................................................................................................................1

2. Literature Review..............................................................................................................2

3. Objective:...........................................................................................................................6

4. Data Collection & Variables Used:..................................................................................6

5. Research Methodology:....................................................................................................8

5.1 Vector Autoregression (VAR)...........................................................................................8

5.2 ARIMA................................................................................................................................9

5.3 Granger Causality Test....................................................................................................10

6. Findings & Analysis.......................................................................................................11

6.1 VAR analysis.....................................................................................................................11

6.2 ARIMA..............................................................................................................................13

6.3 Granger Causality:...........................................................................................................14

7. Government initiatives....................................................................................................17

8. Limitations......................................................................................................................18

9. Conclusion......................................................................................................................19

10. References...................................................................................................................20

11. Annexure.....................................................................................................................23

11.1 VAR:- Order Selection:...................................................................................................23

11.2 VAR output:-....................................................................................................................23

11.3 ARIMA Output:...............................................................................................................26

Index of Tables
Table 1 : Granger Causality Output.......................................................................................15

III
 “Macroeconomic Dynamics of Forex Reserves and
Currency-Index Relationships: Evidence from VAR,
ARIMA, and Granger Causality Analysis.”

Abstract

Foreign exchange reserves and foreign exchange rate play a significant role in the growth and
development of an economy. Macroeconomic factors such as inflation, GDP, money supply,
and FDI have an impact on exchange reserves and the central bank intervenes in the
mechanism of its maintenance. This research examines how macroeconomic factors affect
foreign exchange reserves and analyze the currency-index relationships in India. The study
uses VAR, ARIMA, and Granger Causality analysis to compare the accuracy of forecasting
Forex reserves and determine the impact of currency rates on various Nifty indices. Results
show that the VAR model is more accurate in predicting changes in Forex reserves than
ARIMA. The study also reveals that different industries are affected differently by changes in
currency values. The findings can assist policymakers in making informed decisions about
reserve management and developing effective policy frameworks for sustainable economic
growth.

Keywords: Forex Reserves predictions, Forex Rate impact, Indian Forex System,
Macroeconomic factors, Vector Autoregression (VAR), Granger Causality Test, ARIMA
Model.

1. Introduction

The Indian Rupee is primarily influenced by market forces, and the Reserve Bank of India
actively trades on the currency market to sustain and maintain low exchange rate volatility.
The phenomenon of exchange rate fluctuations is an important issue in international finance,
affecting multinational corporation administrators, international investors, importers, and
exporters. (Venkatesan & Ponnamma, 2017) describes the impact of several macroeconomic
factors on the exchange rate. Inflation, foreign exchange reserves, Gross Domestic Product,

1
money supply, current account deficit, FII, FDI, WPI, and other factors all have an impact on
the exchange rate. Forex is the foreign currency assets held by a country’s central bank or
other monetary authority. During times of economic uncertainty, these reserves are used to
support the value of the nation’s currency and maintain a consistent exchange rate. They may
also be used to purchase foreign currency to stabilize the domestic currency’s value. To
protect economies from abrupt fluctuations in exchange rates, nations must maintain adequate
foreign exchange reserves. To control the foreign exchange rate and maintain adequate
foreign exchange reserves, it is essential to identify the factors that influence India’s foreign
exchange reserves and model the factors that have a significant impact on them.

Foreign exchange reserves play a significant role in determining the value of a nation’s
currency. When a nation has greater foreign currency reserves, it can purchase more of its
currency, thereby enhancing its value. This is because people will seek to purchase the
currency with their foreign reserves, causing the demand for the currency to increase.
Conversely, when there are fewer foreign reserves, the domestic currency may lose value as
people seek to sell it in exchange for more valuable currencies. Therefore, foreign exchange
reserves play a significant role in determining the exchange rate between two currencies,
which ultimately impacts their respective values and has a significant impact on the
commercial sector.

The Reserve Bank of India reported that India's foreign exchange reserves stood at $576.76
billion as of February 3, 2023. India’s foreign exchange reserves consist of foreign currency
assets (FCA), gold reserves, special drawing rights (SDRs) and a reserve position with the
International Monetary Fund (IMF). India’s foreign exchange reserves are among the greatest
in the world, giving the nation a solid position on international financial markets. (The
Economic Times, 2023) The Reserve Bank of India administers the country’s foreign
exchange reserves and uses them to intervene in foreign exchange markets to maintain the
stability of the Indian rupee’s value.

In addition to foreign exchange reserves, macroeconomic factors play a significant influence

on the foreign exchange market. These factors influence the economic performance of a
nation, which in turn influences the value of its currency relative to other currencies. If a
nation has a higher economic growth rate than other nations, its currency will appreciate
against those of other nations. In contrast, if a nation’s economy is feeble or contracting, its
currency will depreciate relative to the currencies of other nations. In an open economy that

2
depends heavily on international trade, macroeconomic factors have a significant impact on
the foreign exchange markets. A key representation of this is the Swiss Economy.
Switzerland’s foreign exchange reserves are predominantly influenced by macroeconomic
factors such as interest rates; higher interest rates than other nations will attract foreign
investment, which can contribute to an increase in foreign currency reserves. The Swiss
National Bank (SNB) determines Switzerland’s interest rates, and any alterations to its policy
will affect the country’s FX reserves. As a flourishing economy can also attract foreign
investments, economic expansion will also affect foreign exchange reserves. (Bank for
International Settlements)

Therefore, the central bank and other market participants closely monitor macroeconomic
factors to determine the resilience of the economy and its capacity to withstand external
disruptions. It is essential to identify the factors that influence India’s foreign exchange
reserves and model the factors that have a significant impact on them to control the foreign
exchange rate and maintain adequate foreign exchange reserves.

This research paper aims to investigate the effect of macroeconomic factors on foreign
exchange reserves by analyzing how changes in these indicators influence the number of
reserves held by central banks. The purpose of this research is to aid policy makers in making
informed decisions regarding reserve management. The study will employ a variety of
quantitative and qualitative research techniques to analyze data and literature on
macroeconomic factors and foreign exchange reserves.

2. Literature Review

Various studies have been conducted to analyze the relationship and effect of macroeconomic
variables on foreign exchange reserves. Understanding this relationship enables effective
macroeconomic decision making. Forex reserves have been also used by many papers as a
variable in their study to determine the impact of reserves maintained by a country on other
macroeconomic variables.

In order to understand the forex mechanism, there are certain variables which form the basis
of these reserves and without understanding these we cannot study the forex reserves. A
research study conducted by (Narayanan & Dash, 2011) to identify and examine the most key
determinants of foreign exchange reserves. To achieve their objective, Maximum-Likelihood

3
Vector Error Correction Model (VECM) was used on reserves, imports and nominal
exchange rate. The results of the study enabled a conclusion that there exists a long term
cointegration relationship among forex reserves and different macroeconomic variables used
in the study, alongside identifying a shock to imports and exchange rate having a direct and
permanent impact on reserves and volatility. Similar can be observed in a study conducted by
(Venkatesan & Ponnamma, 2017) on Indian forex exchange rate wherein an examination of
relationship of the same was conducted with different macroeconomic variables such as
inflation, FOREX, GDP, money supply, interest rate and many more using Vector
Autoregression as one of their statistical tools.

Vector Autoregression as a tool has been used by researchers to determine the relationship
between forex reserves and currency rates with various macroeconomic variables, to name a
few, a study conducted on “Inflows and their Macroeconomic Impact in India,” was
conducted by (Sethi, 2012) analyzing the effect of private foreign capital inflows (FINV) on
India’s various macroeconomic variables such as currency exchange rate, inflation, money
supply, forex reserves and many more. The study revealed that macroeconomic consequences
of financial liberalization are the result of the combined influence of a government’s
monetary, fiscal, trade, and exchange rate policies, implying an existence of a strong
relationship between macro-economic decision making and forex reserves and currency rate
fluctuation impacting FDI. Another study conducted by (Azeem & Khurshid, 2019) made
use of statistical models such as Vector Autoregression and conducted Granger Causality to
estimate the adequacy of forex reserves where macroeconomic variables such as current
account deficit, exchange rate volatility, GDP, FDI were used. It was found that although
foreign reserves are less responsive to opportunity cost, they are strongly responsive to
capital account vulnerability. According to a study, factors like inflation and the ratio of
short-term external debt to GDP have a considerable long-term impact on foreign exchange
reserves. (Dash, Shylajan, & Dutta, 2017) which made use of Auto Regressive Distributed
Lag to arrive at the above-mentioned conclusion. Not only reserves, but also forex currency
fluctuations have been studied using VAR with different variables to identify and establish a
statistically significant relationship between different variables, such as a study by (Azu &
Nasiri, 2015) on “Exchange rate fluctuation and sustainable economic growth in Nigeria.” It
indicated that a regular analysis on similar background variables for different countries can
prove to be a supportive factor in policy decision making and economic development of
different economies.

4
A point to be noted here is that foreign exchange reserves and exchange rates have also been
used as independent variables for determination of many macroeconomic factors, one of them
being FDI in a study conducted by (Kohli, 2001) on macroeconomic implications of capital
inflows in India, suggested by running a cointegration test that both forex reserves and
foreign currency fluctuations form a part of determination of FDI along with many other
economic variables, which is also, in itself, a determinant of forex reserve adequacy, which
can be observed in many studies as above-mentioned. Another study on sovereign debt’s
impact on the exchange market and Forex was conducted by (Woolley, 2021) stating that
long term stress existed due to balance of payments, policy changes as well as inflation.

It is essential to understand if there exists any significant short term and long-term
relationship between forex reserves and the exchange rate, a study on the same by (Gokhale
& Raju , 2013) was conducted through VAR, Johansen Co-integration and ADF Test,
concluding that there exists no significant short-term or long-term association between the
two. However, the limitation of this paper pertains to the fact that the study was undertaken
taking only two variables, the effect of other variables affecting both forex reserves and forex
rates were not taken into consideration. Therefore, the paper suggests that the rise in foreign
exchange reserves may have been a pre-emptive measure to avert a financial crisis or to
attract FDI for economic growth, rather than to regulate exchange rates. However, it did not
consider other factors that could impact FOREX or EXR. The paper did not conduct further
research on these factors.

Foreign currency rate fluctuations play a significant role in determining the relationship
between forex reserves and other variables. USD, is commonly used as a base while carrying
out analysis in many papers. This currency plays a significant role in the determination of
reserves for another country. (Blinder, 1996) in the study conducted has highlighted the link
between the international use of a country’s currency to the centrality of that country in world
trade. The main objective of this paper was to determine the role of Dollar and the worth of
Dollar in international trade through a qualitative method as understanding currency
fluctuations act as a base for many statistical models.

Analyzing the magnitude of the influence of the link between foreign exchange reserves and
currencies with our economy as a whole is crucial. Boosting exports, getting remittances
from overseas, or accepting grants or loans from the government are the three ways to
increase foreign currency reserves. A study conducted by (Ray, 2012) on Forex and its

5
impact on the stock market of India, through various tests such as Unit Root Test, Simple
Linear Test and Granger Causality, concluded that forex reserves tend to have a significant
positive effect on stock market capitalization and granger causes stock market capitalization
in India, as shown by the Granger Causality Test. This research analyzes India’s reserves to
inform stock-related decisions. The study focuses only on the central bank’s reserves’ impact
on stock market capitalization, excluding overall growth and loans. A similar study was
conducted by (Matha, E., Kumar, & Raghavendra, 2022) examines the connection between
economic conditions and the sectoral indexes and stock market in India. The study discovered
that FX rates, oil prices, and FII flows have a discernible impact on India’s stock market
performance using the Johansen cointegration test and Granger causality. The analysis also
discovered that, with the exception of Nifty 50 and Nifty IT, there is a one-way relationship
between FX rates and market and sectoral indices and that the time series data was stable.
Furthermore, there was no, bidirectional, and unidirectional causation between GBP and
specific NSE sectoral indices.

Government policies and reforms have a cause-and-effect relationship with forex currency
fluctuations as there exists excessive government intervention to avoid currency crises. The
reason behind the same is that currency crises hold the potential of causing a downfall in the
economy. A study by (Liargovas & Dapontas, 2008) highlights how currency crises affect the
financial environment, by considering exchange rate, foreign reserves, and many more
variables. The study carried out a Categorical Regression Non-Parametric Uniform Model
(CATREG) to conclude that CPI, reserves, interest rates and money supply have a significant
predictive power with regards to occurrence of crisis. Therefore, there exists a need for
government intervention, as studied by (Karmarkar, Karamchandani , & Mantri, 2012) using
additional indicators other than above mentioned for various studies such as indicators of
financial market (central government, repo transactions, RBI open market operations). The
sectors covered being external, financial and real. The paper suggested that the exchange rate
is less significantly impacted due to the real sector.

For prediction of foreign exchange reserves and exchange rates, ARIMA as a statistical tool
has been incorporated by researchers in their study. (Kamruzzaman & Sarker, 2003) used
ARIMA to forecast forex rate along with Artificial Neural Network (ANN) recommending
that ARIMA is a reliable tool that can be used to for short-term forecasting as the quality of
forecast deteriorates with the increase of number of periods for the predicting phase. A

6
similar study was conducted by (Khushi & Zeng) wherein, additionally, based on their
findings, the researchers have added hedging and speculation strategies, indicating that the
paper demonstrates that the integrated system performs significantly better than single
recurrent neural networks and enables more accurate and desirable outputs.

It is essential to verify the impact of different variables on a regular basis to determine the
viability of already existing studies for future references and economic policy planning.

3. Objective:

1. Comparison between VAR Model and ARIMA Model to predict Forex Reserves of
India using macroeconomic variables, and determine the most accurate model between
the two.

2. Analysis of impact of Foreign Currency Rates on various NIFTY Indices tested

through output received from Granger Causality test.

4. Data Collection & Variables Used:

For the purpose of our first objective with regards to building of our model and analysis we
have made use of quarterly data available on below mentioned variables from 1997 Q1 to
2021 Q4, subject to availability of the same:

1. Foreign Exchange Reserves (FXR): Foreign Exchange Reserves are held by the central
bank of a nation, in our case RBI, in the form of cash reserves in the form of foreign
currencies and other assets. They form a part of the balance of payment of a nation and
are used to influence monetary policies. 1

2. Foreign Direct Investment (FDI): It forms the primary source of external capital as
well as direct revenues for the country. Therefore, it is essential to analyze the impact
it has on the foreign reserves of a country. 2

1
https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!2
2
https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!2

7
 3. Inflation (INF): It refers to a general rise in the price levels in a country. This increase
leads to a direct impact on the purchasing power of the consumers within the country
as well as outside the country. Thus, this factor plays a significant role in our study. 3

4. Gross Domestic Product (GDP): Global Domestic Product measures the monetary
value of all the final goods and services which are produced in India in a given period
of time. This helps us understand the overall health and potential growth of a country.
GDP releases impact many factors. Thus, this factor also has to be taken into
consideration in our test. 4

5. Net Exports as a % of GDP (EXP): Net Exports refer to the value of exports exceeding
the value of goods imported by the country. We use this value for computation of
GDP as well as forex reserves. In our study, % of GDP has been taken for better
representation of contribution of net exports in the economic growth and development
of the country. 5

6. Exchange Rate (ExRt): Exchange rate refers to the relative price of one currency in
terms of another currency. This is a key factor responsible for maintaining relations
with other countries. It becomes necessary to study this factor in order to analyze the
forex reserves of a country. The exchange rate used for our study is as against the US
Dollar. 6

7. Short Term Debt (Debt): The obligation which is to be paid within a period of 12
months or current fiscal year is termed as short-term debt. They are also called current
liabilities. Therefore, we have considered this as our independent variable. 7

8. Nifty 50: The Nifty 50 index, which reflects the weighted average of 50 of the largest
Indian firms listed on the National Stock Exchange, is one of the benchmark indices
for the Indian stock market. 8

9. Money Supply (M3): The expansion of cash and other liquid assets in an economy on
the measurement date is known as the money supply. Additionally, this includes all

3
https://fred.stlouisfed.org/series/INDCPIALLQINMEI
4
https://fred.stlouisfed.org/series/NAEXKP01INQ652S
5
https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!2
6
https://finance.yahoo.com/quote/INR%3DX/history?p=INR%3DX
7
https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!2
8
https://www.niftyindices.com/reports/historical-data

8
 money in circulation and all bank deposits that the account holder can as easily convert
to money in circulation. 9

10. 91- day T-bill Rate (T-bill): these form a part of the money market instruments, short
term in nature. T-bills are issued by the government of India and issued in tenors of 91,
182 or 364 days. They are zero coupon bonds and pay zero interest. 10

For conducting analysis on our second objective, we have extracted daily data on the below
mentioned variables from 1st January 2018 to 6th March 2023:

1. Nifty Indices: Nifty 50, Nifty FMCG, Nifty Metal, Nifty Consumer Durable, Nifty Oil
& Gas, Nifty IT, Nifty FinServ, Nifty Auto, Nifty Media, Nifty Realty, Nifty Private
Bank, Nifty PSU, Nifty Pharma. 11

2. Currency Pairs: GBPINR12; USDINR13; JPYINR14; EURINR15

5. Research Methodology:

5.1 Vector Autoregression (VAR)

VAR stands for Vector Autoregression, which is a statistical method used to model the joint
behavior of multiple time series variables, deriving from the mathematical meaning of vector
meaning direction where we arrange different variables into various columns. (VAR) model
is called the VAR (p) model where in p equals the number of lagged values of the data, which
in case of the model used in this paper would be VAR (10) model which is Multivariate
VAR. Multivariate VAR models are commonly used in macroeconomic analysis, finance,
and other fields where multiple economic variables are analyzed together. It can also be used
for impulse or shock response analysis. (shocks/impulse is the white noise error term)

One of the essential requirements to apply the VAR model on any dataset is that the time
series data which is to be analyzed should be stationary. The stationarity can be tested by
9
https://fred.stlouisfed.org/series/MABMM301INQ189N
10
https://www-indiastat-com.svkm.mapmyaccess.com/table/auctions-of-govt-of-india-treasury-bills/monthly-yield-sgl-
transactions-treasury-bills-resi/8436
11
https://www.niftyindices.com/reports/historical-data
12
https://finance.yahoo.com/quote/GBPINR%3DX/history?p=GBPINR%3DX
13
https://finance.yahoo.com/quote/INR%3DX/history?p=INR%3DX
14
https://finance.yahoo.com/quote/JPYINR%3DX/history?p=JPYINR%3DX
15
https://finance.yahoo.com/quote/EURINR%3DX/history?p=EURINR%3DX

9
running an Augmented Dickey-Fuller (ADF) test on the variables to be analyzed through
VAR. This can be confirmed by checking the tau stat and tau crit values arrived through ADF
test. If the absolute value of tau stat is greater than the absolute value of tau crit then the data
is considered to be stationary. (Gujarati, Topic in time series econometrics , p. 240) In the
analysis of variables undertaken for this study, an ADF test has been conducted to ensure
stationarity of variables.

For the purpose of forecasting with the help of VAR, the coefficients generated from the
models are used for estimating the value of our dependent variable, wherein for Yt+1 we input
values of Xt for all the independent variables used for analysis and model building. We have
used a typical vector autoregressive model to understand the variables concerned and capture
the linear interdependencies. These variables depend on a certain number of lags.

The macro-economic variables describe the diversity and broad concepts of the Indian
financial system. These variables are divided on the basis of their roles and functions.

The study is conducted to predict foreign exchange reserves using variables such as FDI,
Inflation, GDP, Net Exports as % of GDP, Exchange Rate as against USD, Short Term Debt,
Nifty 50, Money Supply and 91-day T-bill rate as independent variables.

Some of these factors are non-stationary in nature, thus, by taking a change in the variables
we will get a better result and a picture. For running VAR in Python we have made use of
Jupyter Notebook and with the help of libraries like NumPy, pandas, statsmodels.tsa.api,
statsamodels.tsa.stattools, statsmodels.tsa.statespace.varmax, Then the same dataset as
explained above was used to find the AIC, BIC, FPE and HQIC and the lag which had most
of the values least was considered, over here the lag being 3, therefore the order of the
model was (3,2).

5.2 ARIMA

ARIMA or Auto Regressive Integrated Moving Average model is a ARIMA(p,d,q)

(ARIMA(1,0,1) model in this case) model which is used on data which is stationary or can be
made stationary by differencing it one or more times where in:

1. We arrive at the p value from the AR part of the model which is obtained by running
the PACF (Partial Autocorrelation Function) test.

10
 2. We arrive at the q value from the MA part of the model which is obtained by running
the ACF (Autocorrelation Factor) test.

3. The part ‘d’ denotes the number of times a time series has been differentiated to make
it stationary.

For both the ARIMA and VAR model an equation is obtained in conclusion which can be
used to forecast future values, which would be an unconditional ex-ante point forecasting.
For running Arima in python we used Jupyter Notebook and libraries like pandas,
statsmodels.api and statsmodels.tsa.arima.model, initially we imported the CSV data file
which had the LN values of all the variables namely: Forex Reserves, FDI, Inflation, GDP,
Net Exports, Exchange Rate, Short Term Debt, Nifty 50, M3 and T-Bill, as a DataFrame and
with the help of statsmodels module we executed the module by keeping Y variable as Forex
Reserves and rest as Exogenous Variables, and instead of running the ADF test we used the
by-default function of enforcing stationarity, we used all the combinations of order (1,0,1) ,
(1,0,2) , (2,0,1) and (2,0,2) and chose the model with least AIC and did predictions for the
same. (Gujarati)

5.3 Granger Causality Test

Granger’s causality test is used to identify the relationship between variables. Granger
Causality is a test that is used to determine whether one set of time series can be used to
predict a second set of time series variables and by doing this it establishes a relationship
between the variables that make use of this test. It is commonly used in analysis of financial
time series wherein relationship between complex economic variables is analyzed and
interdependency is identified. It is also used as a pre-test or prerequisite test that is optional in
nature to create VAR Models to verify which variables are related to each other and which
variables are distinct.

We distinguish the causality into 4 different cases:

1. Unidirectional causality from A to B

2. Unidirectional causality from B to A

3. Feedback or Bilateral Causality

11
 4. Independence

To perform this test manually without use of any ready software or command, we take out a
restricted regression without the lagged values and then we perform an unrestricted
regression with the lagged values. The next step is to create a null hypothesis and test it using
the F value, if the computed F value exceeds the critical F value at chosen level of
significance, then we reject the null hypothesis. We also obtain a cross matrix of p values
between the various nifty indices and the currency basket exchange rates. (Gujarati).

6. Findings & Analysis

6.1 VAR analysis

Vector Autoregression has been carried out for predicting Forex Reserves with different
economic variables that it is dependent on. The independent variables used in this study
include FDI, Inflation, GDP, Net Exports as a % of GDP, Exchange rate as against Dollar,
Short Term Debt, Nifty50, M3 (Money Supply) and 91-day T-bill rate. The log of change of
each of these variables except for Inflation and 91-Day T-Bill Rate has been used for analysis
and a model has been implemented on these values. Prior to implementation of the VAR
Model, a prerequisite is to check for stationarity of the variables in study. These variables
have been checked for stationarity through Augmented Dickey-Fuller (ADF) test, after which
the VAR model has been implemented on the stationary variables.

The test has been implemented and results have been arrived at by carrying the test out on
Python.

Values for Forex as dependent variable and other factors as independent x variable:

1. AIC or Akaike Information Criterion is a statistical way for evaluating how well the
model fits the data it was generated from, AIC for different models generated as an
output of the python code were compared and AIC with the least value was chosen as
that is the one with the best model fit.

2. SIC aka Schwarz Information Criterion also does the same job as an AIC, it similarly
adds a penalty on including unnecessary independent variables. Lower the SIC, better
the model.
12
 3. HQIC or Hannan Quin Information Criteria works similarly way to the AIC but
imposes a bigger penalty than AIC which also means its more accurate than AIC. It
also signifies that there are fewer explanatory variables along with it being a better fit.

For our model, the output of VAR Order Selection is as follows that has been used :

1. AIC: -54.45

2. SIC: -71.501

3. HQIC: - 837.283

4. Log Likelihood: 1235.951

Equation for predicting Change in Forex Reserves.

∆ln FXR (Yt) = 8.6216 + 0.6150 * ∆ln FXR(t-1) + 0.0173 * ∆ln FDI(t-1) – 0.5184 * INF(t-1) –
3.195 * ∆ln GDP(t-1) – 0.0710 * ∆ln EXP(t-1) + 0.8964 * ∆ln ExRt(t-1) + 0.1485 * ∆ln Debt(t-1) +
0.1416 * ∆ln Nifty50(t-1) – 1.5302 * ∆ln M3(t-1) + 4.2195 * T-bill(t-1) – 0.0355 * ∆ln FXR(t-1) +
0.0205 * ∆ln FDI(t-1) + 0.1908 * INF(t-1) – 2.9689 * ∆ln GDP(t-1) -0.1329 * ∆ln EXP(t-1) +
0.6225 * ∆ln ExRt(t-1) + 0.0106 * ∆ln Debt(t-1) + 0.2091 * ∆ln Nifty50(t-1) + 0.1648 * ∆ln M3(t-
 – 1.8780 * T-Bill(t-1) – 0.2652 * ∆ln FXR(t-1) + 0.0090 * ∆ln FDI(t-1) + 0.6829 * INF(t-1) –
1)

1.1081 * ∆ln GDP(t-1) + 0.0809 * ∆ln EXP(t-1) – 0.3374 * ∆ln ExRt(t-1) + 0.0374 * ∆ln Debt(t-1) –
0.0588 * ∆ln Nifty50(t-1) – 0.6737 * ∆ln M3(t-1) – 2.8368 * T-bill(t-1) + et

Where: Log – Log Model; ∆ : Delta (Change); FXR : Forex Reserves; FDI : Foreign Direct Investment;
INF : Inflation; GDP : Gross Domestic Product; EXP : Net Exports as a % of GDP; ExRt : Exchange
Rate (Dollar/Indian Rupee); Debt : Short Term Debt; Nifty 50 : Nifty 50 Index; M3 : Money Supply; T-bill
: 91-day T-bill Rate.

We obtained a VAR model with 3 lags as a result of the python code which implies that the
first lag and the second lag data also affect the model which has been obtained with three
lags, thus the equation would include all the intercepts that are there in the output till the
intercepts of the third lag. (Refer to annexure for python output)

We observe that FDI has a positive relationship with Forex Reserves which means that one
would see an increasing trend on forex reserves with a positive change in FDI. Inflation and

13
Nifty50 have mixed results for different lags. GDP on the other hand has an opposite effect
on forex reserves, meaning an increase in GDP would lead to a fall in forex reserves. A
positive change in short term debt affects the forex reserves positively which can be
interpreted as forex reserves having an increase if short term debt has a positive movement.
Regarding the effect of T-bills on forex reserves, as the coefficient values do not follow a
trend, an absolute relationship cannot be drawn from the given equation. As for money
supply, its increase is seen when there is an increase in the budgetary fund, so forex reserves
also increase with increase in money supply unless they decrease due to some other factors.
To test or predict the values for the change in forex reserves one can input the values of the
previous quarter for which the values need to predicted.

6.2 ARIMA

ARIMA Equation:

∆ln FXR (Yt) = 11.6921 – 0.1238 * ∆ln FDI(t-1) + 0.4911 * INF(t-1) + 6.9224 * ∆ln GDP(t-
 – 0.0871 * ∆ln EXP(t-1) – 0.5688 * ∆ln ExRt(t-1) – 0.2394 * ∆ln Debt(t-1) – 0.5447 * ∆ln
1)

Nifty50(t-1) + 2.3072 * ∆ln M3(t-1) + 3.3515 * T-Bill(t-1) + 0.7335(ar.L1) * ∆ln FXR( t-1) –

0.2768(ma.L1) *  ∆ ln(et-1)+ et

Where: Log – Log Model; ∆: Delta (Change; FXR : Forex Reserves; FDI : Foreign Direct Investment;
INF : Inflation; GDP : Gross Domestic Product; EXP : Net Exports as a % of GDP; ExRt : Exchange
Rate (Dollar/Indian Rupee); Debt : Short Term Debt; Nifty 50 : Nifty 50 Index; M3 : Money Supply; T-bill
: 91-day T-bill Rate; FXR t-1 - Forex Reserves at the previous time period; et-1 - error term at the
previous time period

We obtained the following ARIMA model of order (1,0,1) as it has the lowest AIC of
158.927 and the other models have order (1,0,2) as an AIC of 160.575, (2,0,1) as an AIC of
161.181 and (2,0,2) as an AIC of 162.847, the model with lowest AIC has best fit.

(Refer to the annexure for python output)

In the above obtained equation we can see that FDI, net exports, exchange rate, short term
debt, and Nifty 50 have had a negative impact on forex reserves as per ARIMA, which means
that for 1% increase in the value of FDI the value of forex reserves will decrease by 0.1177%,
1% increase in the value of net exports will decrease the value of forex reserves by 0.0872%
whereas when exchange rate increases by 1% then forex reserves will again decrease by

14
0.325%, forex reserves will decrease by 0.2394% if the value of short term debt increases by
1% and forex reserves will decrease by 0.5447% if the value of Nifty 50 will increase by 1%.

Whereas inflation, GDP, M3 and T-Bills has a positive impact on forex reserves equation, as
when inflation increase by 1% then the value of forex reserves will also increase by 0.4911%,
if the value of GDP increase by 6.9224%, the value of forex reserves will increase by
2.3072% when M3 increases by 1% and the value of forex reserves will increase by 3.3515%
if the value of T-Bills increase by 1%. The major positive impact of the following is of T-
Bills which is 3.3515%. For ar.L1 and ma.L1 lag terms, if the foreign exchange of the
immediately previous time period increases by 1% then forex reserves will increase by
0.7335% whereas the reserves will decrease by 0.2768% if the error term of the immediately
previous time period increases by 1%.

If we back test or check which model would give us a more appropriate figure, VAR would
emerge as a clear-cut prediction model which also implies that ARIMA is not a proper fit for
the chosen topic and also wasn’t accurate for forecasting any future values.

6.3 Granger Causality:

Granger Causality is a test that is used to determine whether one time series can be used to
predict a second set of time series variables and by doing this it establishes a relationship
between the variables that make use of this test. It is commonly used in analysis of financial
time series wherein relationship between complex economic variables is analyzed and
interdependency is identified.

The Granger Causality Test is based on a hypothesis that investigates the nature of the
study’s objective, which is to determine how changes in foreign exchange rates affect the
Indian Stock Exchange. Various Nifty Indices have been considered and tested in order to
develop a hypothesis that summarizes a representation of the Indian Stock Exchange and to
better assess the impact of currencies on specific sectors. The currency pairs undertaken for
the study include the four currency pairs that form a part of the currency basket of Indian
Forex Market, are as follows: GBPINR, USDINR, JPYINR, EURINR.

To test if these currency pairs lead to any impact on the Indian Stock Market, sector wise, the
variables undertaken for our study include Nifty Indices as follows: Nifty50 as it is a
representative of the overall market’s largest 50 companies, followed by sectoral indices such

15
as Nifty Realty, Nifty Pharma, Nifty PSU, Nifty Private Bank, Nifty IT, Nifty Oil & Gas,
Nifty Consumer Durables, Nifty Metal, Nifty Auto, Nifty FMCG, Nifty Fin Serv & Nifty
Media. The test was conducted on python.

The Hypothesis for Granger Causality test is as follows:

H0: Forex Rate does Granger Cause NIFTY Indices

H1: Forex Rate does not Granger Cause NIFTY Indices.

The null hypothesis states that there exists no causal relationship between currency pairs and
Nifty Indices. The output of the test is in the form of p values and the decision making of
whether the currency granger causes a Nifty Index is based on this output. If the p value of a
currency pair and a Nifty Index is less than 5% or 0.05, the null hypothesis is rejected. Prior
to running the test, it is essential to analyze if the variables included in the study are
stationary or nonstationary, which can be verified through Augmented Dickey-Fuller (ADF)
Test. After verifying the stationarity of the variables, the test was run on python to arrive at
the following output:

Table 1 : Granger Causality Output

USD_x JPY_x GBP_x EUR_x

Nifty50_y 0.0001* 0.1272 0.0082* 0.0199*

NiftyRealty_y 0.0337* 0.2317 0.4549 0.1397

NiftyPharma_y 0.0886 0.6306 0.0235* 0.1253

NiftyPSU_y 0.0572 0.2002 0.5147 0.3636

NiftyPrivateBank_y 0.0001* 0.1026 0.0236* 0.0587

NiftyIT_y 0.0001* 0.394 0.0008* 0.0146*

NiftyOilandGas_y 0.0024* 0.316 0.1448 0.0949

NiftyConsumerDurables_y 0.0011* 0.0335* 0.0442* 0.0213*

NiftyMetal_y 0.0205* 0.0838 0.7235 0.0534

NiftyAuto_y 0.0036* 0.5934 0.0084* 0.0476*

NiftyFMCG_y 0.0057* 0.0155* 0.0009* 0.0011*

16
 NiftyFinServ_y 0* 0.0647 0.0138* 0.0436*

NiftyMedia_y 0.0007* 0.0394* 0.16 0.5198

Source: Python Output based on test conducted.

By running the test on our variables, and with reference to above mentioned output generated
through Python, analysis done for the same is as follows:

First looking at US Dollars, we see a significant relationship with majority indices except
Nifty PSU and Nifty Pharma, as the p-value is greater than 0.05 i.e., insignificant. Nifty PSU
is represented by stocks like (Money Control, 2023) Biocon, Glenmark Pharma, Cipla,
Aurobindo Pharma, Sun Pharma along with 16 other stocks. There seems no significant
impact on these companies due to movement in the USD/INR currency rates.

Another frequently traded currency is the Japanese Yen. Looking at the p-values we come to
know that this currency does not have a major impact on most of the indices and significantly
impacts only nifty consumer durables, nifty FMCG, nifty Media. The consumer durable
index includes the following companies like Havells India, VIP industries, Voltas, Whirlpool
Of India, Bata India, Bajaj Electricals and 8 others. (Equity Master, 2023)

The FMCG sector which has been observed to be affected by JPY/INR includes companies
like: HUL, ITC, Varun Beverages, Nestle, Emami etc (Money Control, 2023) and Nifty
Media Index, it includes the following stocks: Nazara, TV18BRDCST, INOXLEISUR,
SUNTV, SAREGAMA, Hathway, Zeel, PVR and DishTV. (Money Control, 2023)

Several sectors of the Indian stock market, including Nifty 50, Nifty Pharma, Nifty Private
Banks, Nifty IT, Nifty Consumer Durables, Nifty Auto, Nifty FMCG, Nifty Finserv, and
Nifty Media, are susceptible to fluctuations in the GBP/INR exchange rate as the p value is
significant and thus there is a significant impact.

The fluctuations in the EUR/INR exchange rate effect several sectors and indices of the
Indian stock market, including Nifty 50, Nifty IT, Nifty Consumer Durables, Nifty Auto,
Nifty FMCG, and Nifty FinServ, are susceptible.

17
7. Government initiatives

By maintaining a substantial quantity of foreign exchange assets, India's foreign reserve

policies aim to ensure the nation's external sector security. The Reserve Bank of India
adheres to a flexible exchange rate system, which means that exchange rates are determined
by market forces with occasional interventions by the central bank to prevent excessive
market instability. The Foreign Trade Policy 2023 was introduced on March 31, 2023 by Shri
Piyush Goyal, Minister of Commerce and Industry, Consumer Affairs, Food and Public
Distribution, and Textiles for the Union. (Press Information Bureau, 2023) The FTP has been
left open-ended in order to accommodate emerging demands. The policy's Key Approach is
founded on the following four pillars:

1. Incentive to Remission : The government is committed to reducing litigation and

developing confidence in order to assist exporters. The "Vivaad se Vishwaas" initiative
sought to resolve tax issues amicably; consequently, the government proposes a one-
time Amnesty Scheme under the FTP 2023 to address export obligation defaults. This
initiative is intended to assist exporters who have failed to comply with EPCG and
Advance Authorization requirements and who are facing costly duty and interest costs
as a result of pending cases. All pending cases of authorization default can be
regularised upon payment of all customs duties exempted in proportion to unfulfilled
Export Obligation (EO). This proposal limits interest at 100 percent of tax exemptions.
The paucity of interest in Additional Customs Duty and Special Additional Customs
Duty will benefit exporters. This amnesty should provide these exporters with the
opportunity to conform. (Press Information Bureau, 2023) &

2. Export promotion through collaboration - Exporters, States, Districts, Indian Missions :

"The FTP seeks to establish partnerships with state administrations and advance the
Districts as Export Hubs (DEH) initiative in order to promote district-level exports and
accelerate the development of a local trade ecosystem. Each district must devise
district-specific export action plans that outline the district's strategy for promoting the
export of specified goods and services." (Press Information Bureau, 2023)

3. Ease of doing business, reduction in transaction cost and e-initiatives : FTP 2023
codifies execution methods in a paperless, online setting, expanding on previous "ease

18
 of doing business" initiatives. Fee reductions and IT-based programmes will facilitate
MSMEs' and others' access to export benefits. (DrishtiIAS, 2023)

4. Emerging Areas – E-Commerce Developing Districts as Export Hubs and streamlining

SCOMET policy : The FTP aims to establish partnerships with state administrations
and advance the Districts as Export Hubs (DEH) initiative in order to promote district-
level exports and expedite the development of a local trade ecosystem. Each district is
required to develop district-specific export action plans that outline the district's
strategy for promoting the export of specified goods and services. (DrishtiIAS, 2023)

8. Limitations

Understanding the constraints of a study is just as important as conducting the analysis.

Describing the limitations also helps develop a holistic perspective towards the study.
Following are some limitations of our study:

1. There existed lack of availability of data. Our study comprised of data points for the
variables from 1997 Q1 to 2021 Q4, subject to availability of independent and
dependent variables. This led to lesser number of variables for us to base our model on.
Monthly data on factors such as forex reserves, FDI, GDP, etc. is not published by the
Government Authorities

2. The conclusion given by the study is limited to the results we got from the three
models namely VAR, ARIMA and Granger Causality

3. The paper represents a particular time frame and predicts the output. This output is a
possibility and does not demonstrate certainty. Thus, the conclusion might not give us
the desired result at all times 

4. This model can only be used by economies that share a similar relationship between
the macroeconomic variables and forex reserves as India. Therefore, this model might
prove to be of limited use for countries that have a different economic system as
compared to India

5. The limitations of the models used can hinder the accuracy of our predictions.

19
9. Conclusion

Conclusion can be drawn that the predictions provided by VAR are much more accurate and
appropriate than the predictions obtained using ARIMA, and as a result, a VAR model for
such data that involves various macroeconomic factors that could affect forex reserves would
be the ideal choice to make if one were attempting to forecast the change in forex reserves.

As for the granger causality, there are some factors, such as Nifty FMCG and Nifty
Consumer Durables, that are caused or affected by all four currencies in the currency basket,
which includes the US Dollar, the Japanese Yen, the British Pound, and the Euro. Both the
automotive and financial services industries are unaffected by changes in the value of the
Yen, despite the fact that shifts in the majority of currencies would have such an effect or
cause. Because it is a Public Sector Undertaking, a change in any of the worldwide currency
rates has essentially no influence on the Nifty PSU. This is because the government of India
provides the majority of the funding for PSUs, which means that this type of funding is
stable.

In conclusion, forex reserves and their dynamics are crucial for long-term policymaking,
especially after an economic uncertainty like the COVID-19 epidemic. Forex reserves help
monetary policy manage external shocks and maintain financial stability. Understanding
forex reserve management can help policymakers determine the ideal level and composition
of reserves and the risks and benefits of different strategies. The epidemic triggered a global
economic slump, with governments facing unprecedented hurdles in maintaining financial
stability and managing its effects. Forex reserves have helped countries cope with the
pandemic's economic impact. (Luis Brandao Marques, 2020)

Moreover, as the global economy continues to evolve and face new challenges, ongoing
research into forex reserves and their dynamics will be crucial for developing effective policy
frameworks that can support sustainable economic growth and resilience. It is therefore
essential for policymakers to continue to prioritize the study of forex reserves and their
dynamics, in order to ensure that they have the tools and knowledge necessary to navigate
future economic challenges.

20
10. References

1. Azeem, M., & Khurshid, M. (2019). Impact of macroeconomic variables on foreign

exchange reserves: A case from Pakistan. Economic Journal of Emerging Markets,
173-182.

2. Azu, N. P., & Nasiri, A. (2015). Exchange rate Fluctuation and Sustainable Economic
growth in Nigeria: VAR Approach. Journal of Economics and Sustainable
Development, 228-237.

3. Bank for International Settlements. (n.d.). Committees & Associations; Switzerland

Currency Area Overview. Retrieved from BIS:
https://www.bis.org/mc/currency_areas/ch.htm

4. Blinder, A. S. (1996). The role of the dollar as an international currency . Palgrave

Macmillan Journals.

5. Dash, A. K., Shylajan, C. S., & Dutta, S. (2017). An Empirical Analysis of

Macroeconomic Variables Affecting Foreign Exchange Reserves Accumulation in
India. Journal of Applied Business and Economics Vol. 19(5) , 69-80.

6. DrishtiIAS. (2023). Daily Updates; Economy. Retrieved from DrishtiIAS:

https://www.drishtiias.com/daily-updates/daily-news-analysis/foreign-trade-policy-
2023

7. Equity Master. (2023). Nifty Consumer Durables Stock. Retrieved from Equity
Master: https://www.equitymaster.com/stockquotes/1-79/list-of-nifty-consumer-
durables-stocks

8. Equity Master. (2023). Nifty Consumer Durables Stocks. Retrieved from Equity
Master: https://www.equitymaster.com/stockquotes/1-79/list-of-nifty-consumer-
durables-stocks

9. Equity Master. (2023). Nifty Consumer Durables Stocks. Retrieved from Equity
Master: https://www.equitymaster.com/stockquotes/1-79/list-of-nifty-consumer-
durables-stocks

21
 10. Gokhale, M. S., & Raju , J. (2013). Causality between Exchange Rate and Foreign
Exchange Reserves in the Indian Context. Bangalore.

11. Gujarati, D. (n.d.). Time Series Econometrics. In D. Gujarati, Econometrics by

Example (pp. 261-284).

12. Gujarati, D. (n.d.). Topic in time series econometrics . In D. Gujarati, Econometrics by

Example (p. 240).

13. Kamruzzaman , J., & Sarker, R. (2003). Comparing ANN Based Models with ARIMA
for Prediction of Forex Rates.

14. Karmarkar, Y., Karamchandani , M., & Mantri, A. (2012). Exchange Rate and Macro-
economic indicators: A causal study for India of the past decade.

15. Khushi , M., & Zeng, Z. (n.d.). Wavelet Denoising and Attention-based RNN- ARIMA
Model to Predict Forex Price.

16. Kohli, R. (2001). Capital Flows and Their Macroeconomic Effects in India.
International Monetary Fund.

17. Liargovas, P., & Dapontas, D. (2008). Currency Crisis in Transition Economies: Some
Further Evidence . Taylor & Francis Ltd.

18. Luis Brandao Marques, C. E. (2020). COVID-19 Shock and Multilateral Aspects of
Foreign Exchange Intervention and Capital Flow Management Policies. IMF;
Monetary and Capital Markets.

19. Matha, R., E., G., Kumar, S., & Raghavendra. (2022). “Dynamic relationship between
equity, bond, commodity, forex and foreign institutional investments: Evidence from
India”. Investment Management and Financial Innovations; 19(4), 65-82, 65-82.

20. Money Control. (2023). Nifty FMCG Stocks. Retrieved from Money Control:
moneycontrol.com/indian-indices/nifty-fmcg-39.html

21. Money Control. (2023). Nifty Media Stocks. Retrieved from Money Control:
https://www.moneycontrol.com/indian-indices/nifty-media-50.html

22
 22. Money Control. (2023). Nifty PSU Bank. Retrieved from Money Control:
https://www.moneycontrol.com/indian-indices/nifty-psu-bank-43.html

23. Narayanan, K., & Dash, P. (2011). Determinants of Foreign Exchange Reserves in
India: A Multivariate Cointegration Analysis .

24. Press Information Bureau. (2023, March 31). Foreign Trade Policy 2023. Retrieved
from Press Information Bureau; Government of India:
https://pib.gov.in/PressReleaseIframePage.aspx?PRID=1912572

25. Ray, S. (2012). Foreign Exchange Reserve and its Impact on Stock Market
Capitalization: Evidence from India. International Knowledge Sharing Platform, 46-
60.

26. Sethi, N. (2012). Inflows and their Macroeconomic Impact in India a VAR Analysis.
The Romanian Economic Journal , 93-142.

27. The Economic Times. (2023, February 3). India's forex reserves drop by $1.5 billion to
$575.3 billion as on February 3. Retrieved from The Economic Times:
https://economictimes.indiatimes.com/news/economy/finance/indias-forex-reserves-
drop-by-1-5-billion-to-575-3-billion-as-on-february-3/articleshow/97802340.cms?
from=mdr

28. Venkatesan , T., & Ponnamma, M. (2017). An Analysis of Macroeconomic Factors

Affecting Foreign Exchange Rate.

29. Woolley, N. (2021). International Institute for sustainable development. IISD.

23
11. Annexure

11.1 VAR:- Order Selection:

11.2 VAR output:-

24
25
26
11.3 ARIMA Output:

27