Foreign exchange reserves (or forex reserves) refer to foreign assets held by the central bank of a country. Foreign exchange reserves comprise assets that are not denominated in the domestic currency of the country. It solidifies the strength of a country in times of crisis.
Foreign exchange reserves are assets like foreign currencies, gold reserves, special drawing rights (SDRs), bonds, and other government securities that are accumulated and controlled by the central government agency, Reserve Bank of India (RBI). These assets, which are of economic value, can be converted to cash anytime. The foreign currency comes in through exports, foreign investment, NRI deposits and external commercial borrowings (ECBs). Government banks hold on to what is required to support other forex outflows and the balance gets accumulated as reserves with RBI.
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A strong forex reserve is important to provide confidence to the markets, especially credit rating agencies that the country will be able to meet external obligations as and when it arises.
Why Does a Country Need Forex Reserves?
Forex reserves have several purposes but the most important one is to provide support, resilience and flexibility to the government in the following manner:
Back-up funds
The most significant objective of holding foreign exchange reserves is to ensure that the RBI has backup funds if the national currency rapidly devalues or becomes all together insolvent. If a foreign currency crashes significantly, the RBI can withstand the shock. During such times, access to borrowing is also curtailed. If a country has good reserves, then it will be able to withstand the shock because it typically holds other currencies.
Formulation of monetary/exchange rate policy
Foreign exchange reserves are used to influence the monetary policy. If the value of domestic currency decreases because of an increase in demand of the foreign currency (due to various reasons like high imports), then the government sells the dollar in the Indian money market so that depreciation of Indian currency can be checked.
Providing market confidence
A strong forex reserve is important to provide confidence to the markets, especially credit rating agencies that the country will be able to meet external obligations as and when it arises.
Where/How are Forex Reserves Kept?
Firstly, it is important to understand that forex reserves are not a box full of foreign currency. There are no physical currencies or bank notes that RBI has stored in its vault. These are rather assets (gold, bank account deposits, foreign sovereign bonds etc) that RBI has held in different forms in India and abroad.
Composition of Foreign Exchange Reserves
The forex reserves are divided into four main categories:
Foreign Currency Assets:
As much as 64% of the forex reserves are held in securities like Treasury bills of foreign countries, mainly the US while 28% is deposited in foreign central banks and 7.4% in commercial banks abroad. The RBI, who is the account holder of all these deposits, earns a regular income in the form of interest rate from these deposits.
Gold:
India held 653.01 tonnes of gold as of March 2020, with 360.71 tonnes being held overseas in safe custody with the Bank of England and the Bank for International Settlements, while the remaining gold is held at RBI’s Gold Vault in Nagpur.
Special Drawing Rights (SDRs):
SDR is an interest-bearing international reserve asset created by the International Monetary Fund (IMF). Think of SDRs as a nest egg kept by the IMF. Should a member suffer a capital outflow, it can draw on these rights. These drawing rights are an asset that appears only on a balance sheet. They are not certificates tradable in financial markets. SDRs can be exchanged for currencies held with the IMF. For instance, a country suffering from a financial emergency can exchange its SDRs for dollars and other major currencies.
Reserve Tranche Position:
SDR amount cannot be used by RBI without the permission of IMF. However, there is a quota assigned to every member and the percentage of that quota can be used as a transactionary amount. That amount is called Reserve tranche position which is accounted among a country’s foreign exchange reserves. Let us understand this with an example: Let’s say SDR consists of $100 million. So, the 25% (India’s quota) is the amount kept as reserve tranche i.e. $25 million. This amount can be used by RBI for buying and selling foreign currency or Indian currency.
How FX Reserves Affect the Country?
To answer this question, we need an understanding of what forex reserve does, how it affects the country’s dynamics or parameters like exchange rate, inflation, GDP, etc. and how RBI uses it to maintain a balance. We have already mentioned how these reserves add to a country’s strength, especially during the times of crisis. It is like extra cash, gold, savings that a common man keeps for emergencies.
Forex reserve and exchange rate management
Foreign exchange reserves are important to stabilise the Indian rupee. The exchange rate is decided by the market forces and the RBI intervenes only when the exchange rate falls below or above it’s comfort zone. Exchange rate works on the principle of demand and supply. If demand & supply of a currency then that currency appreciates with respect to other currencies and if supply & demand, it depreciates. Now, for instance, if our imports are very high or investors pull out money from India, the demand for dollar increases which depreciates the Indian rupee. In such a scenario, RBI uses the forex reserves to buy rupees and sell dollars in the forex market. Additional demand will stop rupee’s fall.
Forex reserves during economic crisis
Maintaining a foreign exchange reserve allows a country to import necessary commodities, otherwise not getting produced locally due to crises like a volcanic eruption or a flood. In such cases, the central bank aids the local exporter by liquidating its foreign reserve. The bank exchanges foreign currency to the local currency, enabling domestic exporters to import important items. Similarly, situations like wars, military coups, or political instability can make foreign investors apprehensive about investing in an unstable country. This can promote them to withdraw their deposits from the country’s bank, creating a foreign currency shortage. This can lead to inflation as imports will become expensive. If a country has enough foreign reserves/curren
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Maintaining a foreign exchange reserve allows a country to import necessary commodities, otherwise not getting produced locally due to crises like a volcanic eruption or a flood.
How Much Forex Reserves Should a Country Have? Do we have enough?
Ideally, a country must have enough foreign exchange reserves to support three to six months of importing essential commodities like food. It should have a reserve surplus to settle its debt payments and current account deficit (when a country imports more goods, services, and capital than it exports) of 12 months.
As per RBI’s report ‘Management of Foreign Exchange Reserves’ (May 8, 2020), the foreign exchange reserves cover of imports increased from 11.4 months as at the end of December 2019 to 12 months as at the end of March 2020. According to the same report (December 8, 2020), it further increased to 14.8 months as at the end of June 2020. From the above, one can infer that current level of reserves is more than adequate as per the import cover criterion. In other words, the level of reserves is in the high comfort zone.
Does RBI Earn Any Interest on Forex Reserves?
The return on India’s forex reserves kept in foreign central banks and commercial banks is very low. A substantial portion of reserves is invested in foreign government securities (mainly US) which bear a low rate of interest of around 1%. To enhance its earnings, RBI has started to invest a part of its reserves in high-yield securities outside the existing system of sovereign bonds.
However, the RBI focuses on liquidity (i.e. assets easily convertible into dollars when required) and safety. Though there have been demands from some quarters that forex reserves should be used for infrastructure development in the country. However, the RBI had opposed the plan. Several analysts argue for giving greater weightage to return on forex assets than on liquidity thus reducing net costs if any, of holding reserves.
Why are India’s Forex Reserves Rising?
Recently, India’s foreign exchange kitty surged 748 million in the week of January 8, 2021. The surge was mainly on the back of an increase in the value of foreign currency assets (FCA) held by the central bank, which constitutes a major component of the overall reserves. FCA rose by $150 million to $541.791 billion. The rise in forex reserves is attributed to increase in portfolio investments from offshore investors and also growth in the foreign direct investments (FDIs) during the period along with sharp fall in the volume and value of India’s imports as compared to exports. Fall in demand coupled with fall in the price of crude oil has brought down India’s oil import bill significantly, saving precious foreign exchange reserves.
