Context:  India’s foreign exchange reserves are rising and are slated to hit the $500 billion mark soon is  a reason to cheer  amidst a gloomy situation on the economic front due to the raging COVID-19 pandemic.

More on the news:

  • Unlike in 1991, when India had to pledge its gold reserves to stave off a major financial crisis, the country can now depend on its soaring foreign exchange reserves to tackle any crisis on the economic front.
  • This is when other economic indicators like the GDP growth is in contraction mode for the first time in 40 years and manufacturing activity and trade are at standstill.
  • Recently (in the month of may), forex reserves jumped by $12.4 billion to an all-time high of $493.48 billion (around Rs 37.30 lakh crore).
  • The level of foreign exchange reserves has steadily increased by 8,400 percent from $5.8 billion as of March 1991 to the current level.

What are forex reserves?

  • Forex reserves are external assets in the form gold, SDRs (special drawing rights of the IMF) and foreign currency assets (capital inflows to the capital markets, FDI and external commercial borrowings) accumulated by India and controlled by the Reserve Bank of India
  • The International Monetary Fund says official foreign exchange reserves are held in support of a range of objectives like supporting and maintaining confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency. 
  • It limits external vulnerability by maintaining foreign currency liquidity in order to absorb shocks during times of crisis or when access to borrowing is curtailed.

Why are forex reserves rising despite the slowdown?

  • Rise in FPIs and FDIs: The major reason for the rise in forex reserves is the rise in foreign portfolio investment(FPIs) in Indian stocks and foreign direct investments (FDIs). 
    • Foreign investors had acquired stakes in several Indian companies in the last two months. 
    • After pulling out Rs 60,000 crore each from debt and equity segments, FPIs  are expecting  a turnaround in the economy and bought stocks worth over $2.75 billion.
  • Fall in crude prices: On the other hand, the fall in crude oil prices has brought down the oil import bill, saving the precious foreign exchange. 
  • Overseas remittances and foreign travels have fallen steeply.

Significance of rising forex reserves:

  • Help in managing external and internal financial issues: The rising forex reserves give a lot of comfort to the government and the Reserve Bank of India in managing India’s external and internal financial issues at a time when the economic growth is set to contract by 1.5 per cent in 2020-21. 
  • A big cushion: In the event of any crisis on the economic front and also are enough to cover the import bill of the country for a year. 
  • Helps rupee to strengthen: The rising reserves have also helped the rupee to strengthen against the dollar. 
  • Provide level of confidence to markets: The foreign exchange reserves to GDP ratio is around 15 per cent. Reserves will provide a level of confidence to markets that 
    • a country can meet its external obligations, 
    • demonstrate the backing of domestic currency by external assets, 
    • assist the government in meeting its foreign exchange needs and external debt obligations and 
    • maintain a reserve for national disasters or emergencies.

What does the RBI do with the forex reserves?

  • The Reserve Bank functions as the custodian and manager of forex reserves, and operates within the overall policy framework agreed upon with the government. 
  • The RBI allocates the dollars for specific purposes. For example, under the Liberalised Remittances Scheme, individuals are allowed to remit up to $250,000 every year. 
  • The RBI uses its forex kitty for the orderly movement of the rupee. It sells the dollar when the rupee weakens and buys the dollar when the rupee strengthens. 
  • Of late, the RBI has been buying dollars from the market to shore up the forex reserves. When the RBI mops up dollars, it releases an equal amount in the rupees. This excess liquidity is sterilized through issues of bonds and securities and LAF (Liquidity Adjustment Facility) operations.  

Where are India’s forex reserves kept?

The RBI Act, 1934 provides the overarching legal framework for deployment of reserves in different foreign currency assets and gold within the broad parameters of currencies, instruments, issuers and counterparties. 

  • According to the RBI data, as much as 64 per cent of the foreign currency reserves is held in the securities like Treasury bills of foreign countries, mainly the US, 28 per cent is deposited in foreign central banks and 7.4 per cent is also deposited in commercial banks abroad.
  • Gold: India also 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 domestically. 
  • In value terms (USD), the share of gold in the total foreign exchange reserves increased from about 6.14 per cent as at end-September 2019 to about 6.40 per cent as at end-March 2020.

Cost involved in maintaining forex reserves:

  • The return on India’s forex reserves kept in foreign central banks and commercial banks is negligible
  • While the RBI has not divulged the return on forex investment, analysts say it could be around one per cent, or even less than that, considering the fall in interest rates in the US and Euro zone. 

Issues with forex reserves in India:

  • There was a demand 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.
  • Another issue is the high ratio of volatile flows (portfolio flows and short-term debt) to reserves which is around 80 per cent. This money can exit at a fast pace.

According to the former RBI Governor YV Reddy, there are some differences among academics on the direct as well as indirect costs and benefits of the level of forex reserves, from the point of view of macro-economic policy, financial stability and fiscal or quasi-fiscal impact.