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Friday, August 07, 2020

Explained: Why India’s forex reserves are rising, what this means for the economy

Forex reserves are external assets, in the form of 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.

Written by George Mathew , Sandeep Singh | New Delhi/mumbai | Updated: June 19, 2020 9:37:31 pm
Forex reserves, India's forex reserves, Indian economy, forex reserves Indian economy, Indian economy forex reserves, Express Explained, Indian Express Hitting an all-time high of 1.7 billion as on June 5, 2020, India has come a long way since its forex reserves of .8 billion as of March 1991.

India’s forex reserves crossed $500 billion for the first time ever in the week ended June 5, 2020. 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. While the situation is gloomy on the economic front with GDP set to contract for the first time in 40 years and manufacturing activity and trade at standstill, this is one data point that India can cheer about amidst the Covid-19 pandemic. While it jumped by $8.2 billion in the week ended June 5, 2020, it is important to note that since the announcement of lockdown in March, it has surged by $31.8 billion. Hitting an all-time high of $501.7 billion as on June 5, 2020, India has come a long way since its forex reserves of $5.8 billion as of March 1991.

What are forex reserves?

Forex reserves are external assets in the form of 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 will also limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.

Why are forex reserves rising despite the slowdown in the economy?

The major reason for the rise in forex reserves is the rise in investment in foreign portfolio investors in Indian stocks and foreign direct investments (FDIs). Foreign investors had acquired stakes in several Indian companies in the last two months. According to the data released by RBI, while the FDI inflow stood at $4 billion in March, it amounted to $2.1 billion in April.

After pulling out Rs 60,000 crore each from debt and equity segments in March, Foreign Portfolio Investments (FPIs), who expect a turnaround in the economy later this financial year, have now returned to the Indian markets and bought stocks worth over $2.75 billion in the first week of June. Forex inflows are set to rise further and cross the $500 billion as Reliance Industries subsidiary, Jio Platforms, has witnessed a series of foreign investments totalling Rs 97,000 crore.

On the other hand, the fall in crude oil prices has brought down the oil import bill, saving precious foreign exchange. Similarly, overseas remittances and foreign travels have fallen steeply – down 61 per cent in April from $12.87 billion. The months of May and June are expected to show further decline in dollar outflows.

The sharp jump in reserves seen over the last nine-months started with the finance minister, Nirmala Sitharaman’s announcement to cut corporate tax rates on September 20. Since then the forex reserves have grown by $73 billion.

What’s the significance of rising forex reserves?

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. It’s a big cushion in the event of any crisis on the economic front and enough to cover the import bill of the country for a year. The rising reserves have also helped the rupee to strengthen against the dollar. 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.

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In his monetary policy statement on May 22, RBI Governor Shaktikanta Das said, “India’s foreign exchange reserves have increased by US$ 9.2 billion in 2020-21 so far (up to May 15) to US$ 487.0 billion – equivalent to 12 months of imports.”

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 rupees. This excess liquidity is sterilised through issue of bonds and securities and LAF operations. “Despite the global dollar weakness, the RBI does not seem to be keen to step off the gas as far as reserve accumulation is concerned… the sentiment in the rupee has been skewed by incessant dollar purchases by the central bank to strengthen its balance sheet,” said Abhishek Goenka, CEO, IFA Global.

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. As much as 64 per cent of the foreign currency reserves are held in 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, according to the RBI data.

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.

Is there a 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. 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. 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, former RBI Governor YV Reddy said in one of his speeches.

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