The Foreign Exchange Reserves of India rose past $400 billion for the first time ever in September 2017. India has the world’s eighth largest foreign exchange reserves. This list is headed by China and Japan.
Foreign exchange (FOREX) reserves are the assets held by a Central Bank of a country in foreign currencies. The Central Bank maintains FOREX to keep its currency’s exchange rate stable.
India has a flexible exchange rate system. But, the RBI intervenes in the currency market from time to time, to prevent short-term volatility in the exchange rate of the rupee.
The RBI maintains the stability of rupee by buying and selling of foreign currencies. For example- If the rupee depreciates against the dollar, the RBI sells FOREX in the market and buys rupee. It decreases the supply of rupee in the market and its price (exchange rate) appreciates.
The FOREX Reserves are shown in the capital account of the Balance of payment.
(Read: Balance of payment Explained)
India’s Foreign exchange reserves consist of:
- Foreign Currency Reserves/ Assets: These are held in US Dollar, European Euro, UK Sterling, Japanese Yen etc.
- Special Drawing Rights (SDRs): SDR is an international reserve asset allocated by the Internation Monetary Fund (IMF). The IMF allocates SDR in proportion to their quotas. IMF assigns quota to each member country. The quota is the monetary contribution that a member country has to make to the IMF. SDRs derives its value from a weighted currency basket of five major currencies: the US dollar, the British pound sterling Euro, the Japanese yen and the Chinese renminbi (RMB).
- Reserve Tranche Position in the IMF: We know that quota is the amount to be paid to the IMF. The Reserve Tranche position is the proportion of IMF’s quota that a country has to pay to the IMF but can designate for its own use. It can be accessed by the member at any time.
The FOREX reserves position of India as on Oct 20, 2017, is shown in this table
|FOREX as on October 20, 2017|
|(US $ billion)|
|Foreign currency Assets||374.908|
|Reserve position in IMF||2.2729|
India has accumulated a huge amount of foreign exchange reserves. The RBI had to intervene in the currency markets and buy foreign exchange reserves with rupee, to control the appreciation in rupee exchange rate. The appreciation in the exchange rate hurt exports.
The appreciation in rupee exchange rate was due to a huge amount of foreign capital inflows in the economy in the form of FDI and FII. (Read: FDI and FII- Explained)
India received an unprecedented amount of capital inflows due to excessive global liquidity and high real rate of interest in India.
The major contributors to FOREX reserves are:
- Foreign Direct Investment (FDI)- $7.2 billion
- Foreign Institutional Investor (FII)- $12.5 billion
(date is for April-June 2017. Source: Economic times)
Foreign exchange reserves help to keep rupee stable and protect against external shocks. It is particularly important in the backdrop of the decision of the US to gradually reverse its policy of quantitative easing/ bond buying. In other words, it will sell bonds it had bought earlier. It will result in a decrease in global liquidity.
(Read: Quantitative Easing- Explained)
The Fed also hinted at a hike in their policy rate in December. This will make the investment in the US more attractive relative to India.
The FOREX will act as a buffer against these external shocks and capital outflows from the country.
In the year 2013, the Fed had announced that it could reduce its Quantitative easing gradually. It led to a flight of this capital from India. The rupee lost 27 % in 3 months.
The economy is in a better position now with high FOREX reserves and strong macroeconomic fundamentals.
Lastly, the RBI has been intervening in the currency market to prevent the rupee from appreciating. The US Treasury has put India on a watchlist because of India’s increasing FOREX. Aggressive intervention in the currency market is perceived to be unfair if it is done to artificially devalue the currency to boost exports.
RBI website for FOREX data