The Reserve Bank of India (RBI) recently shared that India’s forex reserves have plunged by a hefty $110 billion over the past 13 months. This news has led to some concerns about the implications for the Indian economy, particularly given the importance of foreign exchange reserves in today’s globalized market.
Understanding Forex Reserves
Forex reserves are assets stored by a central bank in foreign currencies which often include government securities such as bonds and treasury bills. The majority of these reserves are held in US dollars. The prime components of Foreign Exchange Reserves are Foreign Currency Assets, Gold reserves, Special Drawing Rights (SDRs), and the reserve position with the International Monetary Fund (IMF).
Forex reserves serve several significant functions: they help uphold confidence in monetary and exchange rate management policies, provide the capability to support the national or union currency, and reduce external vulnerability by maintaining foreign currency liquidity, which serves as a buffer during crises or when access to borrowing is restricted.
Special Drawing Rights Explained
The IMF introduced Special Drawing Rights (SDRs) in 1969 as an international reserve asset to supplement its member countries’ official reserves. But SDRs are neither a currency nor a claim on the IMF. They’re a potential claim on the freely usable currencies of IMF members, which can be exchanged for these currencies. The value of SDRs is derived from a weighted basket of major currencies, including the US dollar, the euro, the Japanese yen, the Chinese yuan, and the British pound.
Reasons Behind the Decline in India’s Forex Reserves
As of September 2021, India’s forex reserves touched a record high of USD 642.45 billion, only to fall by $110 billion since then. Notably, the Indian rupee is a freely floating currency, and its exchange rate is dictated by the market rather than the RBI.
Several factors have contributed to this decline in forex reserves. A key cause is the central bank’s efforts to defend the Rupee by selling dollars from the reserves to counterbalance pressures primarily induced by global developments. This intervention helps prevent the free fall of the rupee while minimizing market volatility.
Another significant factor is the capital outflows precipitated by the US Federal Reserve’s aggressive policy of monetary tightening and interest rate hikes. As a result, foreign portfolio investors (FPIs) have started pulling out from the Indian markets.
Additionally, valuation loss resulting from the ascendance of the US dollar against major currencies along with falling gold prices significantly contributed to the dip in reserves.
Factors Influencing Exchange Rates
Inflation rates, balance of payments, and government debt largely influence exchange rates. For instance, a country with a relatively lower inflation rate will witness an appreciation in its currency value. Similarly, a deficit in the current account due to higher Forex spending on imports than earnings through exports could lead to depreciation and further destabilize the domestic currency’s exchange rate.
Government debt too plays a crucial role. A country with substantial government debt is less likely to attract foreign capital, which could result in inflation. In such scenarios, foreign investors tend to divest their bonds in the open market if they predict government insolvency, leading to the devaluation of the exchange rate.
Previous UPSC Civil Services Examination Question
In the 2014 UPSC Prelims, a question was asked concerning the components of the Current Account in the Balance of Payments. It read: “With reference to Balance of Payments, which of the following constitutes/constitute the Current Account? (2014)” with four options given below.
The correct answer was “1 and 3” referring to “Balance of trade” and “Balance of invisibles”. The explanation given was an elaboration on the composition and components of the Current Account and Capital Account of BoP.
Impact on FDI
The fall in Forex reserves also has implications for Foreign Direct Investment (FDI) in India. As per a 2016 Mains question on the gap between Memoranda of Understanding (MoUs) signed and actual FDIs, this decline can widen that gap and affect the development of the Indian economy.
