According to data from the Reserve Bank of India (RBI), India’s foreign exchange (forex) reserves hit a record high of USD 541.431 billion in the week ending on August 28, 2020.
Explaining Forex Reserves
Foreign exchange reserves are assets denominated in a foreign currency that a central bank holds in reserve. These reserves can include foreign currencies, bonds, treasury bills, and other government securities.
The Purpose of Holding Forex Reserves
Central banks hold forex reserves for several reasons. Firstly, they support and maintain confidence in monetary and exchange rate management policies. They also provide the ability to intervene in support of the national or union currency. Lastly, they limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.
India’s Forex Reserves Composition
In India, forex reserves are external assets accumulated and managed by the RBI. These reserves come in the form of gold, SDRs (special drawing rights of the International Monetary Fund – IMF), foreign currency assets such as capital inflows to the capital markets, Foreign Direct Investment, and external commercial borrowings, as well as having a reserve position with the IMF.
Legal Framework for Forex Reserves Storage
The legal framework for deploying reserves in different foreign currency assets and gold lies within the RBI Act, 1934, which sets the broad parameters for currencies, instruments, and issuers.
Why are India’s Forex Reserves so High?
The surge in forex reserves can be attributed to a few factors, including an increase in investment by foreign portfolio investors and higher foreign direct investments. The sharp jump started after the Finance Ministry announced a cut in corporate tax rates in 2019. Falling crude oil prices have also reduced the oil import bill, saving precious foreign exchange. Additionally, dollar outflows from overseas remittances and foreign travels have dramatically decreased.
The Significant Impacts of Rising Forex Reserves
The rise in forex reserves puts the government and the RBI in a comfortable position for managing India’s external and internal financial issues, especially during a time of significant economic contraction. It also serves as a cushion in times of a Balance of Payment (BoP) crisis. The growing reserves have helped the rupee to strengthen against the dollar, providing confidence to markets and investors that India can meet its external obligations.
Debate: Using Forex for Infrastructure
There have been arguments for and against using forex reserves for infrastructure development and other national needs. Supporters claim that with sufficient reserves and contingency arrangements in place, part of the reserves could be used to stimulate the economy. Detractors argue that factors such as oil price unpredictability, unstable portfolio investments, and the need to maintain currency stability make this an unreliable solution.
Moving Forward
If the government decides to use forex reserves as an emergency fund, it must ensure they do not deplete just when they are most needed. Furthermore, it is crucial to carry out structural reforms that can effectively overcome the persistent slowdown in the Indian economy.