By Definition, Foreign-exchange reserves or Forex reserves are foreign-currency deposits (Currency, Bonds, T-Bills, etc.), gold reserves, special drawing rights (SDRs) and International Monetary Fund (IMF) reserve position held by central banks of a country.
The so called foreign-currency deposits are basically financial assets that are held in different types of major reserve currencies (e.g. the U.S. dollar, the Japanese Yen, the Euro, Swiss Franc, the Pound Sterling, Chinese Yuan, etc.) and which are used to back a central banks liability. During the gold standard era, gold was the preferred reserve currency. Some countries also convert forex reserves into sovereign wealth funds, which can at times match foreign-exchange reserves in size.
Recently, India crossed the $600 bn mark in their forex reserves for the first time, and is at the 4th place in elite list of countries having maximum foreign reserves. China tops this list with reserves more than the GDP of India. Yes, you heard that right! This is exactly the reason why China easily shells out money as loans to underdeveloped and financially struggling countries, and in return takes their land and control over natural resources for its military and other usage as the target countries get stuck in what is called a Debt Trap. The whole CPEC (China Pakistan Economic Corridor) is a product of high reserves in China’s central bank. Japan also uses these reserves to fund many projects especially in India like Bullet Trains etc.
However, you will be surprised to know that the mighty US is at 21st position in this list. Strange right?? Let’s understand this. The top 5-6 countries with maximum forex reserve have predominantly US$ currency as their foreign assets. However, it would be futile for the US to keep its own currency in its central bank as a reserve. US doesn’t really like to keep paper currency as a medium of reserve considering its own currency is considered above gold at many places. Thus, the US keeps physical gold as a reserve in its central bank. One would be surprised to know that out of the total reserve that the US has, around 78% is gold alone. Similar trend can be seen in big European countries. On the other hand, India only has around 6-7% of gold in its total reserves.
But, why are the forex reserves rising amid Covid-19 concerns?
We have all heard that economy is in the downturn, covid-19 cases have not been yet stabilized, vaccination pace is still slow, and there is always an impending threat of the third or the fourth wave – with various different mutations going around. The question then is, why are the reserves increasing. They answer to this is the high interest of foreign investors in the Indian markets. Indian markets are considered the leading emerging market in the world. With rising youth population, everyone expects India to perform well post the covid-19 crisis is over. This hope is bringing a lot of money and investments by FPIs (Foreign Portfolio Investment) in Indian equities and the traditional FDIs (Foreign Direct Investment). Foreign investors have even acquired stakes in some of the Indian companies in the last few months.
These foreign investors essentially convert their foreign currency (say, US$) to INR while investing in India, thus leading to an increase in the reserves with the RBI (Reserve Bank of India). In FY21 alone, India received a record FDI of $81.7 bn. This shows the popularity of Indian markets among the developed economy investors.
Another reason for increases forex reserves is the increasing exports. Our IT and Pharma companies have been accumulating record bottom line in the last financial year, which helped in the increase of forex reserve as demand of INR increased. Also, the stringent lockdowns during 2020 led to a decrease in demand and prices of many import commodities which ultimately reduced the import bill further thus helping the reserves further.
Impact of High Forex Reserves in India
An increased reserve buffer provides a cushion (especially in these times) against market ups and downs, and gives a sense of comfort to foreign investors and credit rating companies that the government can easily honour its debt obligations, despite having a bleak fiscal outlook and the economy’s likely contraction in more than four decades. High reserves also lead to assurance to external export companies (like Oil companies), that India has sufficient funds for their import bills. Additionally, in the domestic scenario this also takes care of the seasonal factors in any balance of payments transaction with reference to the possible uncertainties in the monsoon conditions of India. The current figure of $600 bn is enough to meet India’s 12-15 months of pre-pandemic level of imports and approximately equal to a fifth of Indian GDP. Contrasting to this, in 1990 Indian forex reserve covered just 4.8 weeks of imports. That’s a huge jump and an indicator of economic prosperity of a country.
These high reserves actually rekindle a question of usage of these funds for the economy, especially when the government income in constrained due to multiple lockdowns.
Let’s see what the ground reality is:
India’s reserves are a product of capital inflows rather than current account surplus. The CA has been in deficit barring a rare surplus situation in Apr-Jun ‘21 due to fall in imports. Quoting R Gandhi (former RBI Deputy Governor) here, “the alternate use of reserves is very often debated. The moment they are used in any other way, they no longer are forex reserves, they become wealth. Reserves built out of current account surpluses can have wealth like treatment but not those which are built on capital account surpluses.”
Then what can be the alternative route to park these funds? RBI predominantly buys US T-bills & Euro denominated bonds. Most of these developed economies have seen interest rate fall to zero, with some negative trading securities as well. Thus, the only viable option left is to buy additional gold and change the composition of reserves. We have seen gold forming a huge chunk of total reserves of the advanced economies. This can certainly be adopted by RBI, as gold is safe and a universal currency, something which even the US accumulates.
Also, we can take some learning from China, which is managing a huge reserve portfolio through 2 investment vehicles: State Administration of Foreign Exchange (SAFE) and China Investment Corporation (CIC). SAFE is under the purview of China’s central bank (PBOC) and invests in diversified assets across the world. CIC, on the other hand is China’s official wealth or the sovereign wealth fund. Thus, there is a need to create an official sovereign wealth fund of India, a concept which was alien to Indian economists for decades.
With greater liquidity being infused in the developed economies which ultimately end up in in the emerging markets, it’s likely that these reserves might even scale newer heights in the months to come. Most analysts predict the market to remain bullish at least till tapering of interest rates is done through Fed and other central banks. This might be the best opportunity to plan out a sovereign wealth fund kind of a vehicle or invite asset managers to allocate excess funds in diversified asset classes. Government should also make sure that the current account is also supporting the forex reserves by reducing dependence on imports and the recently launched PLI schemes for various sectors is a step in the right direction. RBI is cautious enough to understand that these reserves are a result of capital inflows which can take a hit during a steep market correction.