Foreign Exchange Reserves

Context: Reserves have fallen from an all-time high of $645 billion in October 2021 to $575.27 billion in February 2023. However, India’s forex reserves increased by $6.306 billion to $584.755 billion for the week ended April 7.

What are Foreign Exchange Reserves?

• Foreign exchange reserves refers to the reserves of the RBI kept in the form foreign currency assets, gold, SDR and reserve tranche position with the IMF. 
• The forex reserve is kept as a cushion against any potential balance of payment related crisis. In India, the Reserve Bank of India Act 1934 enables the RBI to act as the custodian of foreign reserves. 

Composition of Foreign Exchange Reserves

• Forex reserves in India comprise of Foreign Exchange assets (FEAs), Gold, Special Drawing Rights (SDRs) and Reserve Position in the IMF.
• Foreign Exchange assets (FEAs): Consists of major global currencies + Investments in US Treasury bonds, bonds of other selected governments, deposits with foreign central and commercial banks. Even though, Foreign Exchange assets (FEAs) are maintained in major currencies, the foreign exchange reserves are denominated and expressed in US dollar terms.
• Reserve Position in the IMF: Subscription of quota consists of two components: (i) foreign exchange component and (ii) domestic currency component. Under the foreign exchange component, a member is required to pay 25% of its quota in SDRs or in foreign currencies. This is termed as “reserve position in the IMF or reserve tranche” and is part of the member country’s reserve assets.
• Foreign Currency Assets (88%) > Gold (8%) > SDR (3.2%) > RTP (0.8%)

Reasons for Decline

• FPI outflows: mainly due global inflation post Russia-Ukraine war and hike of interest rates by US Federal Reserve. 
• Rupee depreciation: by around 10% against the US dollar and became the worst performing Asian currency in 2022. As a result, RBI had to intervene in the forex market to defend the rupee thereby declining forex reserves. 
• Valuation loss: Foreign exchange reserves are maintained as a multi-currency portfolio comprising major currencies such as the US dollar, Euro, Pound sterling, and Japanese yen, among others, but are valued in terms of US dollars. When the dollar strengthens, the valuation of other currencies vis-à-vis the US currency declines, leading to notional fall in the overall reserves position.

How Much Forex Reserves is Sufficient?

• Though there is no objective formula/criterion to arrive at a specific amount, there are few factors that are considered to determine the adequacy of foreign exchange reserves of an economy, which include:
  • Import Cover: Number of months of imports that could be paid for by Forex Reserves.
  • Greenspan-Guidotti rule: Forex reserves should be sufficient to pay the short-term External Debt. 
  • Level of short-term debt: IMF suggests that a country’s reserves should equal short-term external debt (one-year or less maturity), suggesting a ratio of reserves-to-short term debt of one. 
  • Source of accretion of reserves: Whether the forex reserves are made up of export or foreign investments (FDI & FPI) or external borrowings. 
  • Levels of Current account deficit: To what extent the CAD can be financed by the existing foreign reserves.