Economic Indicators and Various Reports On It- GDP, FD, EODB, WIR etc

How much forex reserve is too much

Note4Students

From UPSC perspective, the following things are important :

Prelims level : India's foreign exchange reserves

Mains level : Paper 3-India's foreign exchange reserves.

India’s foreign exchange reserves touched an unprecedented level. Being reserves, the reserves also represent the lost opportunity. This article examines the reasons for and utility of maintaining huge reserves.

Reasons for surge in the forex reserves

  • The recent forex reserves surge was a result of two things:
  • 1) Foreign institutional investors reinvested in the Indian market in May-June after they exited their positions in panic in March.
  • 2) A global fall in fuel prices has reduced India’s oil import bill, allowing it to save up forex reserves.

But why does India keeps huge forex reserves- 3 possibilities

  • Sufficiency of forex reserves is sometimes measured on how many months’ worth of imports a country can afford.
  • While six months is considered sufficient.
  • The RBI in December 2019 said it had enough to sustain for 10 months, the forex reserves were then $0.4 trillion.
  • Today, the cover is 12 months!
  • This is despite having a sufficient credit line from the IMF, should there be a credit shock.
  • So, there are 3 possibilities for why government maintains such huge reserves.
  • 1) Excess forex reserves are likely the government’s contingency fund, in case the economy suddenly topples.
  • The pandemic has increased the government’s insecurity.
  • 2) Another possibility is that the government is accumulating these reserves as “Plan-B” savings should its strategic disinvestment plans fail.
  • 3) Forex reserves are also likely a way for India now to maintain its global rating.
  • The fundamental use of India’s foreign exchange should be to ensure the Rupee (INR) stability.

Stability of Rupee

  •  Despite steadily rising reserves, INR fluctuated between 77 and 75 against the US dollar in the last two months.
  • INR has become one of Asia’s worst currencies.
  • The RBI may allow it to devalue further to support its balance sheet,
  • Devaluation would enable it to transfer a big chunk of its realised profits as dividend to the starving government.

Lost opportunity

  • It is understandable for oil-rich countries to maintain high forex reserves.
  • A single oil trade hiccup can derail their economy.
  • Economists have theorised that holding high forex reserves is unnecessary.
  • In fact, not using them to finance mega infrastructure projects are lost opportunities.
  • And yet the Indian government has held these reserves in liquid, possibly for its feared D-day.

Perils of using forex reserves as emergency funds

  •  Over-reliance on these floating funds to stimulate the economy might be poorly informed.
  • The potential of these funds to switch direction [i.e. they could exit as fast] should not be underestimated.
  • In March alone, foreign institutional investments in India fell by Rs 65,000 crore.
  • India’s foreign exchange reserves registered this impact.
  • Reversing the dip, investments went up in May and now in June with some big corporate deals.
  • If the government intends to use forex reserves as an emergency fund, it should ensure that they do not shrink just when they are most needed.

Consider the question “India’s foreign exchange reserves touched new height recently. This also giver rise to the argument of lost opportunity. In light of this discuss the utility of maintaining foreign exchange reserves and issue of optimum level of foreign exchange reserves.”

Conclusion

Maintaining high foreign exchange reserves definitely entails cost. The cost-benefit analysis and the lost opportunity must be the basis for deciding the level of the reserves.

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