From UPSC perspective, the following things are important :
Prelims level : India's Forex reserves, SDR, Reserve tranche
Mains level : Forex Reserves and its significance
India’s foreign exchange reserves are rising and are slated to hit the $500 billion mark soon. In the last month, it jumped by $12.4 billion to an all-time high of $493.48 billion.
Aspirants must make a note here:
1.Authority managing FOREX in India
2.Components of FOREX
4.Emergency use of FOREX
Rising above the 1991 crisis
- Unlike in 1991, when India had to pledge its gold reserves to stave off a major financial crisis, the country can now depend on its soaring Forex reserves to tackle any crisis on the economic front.
- The level of Forex reserves has steadily increased by 8,400 per cent from $5.8 billion as of March 1991 to the current level.
What are Forex Reserves?
- Reserve Bank of India Act and the Foreign Exchange Management Act, 1999 set the legal provisions for governing the foreign exchange reserves.
- RBI accumulates foreign currency reserves by purchasing from authorized dealers in open market operations.
- The Forex reserves of India consist of below four categories:
- Foreign Currency Assets
- Special Drawing Rights (SDRs)
- Reserve Tranche Position
- The IMF says official Forex reserves are held in support of a range of objectives like supporting and maintaining confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency.
- It will also limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.
Why is Forex rising despite the slowdown in the economy?
1.Rise in FPIand FII
- The major reason for the rise in forex reserves is the rise in investment in foreign portfolio investors in Indian stocks and foreign direct investments (FDIs).
- Foreign investors had acquired stakes in several Indian companies in the last two months.
- Forex inflows are set to rise further and cross the $500 billion as Reliance Industries subsidiary, Jio Platforms, has witnessed a series of foreign investments totalling Rs 97,000 crore.
2.Crash in oil prices
- On the other hand, the fall in crude oil prices has brought down the oil import bill, saving the precious foreign exchange.
3.Fall in overseas remittances and foreign travel
- Similarly, overseas remittances and foreign travels have fallen steeply – down 61 per cent in April from $12.87 billion.
What’s the significance of rising forex reserves?
- The rising forex reserves give a lot of comfort to the government and the RBI in managing India’s external and internal financial issues at a time when the economic growth is set to contract by 1.5 per cent in 2020-21.
- Provides Cushion: It’s a big cushion in the event of any crisis on the economic front and enough to cover the import bill of the country for a year.
- Appreciation of Rupees: The rising reserves have also helped the rupee to strengthen against the dollar.
- The forex reserves to GDP ratio is around 15 per cent.
- Provides confidence to Market: Reserves will provide a level of confidence to markets that a country can meet its external obligations, demonstrate the backing of domestic currency by external assets, assist the government in meeting its US dollar needs and external debt obligations and maintain a reserve for national disasters or emergencies.
What does the RBI do with the forex reserves?
- The RBI functions as the custodian and manager of forex reserves and operates within the overall policy framework agreed upon with the government.
- The RBI allocates the dollars for specific purposes. For example, under the Liberalized Remittances Scheme, individuals are allowed to remit up to $250,000 every year.
- The RBI uses its forex kitty for the orderly movement of the rupee. It sells the dollar when the rupee weakens and buys the dollar when the rupee strengthens.
Where are India’s forex reserves kept?
- The RBI Act, 1934 provides the overarching legal framework for the deployment of reserves in different foreign currency assets and gold within the broad parameters of currencies, instruments, issuers and counterparties.
- As much as 64 per cent of the foreign currency reserves is held in the securities like Treasury bills of foreign countries, mainly the US.
- 28 per cent is deposited in foreign central banks and 7.4 per cent is also deposited in commercial banks abroad.
- In value terms, the share of gold in the total foreign exchange reserves increased from about 6.14 per cent as at end-September 2019 to about 6.40 per cent as at end-March 2020.
Is there a cost involved in maintaining forex reserves?
- The return on India’s forex reserves kept in foreign central banks and commercial banks is negligible.
- While the RBI has not divulged the return on forex investment, analysts say it could be around one per cent, or even less than that, considering the fall in interest rates in the US and Eurozone.
- There was a demand from some quarters that forex reserves should be used for infrastructure development in the country. However, the RBI had opposed the plan.
- Several analysts argue for giving greater weightage to return on forex assets than on liquidity thus reducing net costs if any, of holding reserves.
- Another issue is the high ratio of volatile flows (portfolio flows and short-term debt) to reserves which are around 80 per cent. This money can exit at a fast pace.