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Explained: Why are forex reserves shooting up when Indian economy is hit?  

8th August, 2020 Economy

Context: Covid-hit India’s foreign exchange reserves jumped by a record $11.9 billion in the week ending July 31, hit a fresh high of $534.5 billion, making it the fifth largest holder of reserves in the world.


India’s foreign exchange reserves: How has the rise been?

  • The trend of rising foreign exchange reserves started after Finance Minister Nirmala Sitharaman announced a sharp cut in corporate tax rates on September 20, 2019.
  • While investor sentiments turned weak after the budget announcement in July to impose higher surcharge, the government’s decision to reverse its budget decision relating to higher surcharge impact on FPIs along with a cut in the corporate tax rate played a significant role in turning the investors mood.


What has led to this rise in forex reserves?

  • The rise in foreign exchange inflows through Foreign portfolio investment (FPI) and Foreign Direct Investment (FDI and has also been supported by decline in import bill over the last 4-5 months on account of dip in crude prices and trade impact following Covid-19 pandemic.
  • India’s oil import bill declined as the global spread of corona virus since February 2020 not only roiled the stock markets but also led to a crash in the Brent crude oil prices.
  • Lockdown across countries in response to Covid-19 pandemic affected global trade and has resulted in a sharp dip in import expenditure — electronics, gold and crude oil prices among others.
  • Gold, which was a big import component for India, witnessed a sharp decline in the quarter ended June 2020 following the high prices and the lockdown induced by the Covid-19 pandemic.


What does the rising forex reserves mean?

  • The rising forex reserves give a lot of comfort to the government and the Reserve Bank of India in managing India’s external and internal financial issues at a time when the economic growth is set to contract by 5.8 per cent in 2020-21.
  • It is 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.
  • The rising reserves have also helped the rupee to strengthen against the dollar. The foreign exchange reserves to GDP ratio is around 15 per cent.
  • 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 foreign exchange needs and external debt obligations and maintain a reserve for national disasters or emergencies.


What does the RBI do with the forex reserves?

  • The Reserve Bank 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 Liberalised 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.
  • Of late, the RBI has been buying dollars from the market to shore up the forex reserves. When the RBI mops up dollars, it releases an equal amount in the rupees.
  • This excess liquidity is sterilised through issue of bonds and securities and LAF operations to prevent a rise in inflation.


Are forex reserves giving returns to India?

  • While the RBI has not disclosed the actual returns from forex reserves, experts estimate India is likely to get only negligible returns as interest rates in the US and Euro zone are around one per cent.
  • On the contrary, India could be facing a cost to keep the reserves abroad. Out of the total foreign currency assets, as much as 59.7 percent was invested in securities abroad, 33.37 per cent was deposited with other central banks of other countries and the BIS and the balance 7.06 per cent comprised deposits with commercial banks overseas as of March 2020.
  • Further, as at end-March, 2020, the RBI held 653.01 tonnes of gold, with 360.71 tonnes being held overseas in safe custody with the Bank of England and the Bank for International Settlements, while the remaining gold is held domestically.
  • With gold prices shooting up around 40 per cent to over Rs 55,000 per 10 grams this year, the value of gold holdings has shot up.