Why is the RBI buying foreign exchange reserves aggressively?

India Jun 28, 2021

India’s foreign exchange reserves hit a historical high in the second week of June 2021 by crossing the $600 billion mark for the first time, after continuously rising for the past few months now. The forex reserves surged by USD 3.074 billion to reach an all-time high level of 608.081 billion by the week ending June 11, 2021. India now has the 4th largest pool of forex reserves in the world. As per the Reserve Bank of India’s (RBI) weekly data, this unprecedented rise in India’s forex reserves has been in line with the increase in foreign currency assets (FCA), which comprise the major chunk of the overall reserves.

What are Foreign exchange reserves?

Forex reserves comprise the external assets in the form of gold, special drawing rights (SDRs) of the International Monetary Fund (IMF), foreign currency assets (inflows to the capital markets, FDI and external commercial borrowings). The IMF defines forex reserves as the external assets that a country’s monetary authority uses to finance any deficit in its overall balance of payments. In simple words, foreign reserves are used as a payment mode for imports into a country.

The U.S. dollar dominates the share in the foreign currency reserves of most of the countries around the world, followed by Euro.

Reasons behind the historic high

The rise in foreign portfolio investment (FPI) and foreign direct investment (FDI) have led to this huge swell in the forex reserves. Expecting a turnaround in the Indian economy later this financial year, foreign investors have been increasingly acquiring stakes in several Indian companies by buying stocks. When foreign investors buy stocks, they do so by converting the dollars into rupees which in turn leads to a  rise in the forex reserves with the central bank of India. Similarly, foreign companies invest directly through FDI  and as per the latest statistics, India has received a record $81 billion FDI in FY21.

Another major reason attributed to this huge spike in forex reserves amid the pandemic has been the spurt in global liquidity. With the U.S. easing interest rates and increasing the supply of the dollar to revive its economy, investors moved towards emerging market economies including India in search of yield on investments. Various other measures taken by the Reserve Bank of India to stabilise the rupee have also contributed to this surge in foreign reserves.

Importance of rising forex for a country

The rising forex reserves provide a safety net to the countries especially in times of crises like the one we are currently facing. They also help the government and central bank in managing the external and internal financial issues facing a country. Most importantly, it instills confidence in the market comprising credit rating agencies and investors, regarding a country’s ability to meet its external debt obligations, thus making it an attractive investment destination. India, being a net importer of something as critical as crude oil, inevitably needs an adequate amount of forex reserves at all times to finance the same. Currently, India’s forex reserves are enough to cover up imports for around 15 months.

Will the RBI continue its aggressive buying of forex?

As some policy commentators suggest, accumulating reserves is a priority for the central bank given the economic uncertainty looming around. However, the monetary authorities will need to be cautious of the continuing rise in the reserves given the added risk of the reserve management. Also, over-reliance on forex reserves beyond a certain level can pose a threat to a country’s economy. Economists suggest using the forex reserves majorly to smoothly cover up the import bill and ensure the stability of the currency. With India currently riding high on its forex reserves, it remains to be seen how well the central bank will be able to balance its benefits and risks.

This article has been written by Khanak Sharma for the Paradigm

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