Flip side of forex reserves

Flip side of forex reserves

Subject: Economy

Context:

• The build-up in foreign exchange reserves to $610.01 billion as on July 2, an increase of around $33 billion over March 2021 and $96.8 billion on a y-o-y basis, comes amid an overall decline in India’s macroeconomic performance. The accumulation of reserves has its benefits as well as associated costs, raising complex questions and dilemmas on the trade-off between the quantum of reserves and the costs of managing them.

How does India’s forex reserve compare with its neighbour?

• India is the fourth largest holder of forex reserves in the world but to put the number in perspective, India’s reserves now are just 18 per cent of the forex reserves held by neighbouring China, which reported $3,362 billion of forex reserves and is the country with the highest reserves, followed by Japan ($1,376.5 billion) and Switzerland ($1,074.8 Billion).
• The components of the forex reserves as on July 2include the foreign currency asset or ($567 billion), gold ($36.4 billion), special drawing rights or SDR ($1.6 billion) and reserve tranche with IMF ($5.1 billion). Reserve assets constituted 67.2 per cent of the total international financial assets and 21.4 cent of GDP as on March 2021.

Benefits of large forex reserve:

• The build-up of reserves helps meet the challenges of the balance-of-payments (BoP) along with the pressure on depreciation in the exchange rate, thereby providing a source of comfort in addressing disorderly market conditions.
• The accumulation of reserves has its benefits as well as associated costs, raising complex questions and dilemmas on the trade-off between the quantum of reserves and the costs of managing them. the build-up of reserves helps meet the challenges of the balance-of-payments (BoP) along with the pressure on depreciation in the exchange rate, thereby providing a source of comfort in addressing disorderly market conditions

History of forex reserve build up:

• A look at the trends in the increasing reserves in nominal terms (including valuation) reveals that on four occasions there were significant reserves built up — 2007-08 ($101 billion), 2017-18 ($83 billion), 2019-20 ($66 billion) and 2020-21 ($103 billion) — which aggregated $353 billion, accounting for nearly 61.2 per cent of the total reserves
• (up to March 2021).

Contributing factors

• In 2020-21 the contributing factors are the current account surplus ($23.9 billion) and net capital flows ($63.7 billion).
• On the other three occasions (2007-08,2017-18, 2019-20), the net capital in flows contributed to forex reserves after meeting the current account deficit.

Periods of decline:

• In contrast to this, in the period immediately after the global financial crisis, there were three episodes of decline in forex reserves — in 2008- 09 ($20.1 billion), 2011-12 ($12.8 billion) and 2018-19 ($3.3 billion). The decline in forex reserves was on account of a higher current account deficit and lower net capital flows.

Where are forex reserves invested?

• The Reserve Bank of India Act, 1934, provides an overarching legal framework for the deployment of reserves in different foreign currency assets (FCA) and gold.
• By end- March 2021, out of the total FCA of $536.69 billion, $359.88 billion or 67.1 per cent was invested in securities, $153.39 billion or 28.6 per cent was deposited with other central banks and the BIS and the balance of $23.43 billion or 4.4 per cent comprised deposits with commercial banks overseas.

Returns from investment:

• According to the RBI Annual Report 2020-21, the income from foreign sources decreased by 2 per cent from ₹82,367.02 crore in 2019- 20 to ₹80,715.82 crore in 2020-21. The rate of earnings on foreign currencyassets was at 2.10 per cent in 2020-21 as compared with 2.65 per cent in 2019-20.

Challenges of maintaining huge forex reserves:

• Fiscal Cost: The fiscal cost of sterilisation of durable liquidity emanating from capital flows. If we take into account only the fixed overnight reverse repo, which carries an interest rate of 3.35 per, the fiscal cost thus works out to 1.25 per cent (3.35 per cent minus 2.10 per cent). But the fiscal cost works out to be much higher if the OMO purchase/sale of securities is considered. Thus, the fiscal cost is a burden when we build up forex reserves. This is essentially the outcome of interest rates abroad being lower than the interest rates In India.
• The forex reserves build-up has the potential risks of growing debt liabilties and facing the vagaries of “hot” money. The Reserve Bank of India Act, 1934, provides an overarching legal framework for the deployment of reserves in different foreign currency assets (FCA) and gold
• The increase in forex reserves aggregated $99.2 billion. Such an increase in the flow of reserves has resulted in an appreciation of the rupee against the dollar
• Sterilization is a monetary action used by central banks in order to stem the negative effects emerging from capital inflows or outflows from a country’s economy.
• Classical sterilization involves central banks conducting buy and sell operations in open markets.
• Usually, central banks modify classical sterilization by including fiscal policy measures in order to overcome problems like inflation.
• Sterilization most frequently involves the purchase or sale of financial assets by a central bank and is designed to offset the effect of foreign exchange intervention.
• The sterilization process is used to manipulate the value of one domestic currency relative to another and is initiated in the foreign exchange market.
• Sterilization requires a central bank to look beyond its national borders by getting involved in foreign exchange.
• Another important aspect is the adequacy of forex reserves. Our reserves can meet 17.5 months’ imports nas against the benchmark of three months. The Guoditti-Greenspan rule, however, suggested “liquidity- at–risk” to measure adequacy of reserves.