Forex accumulation and valuation effect

Forex accumulation and valuation effect

Subject: Economy

Section: External Sector

Context:

From a peak of $642.45 billion on September 3, India’s foreign exchange reserves have dipped to $572.71 billion as of July 15 i.e. a fall of $70 billion in 10 months.

How is forex accumulated?

• Through current account surplus-when a country’s earnings from export of goods and services exceed payments against imports which in turn is bought by the Central Bank to avoid a volatile exchange rate appreciation.
  • The forex reserves are accumulated as a buffer against currency volatility, external shocks and sudden stops in capital flows.
  • A higher supply of foreign currency with respect to the domestic currency leads to appreciation of domestic currency.
  • Further, the current account surpluses (excess of incomes over expenditures or retained profits)  of a country may be invested in other countries and it becomes a net exporter of ‘capital’, in addition to goods and services.
• The top 12 countries holding the highest foreign exchange reserves at the end of 2021 have large and persistent current account surpluses except for India, USA and Brazil.

Causes of Reserve Accumulation in India:

The combined merchandise trade deficit during the eight years from 2014-15 to 2021-22 was close to $1.2 trillion. This has been offset by:

• Surplus in “invisibles’-
  • The deficit was partly offset by a net surplus of $968 billion on the “invisibles” account of the balance of payments.
  • Invisibles mainly comprise receipts from export of software services, remittances by overseas Indians, and tourism.
  • In India’s case, these receipts have always exceeded payments on account of interest on loans, dividends, royalties, licence fees, foreign travel and assorted business and financial services.
• Capital inflows-
  • Capital inflows – averaging $68.4 billion respectively in the last 10 years – have led to India’s forex reserves going up in all but five out of the 32 years from 1990-91 to 2021-22.
• Valuation effect-
  • Foreign exchange reserves are held in the form of dollars as well as non-dollar currencies and gold, whose values are influenced by movements in exchange rates and gold prices.
    •  A depreciation of the US dollar or higher gold prices, then, causes valuation gains in the existing stock of reserves.
    •  An appreciation of dollar or fall in gold prices, likewise, brings down the value of the non-dollar portion of the reserves.
    • For instance– if a portion of the reserves are in euros and the euro depreciates against the dollar, this would cause a drop in the value of forex reserves.