WHY ARE FOREIGN EXCHANGE RESERVES IMPORTANT?
“Forex Reserves Decline To Over Two-Year Low To $532.66 Bn: RBI Data “, 67% Of Fall In Forex Reserves Due To Valuation Changes: RBI Governor Das”. These are a few headlines hitting the news in the recent past. But, have you ever wondered why is it essential for any country to maintain foreign exchange reserves and worry about it?
Before we dive deep into the topic, let’s understand what foreign exchange reserves are. Foreign exchange reserves are the foreign currencies, treasury bills, and gold reserves maintained as assets by the country’s central bank. For instance, the central bank in India is the Reserve Bank of India.
India’s foreign reserves consist of foreign currency assets such as foreign currencies and US Treasury bills, Gold, Special drawing rights from the IMF and Reserve Tranche Position. Let’s understand about few of these instruments.
The Treasury bill refers to the government’s short-term promissory notes that yield no interest and are issued at a discount. The maturity period of such instruments is a maximum of one year.
Special Drawing Rights is a reserve of foreign exchange assets that consist of foreign currencies and is maintained by International Monetary Fund. The basket of national currencies is US Dollar, Euro, British Pound and Yen. The IMF reviews these baskets every five years.
Reserve Tranche Position is the percentage of SDR held by IMF, which RBI can use without IMF’s permission. For example, the SDR held by RBI is USD 100 million. The Reserve Tranche position is 30%. RBI can use USD 30 million without any permission from IMF. However, the remaining USD 70 million will be used only after getting approval from IMF.
REASONS FOR FOREX RESERVE DECLINE
Primarily there are three reasons for any country to maintain forex reserves. Firstly, to protect a country from insolvency. Suppose the rupee devalues and reaches a situation where the government cannot repay the credit purchases. In that case, RBI will have a stock of funds. Secondly, the forex market is freely competitive. Hence, if the demand for other currencies increases, then the value of the rupee decreases. In such a situation, in an attempt to increase the value of the Rupee, RBI can and will sell the dollar in the Indian money market, facilitating to control of rupee depreciation. Thirdly, any country with a good forex reserve will provide confidence to any other country to trade with the country.
It is a source of confidence for the country.
INDIA’S FOREX SITUATION
We have seen in the news recently that India has declined to two years low of USD 532 Billion. The main reason is that with India’s Rupee depreciating, RBI had to sell USD 110 billion to arrest the fall in the Indian Rupee. The value of the Indian rupee (Rs. 82 per dollar) has fallen by 10% this year. In an attempt to arrest the devaluation of the Indian rupee, RBI had to sell the Forex reserves. 67% of the decline in the reserves during the financial year starting from April 1 is mainly due to valuation changes arising from US Dollar appreciation and higher US bond yields. As reported by a Reuters poll, the shrinking Forex reserve has stirred memories of the 2008 crisis.
STEPS TO IMPROVE FOREX RESERVES
A few measures taken by the RBI to improve the Forex inflows are encouraging nonresident Indians to deposit money in India by providing higher interest rates and allowing foreign portfolio investors to buy shorter-term local debts.
