India’s Foreign exchange reserves crossed half a trillion Dollars despite worsening economic conditions. Is that even possible? And the Rupee is showing no signs of strengthening. Why isn’t the RBI intervening and helping the rupee gain a little? (RBI sometimes intervenes and sells dollars in the open market if the rupee is sliding, so as to increase the supply of dollars and in turn making the rupee stronger) Let’s learn a little about what constitutes Forex reserves and how do increasing Forex reserves safeguard the economy? Â
Let's start with some context for the unversed..
What Would you Find in a Basket of Foreign Exchange Reserves?
Take some Gold, Dollar, Dollar denominated assets (capital inflows and FDI), some of Euro and Euro denominated assets and there you have a basket of Forex reserves. A part of the reserves is also parked in the International Monetary Fund. But of course, most of the reserves consist of Dollar and assets denominated in dollar, because well it is given the throne of a global reserve currency.
Why are Forex Reserves Showing no Signs of Declining Despite Weakening Economic Conditions?
Half a trillion dollars is a lot; they could cover imports of up to a year. These reserves are also 88% of external debt which stands at around $564 Billion. So what’s the reason for them to continue increasing?
The main reason can be attributed to the large amount of inflows that we have seen in the month of May and June. Foreign portfolio investors and direct investors kept pouring in money into the economy despite the deteriorating economic conditions. And there’s no stopping to this, Reliance Jio has managed to raise close to 1.15 Lakh crore in these unprecedented times (Take a bow), so if things go well we could see more dollars coming into the country and hence more Forex reserves.
Another reason can be attributed to ‘Oil’. India imports close to 80% of its oil. And payments for all these imports are done via Dollar (because well, it is the global reserve currency) We are all well aware of how drastically the oil prices reduced and the oil futures also went into negative for a while. The falling oil prices along with the reduction in demand for oil due to Covid-19 has reduced our import bill drastically and saved precious foreign exchange reserves for us.
This Takes us to Our Next Question, Why is the RBI not Intervening in the Currency Market and Letting the Rupee Depreciate?
The rupee has weakened quite a lot (close to 6.5%) in the past couple of months beginning March and is also one of the worst performing currencies in the Asian markets. Though RBI did intervene here for a bit by selling dollars (The RBI can try to stabilize the currency by selling dollars which in turn strengthens the rupee), it just doesn’t seem to be in the mood to help rupee anymore. But well the RBI has its own reasons. Let’s figure them out, shall we?
The story goes back in time to the year 1991 when India just ran out off enough reserves. By June 1991 the country had less than $1 billion in Forex reserves, which was just enough to cover imports of 3 weeks. This was later termed as the Balance of Payment crisis. Over a span of 3 days, the rupee depreciated by close to 23%. And since RBI was out of reserves it could only partially help stabilize the currency markets. The 1991 crisis eventually lead the government to take several measures to liberalize the Indian economy. And a result of these reforms was an increase in Forex reserves.
The times are unprecedented again, and RBI with the help of accumulating reserves is preparing just in case the rupee sees a stark depreciation again. So even if the value of rupee has tumbled by close to 6.5%, the RBI isn’t intervening right now cause just in case something worse happens and the Indian currency starts fluctuating rapidly, it will have to intervene then. In that case it will start selling the dollars (Forex reserves to stabilize the rupee).
Another reason is that the RBI wants to shield the economy just in case we see another downgrade in our ratings. Globally there are mainly 3 rating agencies that include Moody's, Standard and Poor and Fitch Rating Ltd. Their sole purpose is to assess the ability of the borrower (either government or private enterprise), in this case India, to repay their debt. They consider various factors impacting the Economy and accordingly assign a rating to the country. And if they feel that the future prospects of the entity seem to be deteriorating, they downgrade it. And trust me rating downgrade is pretty bad for an economy, it would mean that the cost of borrowing would increase further. And these rating downgrades are usually followed by a depreciation in the currency.
Lastly, a rather speculative reason is that the RBI is doing it just so it can make some extra money and pass it on to the government as dividends. So how does this work? By simply letting the rupee to depreciate. Suppose an asset costs $5 which is 71*5 in March 2020 the same asset now costs $5*76 in June 2020, the extra 5 Rs is the profit to the RBI. Voila. This profit is transferred to the government in the form of dividends..
Hopefully now you know why :)