by Tavaga Invest

India’s foreign exchange reserves reached a record high of USD 642 billion last September. The reserves are since then fallen. Forex reserves are down by $38 billion of which $28 billion has come in the last five weeks itself. What is even more worrying is that this fall is not likely to slow down anytime soon as dollar outflows from domestic equity and bond markets are likely to persist. If the current pace of about $6 billion weekly declines continues, reserves could drop by $100 billion in just four months! What is causing this fall and do we need to press the panic button soon? Let us find out

Why are forex reserves important?

Foreign exchange reserves are assets held by the central bank of a country. We need foreign exchange reserves to pay the foreign debt as well as imports. They are also used as a backup fund in case of emergencies like the devaluation of the currency. In India, the Reserve Bank of India (RBI) maintains the reserve. More than anything else, they are used to provide comfort that there is enough buffer to tackle any balance of payment or insolvency crisis that can come in the future. 
Foreign exchange reserves comprise deposits, bonds, banknotes, treasury bills, and other government securities. Most of the forex reserves are held in US Dollars ($) as it is the world’s most traded currency.

India's Foreign Exchange Reserves (Sep-21 to Apr-22)

Source: RBI Weekly Statistical Supplement

Why have the reserves declined…

RBI has been selling dollars from its reserves to ensure that there is no sharp decline or depreciation in the value of the Rupee in the midst of oil prices surging globally.
Apart from this, foreign portfolio investors have been net sellers for the past few months, pulling out roughly $15 billion from Indian markets so far in 2022. Higher cost of imports due to spike in commodity prices have also increased the import bill leading to depletion in reserves. India’s total imports increased by more than 50% in FY22 to $612 billion. 

… and why do we not see the decline to reverse?

Uncertain geopolitical situation – The tussle between Russia and Ukraine shows no signs of cooling off. Peace talks have not resulted in any truce possibility. As a result, global investors have refrained from investing in emerging countries like India and have reduced their exposure. We have thus seen Foreign Portfolio investors being net sellers in the past few months and moving to safe-haven dollar investing. 

Fed Tightening – With Inflation in the US still at decadal highs, Fed is expected to increase interest rates and reduce its balance sheet size or the quantitative tightening program at a much faster pace. inflation in the USA at 8.5 % the feds may hike rates faster and reduce balance sheets. This will also result in investors pulling away from India to regions offering higher interest rate economies. 

Higher import bill – With a global spike in commodity prices especially crude oil prices, India’s import bill has gone up too. The current account deficit has already widened to around 1.5% in FY22 and could potentially worsen in FY23 if oil prices remain elevated at current levels. FYI, due to a sharp rise in the import bill and an economic downturn, India’s current account deficit (CAD) shot up to $78.2 billion or 4.2% of GDP in FY12. 

Time to press the panic button?

Forex reserves were at their peak in September last year at $642 billion and have contracted to $607 billion in March. It was in December 2021 that imports reached their all-time high at $60.3 billion and have been above the $50 billion mark for the past 7 months.
This has caused the forex cover for the import bill to shrink considerably.
Crude oil prices are expected to remain at elevated levels and average at $100/barrel for FY23. This may translate to a current account deficit of about 2.5% – meaning more dollar outflows. Even if there is some resolution to the Russia Ukraine conflict, oil prices may remain high due to Russian sanctions. 
While currently, the forex reserves are sufficient to cover 1 year of imports, we are still better off compared to the global financial crisis of 2008-09 when the reserves covered imports for 10 months only.

While the situation is not ideal as forex reserves will be needed to cover the increasing cost of fuel and commodity imports, it is not something to be extremely worried about and make any panic decisions and investment moves.

India's historical Forex Reserves (1994-2021)

Related Posts

Leave a Comment