scorecardresearchWhat is causing India's foreign exchange reserves to dwindle?
The rupee has repeatedly hit new lows and breached the psychological level of 80 per dollar for the first time ever last week.

What is causing India's foreign exchange reserves to dwindle?

Updated: 26 Jul 2022, 09:46 AM IST
TL;DR.
Since the start of the US Fed rate hike in May, the Indian rupee has lost over 4.72% and since the beginning of this year, it has fallen 7.42% against the dollar and stands as the third-worst performing Asian currency.

Indian foreign exchange reserves have fallen by about $7.5 billion to $572.7 billion as of July 15, the lowest since November 6, 2020, Bloomberg reported, quoting RBI data.

The recent data shows that nearly $70 billion has been wiped out from the record high reserves of $642.45 billion on September 3, 2021. However, the RBI's reserves of $572 billion remain the fifth largest in the world.

The fall in forex reserves started during the week ending March 11, 2022, when the Indian rupee hit an all-time low, besides that, a variety of other factors have also caused this fall.

But why are forex reserves depleted so much in such a short period of time? To understand this, one must first understand how they got acquired. If a country's exports exceed its imports, more dollars will flow in, assisting in the accumulation of reserves. But for many years, India has been running a current account deficit. However, forex reserves hit an all-time in September last year and the reason behind it was the capital flows attracted by India. This has not only financed its excess of imports over exports but also contributed to the accretion of the official reserves. And most of the capital flows are moving back from emerging markets due to recession fears.

Indian Foreign exchange reserves 
Indian Foreign exchange reserves 

Last month, the Bank of America said that the rupee might extend declines to a record low of 81 per dollar by year-end due to rising crude and other raw materials prices.

Here are some of the key reasons behind the decline in Forex Reserves.

US Fed Aggressive rate hikes

The US Federal Reserve in its June 2022 meeting lifted its benchmark rate by 0.75 percentage points, instead of the 50bps initially expected. This is the greatest increase since 1994 after the country's inflation reached multi-decade highs. The Fed policy makers anticipate a 50 or 75 basis point hike in July.

Since the start of the US Fed rate hike in May, the Indian rupee has lost over 4.72% and since the beginning of this year, it has fallen 7.42% against the dollar and stands as the third-worst performing Asian currency after the Philippine peso and Thai baht. The rupee has repeatedly hit new lows and breached the psychological level of 80 per dollar for the first time ever last week.

USD/INR - chart 
USD/INR - chart 

So far this year, all major currencies have fallen by about 8 to 17 per cent against the dollar, including the euro, pound, yen, Australian dollar, Swiss franc, and New Zealand dollar. The euro has reached parity against the dollar for the first time in 20 years. The last time it happened was in November 2002, when the euro was worth $0.99.

Further, the US Fed is shifting from quantitative easing to quantitative tightening, which also makes the dollar stronger as it restricts the free flow of dollars. The Fed used quantitative easing in the wake of the 2008 financial crisis to restore stability to financial markets, and now it wants to reverse much of that in relatively short order.

To arrest the plunging domestic currency, the RBI has intervened in the spot and futures markets through state-run banks. Typically, spot market interventions will immediately deplete dollar reserves as the central bank sells dollars to receive rupees. However, the obligation of delivering dollars can be pushed forward via buy/sell swaps at a later date, said, market experts.

Adding to that, the RBI has spent more than $41 billion of its reserves since February this year to defend the rupee, Barclays said in a report.

RBI recently said that it is prepared to spend $100 billion more defending the rupee, Reuters reported. The RBI "can afford to spend even $100 billion more if required to defend the rupee," the source told Reuters.

FPIs Sell-off Continues

Foreign portfolio investors (FPIs) have sold an average of $225 million ( 1,720 crore) per day of domestic stocks. The intensity of selling is the highest ever the Indian market has witnessed as FPI selling this year has neared $30 billion ( 2.3 trillion), Business Standard reported. Among emerging market (EM) peers, the FPI pullout from India is the worst after China and Taiwan.

With the US Fed raising interest rates twice in a row, foreign investors are leaving emerging markets and moving back to the US as the Fed's rate hikes cause yields on US Treasury bonds to climb, attracting investors seeking higher yields than they can find elsewhere in the world.

Moreover, as interest rates go up, the equity risk premium tends to go down, and this makes investing in equities less attractive. Due to this, the incremental flows to equity may go down. And many more FIIs may pull out from the Indian stock market as the incentive to invest in equities remains low.

According to the RBI study, there is a 5% chance of portfolio outflows from India of the order of 3.2 per cent of GDP, or $100.6 billion per year, in response to a COVID-type contraction in real GDP growth, a GFC (global financial crisis)-type decline in interest rate differentials vis-à-vis the US, or a GFC-type surge in the volatility index (VIX).

Forex reserves may fall if CAD gets wider

The trade deficit in the June quarter jumped to a record $70.8 billion, way above that of $31.4 billion in the same quarter last fiscal. The country’s merchandise exports rose 23.5 per cent in June, while imports increased 57% on the back of elevated global commodity prices.

In the absence of dollar inflows from foreign investors, a bigger CAD could force India to delve into its foreign exchange reserves to pay the deficit. Bank of America Securities (BofA) in a report said, "India's current account deficit will likely touch USD 105 billion, or 3 per cent of the GDP this fiscal, mainly due to the continuously widening trade deficit.

External debt includes private and sovereign of about $267 billion of which a total of $621 billion is due for repayment in the next nine months.

This might cause a big hit on the forex reserves as this is equivalent to about 44% of India's foreign exchange reserves.

Meanwhile, the Indian government has raised import duty on gold amid a widening trade deficit. The Centre has raised the basic import duty on gold from 7.5 per cent to 12.5 per cent, effective July 1st 2022, as per ET.

RBI measures to prevent rupee depreciation

The RBI has introduced a rupee settlement system for international trade. This settlement in rupees will help the central bank to save some foreign exchange reserves as Indian importers will make payments in rupees instead of standard international currencies such as dollars or Euros.

Prior to this, the central bank announced various measures to boost foreign exchange inflows.

Among the fresh steps, the cap has been removed on the interest rate that lenders can offer on foreign deposits made by NRIs. The relaxation will be in force till October, and it raises the external commercial borrowing limit.

Further, the central bank also announced major changes to attract foreign portfolio investors' (FPIs') investments in government securities and corporate bonds.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of MintGenie.

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