scorecardresearchWhat are the benefits of foreign exchange reserves

What are the benefits of foreign exchange reserves

Updated: 17 Jul 2022, 09:39 AM IST

India’s foreign exchange reserves, which cushion the economy against unforeseen external shocks, have been touching new historic highs. Let us find out why this is relevant.

The Reserve Bank of India (RBI) holds foreign currency in US dollars because it is a widely traded currency around the world.

The Reserve Bank of India (RBI) holds foreign currency in US dollars because it is a widely traded currency around the world.

India's foreign exchange reserves declined by a $8.062 billion to $580.252 billion in the week ended July 8, according to Reserve Bank of India (RBI) data.

In the previous week ended July 1, the reserves had dropped by $5.008 billion to $588.314 billion.

During the reporting week ended July 8, the decrease in the reserves was on account of a fall in the Foreign Currency Assets (FCA), a major component of the overall reserves, and in the gold reserves, RBI said.

What does this mean?

The total amount of assets held by a central bank in foreign currency, are known as foreign exchange reserves. Holding them in adequate quantities is imperative for a variety of reasons — most importantly, to maintain a cushion against the economy’s collapse. The countries that depend heavily on imports such as India are expected to hold large foreign reserves. The Reserve Bank of India (RBI) holds foreign currency in US dollars because it is a widely traded currency around the world. The forex reserves may include foreign currencies, bonds, treasury bills, and other government securities.

On June 5, 2021, RBI’s forex reserves hit an all-time high of $605 billion that are sufficient to meet the import bill of 15 months. The reserves were ranked fifth in the world after Switzerland, Japan, Russia and China. The foreign exchange reserves stood at $412.9 billion in March 2019, $459.9 billion in December 2019, $477.8 billion in March 2020, and $585.8 billion in December 2020.

Optimum level of forex

It is significant to maintain an optimum level of foreign exchange reserves to cover import bills over a long duration of time. However, some skeptics opine that the reserves should not exceed beyond a threshold. There is a debate around holding more reserves than required. They argue that since holding forex reserves bears a cost, they should not surpass beyond a level because higher the reserves are, the higher would be the cost.

The RBI, in a report released on June 14, 2021 on the state of economy, rubbished the claims that the foreign exchange reserves are more than required. “While foreign exchange reserves provide cushions against unforeseen external shocks, levels are often deceptive, and a better gauge of external vulnerability is an assessment of specific indicators,” reads the RBI statement.

The statement further states that in terms of projected imports for 2021-22, the reserves provide cover for fewer than 15 months, whereas other countries with higher reserves hold them for relatively longer duration — ranging between 16 months (for China) to 39 months (for Switzerland).

“India’s reserves co-exist with a net international investment position of (-) 12.9 percent of GDP. These factors warrant a pragmatic assessment of reserve adequacy on forex reserves, including exposure to valuation changes and market risk in a world of heightened global uncertainty,” the statement reads.

Large foreign exchange reserves are maintained to prevent the economy from global shocks. 

As a matter of fact, another reason to maintain adequate foreign exchange reserves is to avoid big currency fluctuations. Forex reserves play a significant role in strengthening local currency. The Indian rupee, for instance, became stronger by 2 percent in May 2021 in one month when the forex reserves were soaring.

So, the RBI tends to maintain large reserves to prevent the economy from global shocks, to maintain a level of confidence in the Indian rupee, and also to give a strong ammunition to the government against unforeseeable economy’s decline.


First Published: 17 Jul 2022, 09:39 AM IST