India’s Forex reserves breached the $500 billion for the first time ever and people have been talking about it quite a bit.
The Story
Take a pinch of Gold, Dollar, Dollar-denominated assets, Euros, Euro-denominated assets, some other valuable things; put them all together and you’ll get a part of what constitutes foreign exchange reserves. But it’s hard to keep a tally of everything. So we’ll restrict ourselves to dollars and dollar-denominated assets for now. Anyway, the story goes that India’s Forex Reserves have been reaching new highs despite deteriorating economic conditions and it’s imperative to ask — why?
- The Oil Use case
Usually, we import a lot of oil. It’s quintessential to our cause. But the payment here is dollar-denominated since very few countries are going to accept our currency (Rupee) as is. So, you have to expend dollars i.e. the foreign exchange reserves to keep the flow of crude oil intact. However, with the nationwide lockdown in place, our import bill has reduced drastically. We simply don’t need as much oil anymore. And considering oil prices have also taken a beating simultaneously, our Forex Reserves have been piling up.
Less oil import. More Forex reserves. It’s simple.
2. Dollars incoming
Contrary to popular opinion, foreign investors have been pouring money into India of late. And it's not looking like it's stopping anytime soon. Consider for instance— Reliance Jio. They’ve been enticing investors all over the world and they’ve been doing it at a pace that belies all rational expectations. They’ve raised close to $15 Bn over the course of a few months and if all goes well, our Foreign reserves could get a boost soon enough. So technically, dollar inflows spikes translate to higher Forex Reserves.
3. RBI is preparing a war chest
Another popular explanation is that the RBI is preparing a war chest to stave off future uncertainties. At a time when the world economy is reeling from an unprecedented crisis, it’s perhaps prudent to build up reserves for a rainy day.
So the RBI buys gold and dollar-denominated assets using our national currency and builds up the foreign exchange reserves. Inadvertently, this increases the money supply within the economy. There will be more “Rupees” floating around. As more Indian currency keeps entering the ecosystem, the value of the rupee depreciates.
And yes, the value of rupee has tumbled recently, but we are not in dire straits yet. But if India’s economy takes a turn for the worse, it becomes incumbent on the RBI to ensure price stability. Imagine the value of the rupee starts fluctuating wildly because of economic uncertainties. The RBI has to intervene.
It has to exchange the foreign reserves for the Indian currency. Ergo, if they keep mopping up the excess Rupees floating in the system, they could ensure the value of the rupee remains stable. So long as the value of the rupee remains stable, prices of commodities will follow the same cue, all things remaining equal that is.
Now, bear in mind, there’s still no clear consensus on what kind of reserves we might need if things do go south. Although there have been recommendations made in the past about hoarding too much, it’s still the RBI’s call at the end of the day. So yeah, make of it what you will.
4. The RBI is doing it for the government
Now this one is tricky because it's highly speculative. However, theoretically, you could still make a case and that’s exactly what we are going to do.
So here’s what you should know. The RBI can turn a profit if it wants to. And once it does turn a profit, it can transfer a part of the surplus to the government — as dividends. Now if the RBI wanted to offer the government a higher dividend, it has to simply turn a higher profit. One way to accomplish this is to simply let the value of the rupee depreciate. Do not intervene. Do not forego the reserves. Let the rupee tumble.
And so long as you don’t intervene, all the dollar-denominated assets you own will be worth more in rupee terms.
Here’s a hypothetical example
March 2020
$1 Asset = ₹ 71
Then the rupee loses value and you see the same line item once again in June 2020.
$1 Asset now equals ₹ 76
The extra ₹ 5 is treated as a profit*. And this profit could be ploughed back to the government. Easy peasy!!!
And now you know why Forex Reserves have reached an all-time high.
Until next time…
*The gain here is still unrealised and RBI's accounting method does not allow for the transfer of unrealised gains. However if the RBI deems it has enough surplus reserves (based on recommendations of the Bimal Jalan Committee), it can monetize this gain by selling and buying the dollar denominated asset on the same day. Or it could realise the gain some other way.
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