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Should India’s policy-makers celebrate the unprecedented rise in foreign exchange reserves in recent months or should they worry about finding gainful avenues to utilise the fund? The country's foreign exchange reserves swelled to an all-time high of $516.36 billion in the week to July 10 from $513.54 billion on July 3. In fact, after crossing the $500 million-mark ($501.70 precisely) for the first time in the week ended on June 5, the forex reserves have increased steadily week after week. In the six weeks between June 5 and July 10, the forex reserves have increased by about $15 billion.

India has added over $40 billion in the current financial year. In the last one year, between the week ended on July 12, 2019, and the week ended on July 10, 2020 the forex reserves have increased by a record $87.56 billion or by 20.4%. At $516.36 billion, India’s forex reserves are now the fifth largest in the world after China, Japan, Switzerland, and Russia.

A healthy forex kitty works as a cushion against market volatility and gives foreign investors and international rating agencies extra comfort that the government can meet its debt obligations despite a faltering fiscal outlook and a contraction in economic growth.

The strong forex reserves come as an advantage for the central bank in managing the country’s external and internal financial issues at a time when the economic growth is decelerating. The large forex reserves will act as a big help against any financial crisis and external exigencies as it will cover the country’s import bill for about a year and half. The rising reserves have also helped the rupee to strengthen against the dollar. The strong reserves will provide a level of confidence to international markets that the country can meet its external obligations and will demonstrate the backing of domestic currency by external assets.

What took India’s forex reserves to record high?

The question is: What made the forex reserves increase so fast in recent months? One of the reasons for the recent increase in forex reserves was the large inflow through foreign direct investments (FDI). Total FDI inflows were much higher at $43 billion last year compared to $39 billion in 2018-19. According to the Reserve Bank of India (RBI), the reserves shot up by $59.5 billion in the last fiscal against a reduction in the year before.

The reserves were further boosted by the current-account surplus in the first quarter of the current year, a return of inflows into the local stock market and foreign direct investment that allowed the central bank to mop up close to $25 billion in foreign exchange to add to its reserves in the quarter through June.

The foreign investment in Indian stocks has increased in the past two months. Foreign fund flows into India significantly improved during the June 1 to June 26 period even as concerns over steep valuations and weak fundamentals remain in the air. Foreign institutional investors’ (FIIs’) capital inflows into Indian equities stood at $2.87 billion in June, highest ever in the year. Earlier in May, FIIS invested $1.71 billion into Indian shares.

Foreign currency assets (FCAs), which form the key component of reserves and account for over 90% of total reserves rose steadily over the months. FCAs are maintained in major global currencies like the US dollar, euro, pound sterling and Japanese yen. Movement in the FCA occurs mainly on account of purchase or sale of foreign exchange by the RBI, income arising out of the deployment of foreign exchange reserves, by external aid receipts of the government and through revaluation of assets.

Cost of maintaining forex reserves

India's record foreign exchange reserves seem to be the only hope for the pandemic-ravaged economy. But there is another story to this rise. Forex reserves are built through absorption of dollars by the RBI, preventing the inflows to reach the real economy. RBI fears that allowing all the flows to reach the economy would mean asset price inflation and a threat to financial stability. Following this logic, RBI opposed the demand by economists to use a part of the reserves for infrastructure development.

While the servicing cost of the reserves, especially as the fund coming through external borrowing is high, the return on the reserves kept in foreign central banks and commercial banks is negligible. The RBI does not divulge the rate of return but investment analysts believe that it may be around one per cent or even less, considering the fall in the interest rate in the US and Euro zones - where the larger part of the fund is kept.

Another issue is the high ratio of volatile flows (portfolio flows and short-term debt) to reserves which can exit at a fast pace. FDI money is much more stable as it is more long-term in nature. More FDI inflows can be considered as an expression of confidence of foreign investors in the long-term prospects of the Indian economy.

The former RBI Governor Y.V. Reddy argued that if it is assumed that the direct financial cost of holding reserves is the difference between interest paid on external debt and returns on external assets in reserves, such costs have to be treated as insurance premium to assure and maintain confidence in the availability of liquidity.

Given the low interest on deposits abroad, the opportunity cost of reserves holding is high for the Indian central bank as returns from the foreign currency asset deposits are low whereas the domestic interest rate is comparatively high.

This poses a question: What is an adequate level of international reserves for India? There is no definite answer. According to Reddy, the level of reserves will vary as per the basic motive for holding reserves. Given that the Indian economy is decelerating and the government’s fiscal accountings are failing, the RBI has to find out ways to use the rising forex reserves for the best interest of the country.