India’s foreign exchange reserves have declined by $70 billion in 10 months. Before that, India had accumulated these in a very unconventional way, which it now uses to protect the rupee.
Harish Damodaran
Explained: Making use of forex reserves: India’s foreign exchange reserves have declined to $572.71 billion as on July 15, from a peak of $642.45 billion on September 3, 2021. That’s a drop of nearly $70 billion in just 10 months.
How did the stock drop so fast? To answer this, we must first understand how they accumulated. A country usually accumulates foreign exchange reserves when earnings from exports of goods and services exceed expenditures against imports. Current account surpluses create reserves as the RBI clears all excess foreign currency coming into the country.
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To put it more clearly, the excess income or retained earnings of households or firms over their expenditure is added to their savings or reserves. A country’s current account surpluses can be invested in other countries, as these savings/reserves are available to households, firms and governments for other purposes. In the process, the surplus becomes a net exporter of ‘capital’, in addition to goods and services.
Unique status
Table 1 shows the top 12 countries with the highest foreign exchange reserves at the end of 2021. Almost all these countries use large and stable current account surpluses for other purposes. Take China, whose gross surpluses of $2.1 trillion over an 11-year period helped build an official reserve portfolio of $3.4 trillion. Or Germany, where current account surpluses totaling about $3.1 trillion in 2011-21 have been exported as capital rather than accumulated as reserves.
India (along with the US and Brazil) is in a unique position among countries that have accumulated significant foreign exchange reserves. Only in 2020 in 11 years has its current account had a surplus in its balance of payments. Its reserves stood at $638.5 billion in 2021, despite a current account deficit of more than $400 billion in 11 years. Reserves are built up by importing capital; In other words, balances from others are shown, not India’s own current account surpluses.
Capital flows attracted by India not only financed its excess imports over exports, but also contributed to increasing official reserves. The US and Brazil have similar stories, although the current account deficit is larger than India’s and relative to their reserves. Also, since the US is the owner of the reserve currency used in most international transactions, foreign exchange reserves and current account balances are not important to the US.
Sources of Aggregation
Between March 31, 1990 and March 31, 2022, India’s foreign exchange reserves increased from $3.96 billion to $607.31 billion. Table 2 provides evidence of this increase over four- and eight-year periods. More than 50% of the $603.35 billion mobilization took place during the tenure of the Narendra Modi government in the last eight years.
However, in none of the four periods was stockpile accumulation the result of exports of goods exceeding imports. In contrast, the combined trade deficit for the eight years from 2014-15 to 2021-22 was $1.2 trillion. This deficit was a net surplus of $968 billion in the “indirect” balance of payments account. The indirect account mainly includes receipts from exports of software services, overseas Indian remittances and tourism. In the case of India, these receipts are always higher than the disbursements on account of interest on loans, dividends, royalties, license fees, foreign travel and classified business and financial services.
Indirect surpluses have kept the country’s current account deficit manageable, with some periods (1998-99 to 2005-06) and even individual years (2001-02, 2002-03, 2003-04 and 2020-21) recording surpluses. A manageable current account deficit combined with capital inflows of $25.2 billion and $68.4 billion over the last 10 years, respectively, led to India’s foreign exchange reserves increasing in all but five of the 32 years from 1990-91 to 2021-22. These five years are 1995-96, 2008-09, 2011-12, 2012-13 and 2018-19.
Apart from current account deficit and capital inflows, there is another source of balance increase or decrease: the valuation effect. Foreign exchange reserves are held in the form of dollars and non-dollar currencies and gold, the value of which is affected by changes in exchange rates and gold prices. A depreciation of the US dollar or higher gold prices results in gains in the valuation of existing reserves. A strong dollar or a drop in gold prices, likewise, reduces the value of non-dollar reserves.
Where do reserves go?
India’s merchandise trade deficit stood at $70.8 billion in April-June 2022. It will cross $250 billion in the full fiscal year. Net indirect receipts touched $150.7 billion in 2021-22, as against $126.1 billion and $132.9 billion in the previous two years. Due to the impending recession in the US and Europe, software exports are likely to be impacted, with the net indirect account expected to be close to $140 billion this fiscal.
In any case, the current account deficit will be over $100-110 billion, breaking the previous records of $88.2 billion in 2012-13 and $78.2 billion in 2011-12. In that case, balance inflows are a function of capital flows.
In 2021-22, net capital was $87.5 billion in April-December. But the net outflow in the last quarter (January-March) was $1.7 billion. Given the rising global interest rates and bond yields against a backdrop of monetary policy tightening by the US Federal Reserve and other major central banks, the prospects for capital inflows for foreign portfolio investors, private equity firms or start-up funds do not appear to be bright in the current financial year either.
India’s foreign exchange reserves fell by $69.7 billion at the start of September 2021, down by $34.6 billion this fiscal year alone. Ensuring an “orderly evolution” of the exchange rate and “zero tolerance for volatile and uneven movements”, RBI Governor Shaktikanta Das is quoted as saying, the Reserve Bank of India’s willingness to use reserves to protect the rupee cannot avoid a further fall in reserves below $550 billion.
After all, foreign exchange reserves are accumulated as a buffer against currency volatility, external shocks and sudden stops in capital flows. As Shaktikanta Das recently said, “Buy an umbrella to use when it rains”.
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