How did India become the fourth largest Forex holder in the World?

This weekend was special. India surpassed Russia to become the 4th largest holder of foreign exchange reserves in the world. With a forex reserve of $580.3 Bn, we're only next to China, Japan and Switzerland. And if you're imagining, that's huge!

And how did we achieve this milestone, you ask? Well, hold on, we'll obviously cover that. But first thing first, what are these foreign exchange reserves exactly?

Foreign Exchange Reserves

Reserves, as the name suggests, are stuff you accumulate in the present to utilize in the future. Remember how ants accumulate their food in autumn to consume it later in winter. Yeah, you could call it reserves. Likewise, a nation, too, is forward-looking and thus, fills up its piggy bank to utilize it in the future. For an economy, reserves could comprise cash, bank deposits, bonds and other financial assets. And when all of these are in denomination of foreign currencies (usually dollars), you name it -- Foreign Exchange Reserves (or Forex Reserves). Simple, isn't it?

And who does all of this? Most probably, you guessed it right; it's our central bank, the Reserve Bank of India (RBI).

Okay. Now, this is important. Why do we need forex reserves at all?

Why does a country need Foreign Exchange Reserves?

You see, we import a lot of stuff from foreign countries, things that are actually essential… cereals, edible oils, fuel, etc. And, god forbid, if another pandemic breaks out and the entire country is in dire streets, from where do you think will the Government get its revenues (taxes) to clear its import bill? That's when forex reserves do their magic. You can use it during fighting times to fetch essential imports for your country.

At least things won't be like 1991 anymore when we had to pledge our gold reserves to stave-off a major financial crisis. Now, we can use our soaring forex reserves to handle a crisis in the economic front.

What's more is that an open economy, like India, doesn't run isolatedly on its own. When the country's friends need funds, we lend them. And when we need it, they lend us. A friend in need is a friend indeed, isn't it? But do you think they'll just lend us without having an assurance of the safety of their capital? Let us remind you; we aren't talking of thousands or lakhs here; it's in billions! Thus, it's risky. So, before lending, these countries look upon credit rating agencies, which assess the credibility of the borrowing nation. They'll lend you only if your credit ratings are good enough. Now, when the nation is in a crisis and is showing a grim outlook, do you think the credit ratings will be in your favour? No, right?

In such a scenario, increasing forex reserves enables a nation to repay its debts in time and thus, gives credit rating companies a hope that the nation's Government can meet its obligations, despite a declining fiscal outlook. And so, perhaps, the nation's credit ratings may improve, and our foreign peers will come forward to help us out of the crisis.

Likewise, foreign investors will hesitate to invest in a country struggling with wars, pandemic or any other adverse events. They'll withdraw their deposits from the country's banks and stop pouring in money into the stock markets. And again, we may run short of funds. But thanks to these accumulated reserves, the confidence is restored, and foreign investors don't back out.

And even if the borrowings and investments are curtailed, remember we have funds in our forex piggy bank. And that's a real ray of hope amidst the darkness, isn't it?

Now, this is what no country will tell you, but they have this motive in the back of their mind… forex reserves are used to manipulate the currency rates. Oh, hold on, we'll talk of it when we discuss the Indian scenario a little while later.

Why are India's foreign exchange reserves rising?

Welcome to the 1960s. We rejoice as our forex reserves touch $1 Bn. And then, in a matter of just six decades, it becomes 500x! That's huge! Well, we won't take you on a very long flashback, but let's just see what's happened since 2020.

So, we started off with a foreign exchange reserve balance of somewhere around $460 Bn, and by the beginning of June, we had already crossed the half a trillion dollars ($500 Bn) mark. Mind you, it ain't no usual feat! Some push came from our deliberate efforts, some from external factors and some more from the circumstances.

The reasons were simple. We didn't know exactly how long the pandemic spree was gonna continue. And there was this heavy medical expenditure, infrastructure cost, a nation-wide vaccination drive, imports, etc., on the cards. And you never know when you'd be in need of funds. That's why the RBI accumulated its reserves to shield the country against any future shocks and contingencies.

But that's not all. Our friends from foreign countries also helped to pump up the reserves. You probably have at least some idea of how foreign investors loosened their purse strings and went heavy with investment in Indian markets (both equity and debt). For instance, total FDI (Foreign Direct Investment) inflows between April-November 2020 was a record $58.37 Bn, 22% higher than the same period the previous year! Remember, Facebook and all going heavily long on Jio (over $20.6 Bn FDI in 2020 alone)? Yeah, and there were a lot more you probably didn't notice.

So anyway, when more dollars inflow, our forex reserves increase, simple as that.

Moreover, we weren't importing much during the pandemic either. Take, for example, one of our significant imports, Oil. The nation was locked down. People weren't moving out a lot. Demand for fuel was curtailed. So, it made sense for us to import less Oil, which significantly cut down our imports bill. Also, overseas remittances and foreign travels fell down. All of this saved precious dollars from flowing out of our forex reserves.

Remember we said to you, we would talk about the currency manipulation bit. Here we go. You see foreign exchange reserves and foreign currency rates are interlinked. For instance, suppose you mop up your forex reserves by buying dollars. To buy dollars, you'll have to sell rupees. This essentially increases the supply of rupees in the economy. Thus, when rupees' supply increases, it becomes weaker against dollars. (If you have an idea of the demand-supply equation, usually, when supply increases, price decreases.)

And thus, you'll have to pay more rupees to fetch one dollar, which could make our imports expensive as, ultimately, we have to pay our foreign trade partners in dollars. What to do then?

Now see how accumulated reserves can help you stabilize this volatility in rupees' value. If you have enough dollars in your reserves, you can sell them off and fetch rupees. This will squeeze out rupees from the market, making it stronger against dollars. And now, we're even, isn't it? 

You won't believe, due to this (deliberate) surge in forex reserves, last year, the rupee became the worst performer among Asia's major currencies, as against the dollar! And this led the US treasury department to put Indian Rupees in the currency manipulation watchlist. Anyway, the RBI doesn't seem to care, as hinted by the RBI governor, who said that emerging nations need to build reserves as buffers in spite of the risk of being put on the watchlist. And there you go!

What happened in 2021?

So, our forex reserves touched an all-time high of around $590 Bn in Jan-end this year. And then, the reserves have been, more or less, static or declining due to less FPI inflows or FPI outflows (over Rs.7000 crores in March, probably due to profit-booking). Okay, then, how did we beat Russia, you ask?

Well, their reserves fell at a sharper rate than ours. And here we are, in the 4th position with a forex reserve balance of about $580.3 Bn, while Russia stands two hundred million dollars behind us. We're only next to China, Japan and Switzerland in the ranking. So, kudos to the RBI.

Help yourself with a snapshot of the Forex reserves ranking table 

The Bottom Line

You see, with our accumulated forex reserves, experts predict that we can go about procuring 18 months of imports or pay off 90% of our external debts. While this shows a good progressive outlook, it provides a very narrow idea about the present health of the economy. As the last year was evident, though we may be preparing for the future thorns, our present condition need not necessarily be all rosy.

However, perish the thought, but if there is another economic mess, we may have some respite. And probably, we can fight back with confidence this time around, thanks to our forex kitty!

All hail the RBI lord.