What are forex reserves and why are they important?

The Reserve Bank of India on Wednesday announced a host of measures to boost forex inflows and push the value of rupee. The steps include doubling the borrowing limits for companies from overseas to $1.5 billion, temporarily removing interest-rate cap for banks to attract deposits from NRIs and relaxing rules for foreigners to invest in local-currency bonds.

In the first quarter of the current financial year, the merchandise trade deficit more than doubled to $70.25 billion year-on-year from $31.42 billion. This comes on the back of a surge in global crude and commodity prices due to war in Europe. Also, the rupee has plunged six per cent against the dollar this year.  

Apart from the falling rupee, the country’s depleting foreign exchange reserves or forex reserve is also troubling the central bank. It has dropped nearly six billion dollars to about $593 billion.

All that we have told you so far begs the question, what exactly do we mean when we say forex reserves? Forex reserves are regarded as the health meter of a country. These reserves are assets like foreign currencies, gold reserves, and treasury bills, among other things, maintained by a country’s central bank or other monetary authority, which checks the balance of payments, deals with the foreign exchange rate of currency and maintains financial market stability.

So what are the key components of forex reserve? RBI Act and the Foreign Exchange Management Act, 1999 govern the foreign exchange reserves. It can be broken into four categories. The first and largest component is foreign currency assets — it constitutes about 80% of the total portfolio. India invests heavily in US treasury bills and about 75% of the country’s foreign currency assets are invested in dollar denominated securities.

Then comes the investment in gold, and special drawing rights from the IMF. And the last is the Reserve Tranche Position.

So, what is the purpose of the foreign exchange reserves? First, to ensure that the RBI has backup funds if the rupee rapidly devalues or becomes altogether insolvent. Second, if the value of the rupee decreases due to an increase in demand for foreign currency, then the RBI can and does sell the dollar in the Indian money market so that rupee depreciation can be checked. Third, a good stock of forex establishes a good image for the country at the international level as trading countries can be sure about their payments, thus helping in attracting foreign trade.