From a peak of $642.45 billion on September 3, India’s foreign exchange reserves have dipped to $572.71 billion as of July 15. That’s a fall of almost $70 billion in just over 10 months.
How have the reserves depleted so much so fast? To answer this, one must first understand how they got accumulated in the first place. A country typically accumulates forex reserves when its earnings from export of goods and services exceed payments against imports. The current account surpluses result in a build-up of reserves, as the central bank mops up all the excess foreign currency flowing into the country.
The most obvious parallel one can draw is with households or firms, whose excess of incomes over expenditures or retained profits get added to their savings or reserves. Just as these savings/reserves are available for use by other households, firms and the government, the current account surpluses of a country may be invested in other countries. In the process, it becomes a net exporter of ‘capital’, in addition to goods and services.
Table 1 shows the top 12 countries holding the highest foreign exchange reserves at the end of 2021. Nearly all of them run large and persistent current account surpluses. Take China, whose $2.1 trillion cumulative surpluses over an 11-year period have helped build a $3.4 trillion official reserve chest. Or Germany, whose current account surpluses totaling about $3.1 trillion over 2011-21 have been mostly exported as capital rather than getting accumulated as reserve.
India is an outlier (along with the US and Brazil) among the countries that have accumulated sizeable forex reserves. Only in one out of the 11 years – 2020 – has it run a surplus on the current account of its balance of payments. Its $638.5 billion reserves in 2021 were despite current account deficits aggregating over $400 billion during the 11 years. The reserves have been built through import of capital; in other words, from others’ and not its own current account surpluses.
The capital flows attracted by India have not only financed its excess of imports over exports, but also contributed to an accretion to the official reserves. The US and Brazil have had similar stories, albeit with current account deficits larger than India’s and even relative to their reserves. Moreover, forex reserves and current account balances hardly matter to the US, when it is the owner of the reserve currency used in most international transactions.
Sources of accretion
Between March 31, 1990 and March 31, 2022, India’s forex reserves rose from $3.96 billion to $607.31 billion. Table 2 gives the sources of this rise over four eight-year periods. More than 50% of the $603.35 billion accretion has happened in the last eight years coinciding with the Narendra Modi government’s tenure.
In none of the four periods, however, has reserve accumulation been an outcome of export of goods surpassing imports. On the contrary, the combined merchandise trade deficit during the eight years from 2014-15 to 2021-22 was close to $1.2 trillion. This deficit was partly offset by a net surplus of $968 billion on the “invisible” account of the balance of payments. Invisibles mainly comprise receipts from export of software services, remittances by overseas Indians, and tourism. In India’s case, these receipts have always exceeded payments on account of interest on loans, dividends, royalties, license fees, foreign travel and assorted business and financial services.
The invisible surpluses have by and large contained the country’s current account deficits to manageable levels, with some periods (1998-99 to 2005-06) and individual years (2001-02, 2002-03, 2003-04 and 2020-21) even registering surpluses. Manageable current account deficits in combination with capital inflows – averaging $25.2 billion and $68.4 billion respectively in the last 10 years – have led to India’s forex reserves going up in all but five out of the 32 years from 1990-91 to 2021-22. These five years were 1995-96, 2008-09, 2011-12, 2012-13 and 2018-19.
Besides current account deficits and capital flows, there is another source of reserve accretion or depletion: valuation effect. Foreign exchange reserves are held in the form of dollars as well as non-dollar currencies and gold, whose value is, in turn, influenced by movements in exchange rates and gold prices. A depreciation of the US dollar or higher gold prices, then, causes valuation gains in the existing stock of reserves. A strong dollar or fall in gold prices, likewise, brings down the value of the non-dollar portion of the reserves.
Where reserves are headed
India’s merchandise trade deficit amounted to $70.8 billion in April-June 2022. This could cross $250 billion for the whole fiscal. Net invisible receipts touched an all-time-high of $150.7 billion in 2021-22, as against $126.1 billion and $132.9 billion in the preceding two years. Given the impending recession in the US and Europe, which might have a bearing on software exports, net invisibles are likely to be closer to $140 billion this fiscal.
Either way, the current account deficit would be upwards of $100-110 billion, breaking the previous records of $88.2 billion in 2012-13 and $78.2 billion in 2011-12. That being the case, the extent of reserve drawdown would be a function of capital flows.
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In 2021-22, net capital inflows were at $87.5 billion during April-December. But the last quarter (January-March) saw net outflows of $1.7 billion. Given rising global interest rates and bond yields on the back of monetary policy tightening by the US Fed and other major central banks, the prospects for capital inflows – whether from foreign portfolio investors, private equity firms or start-up funds – don’t seem that bright in the current fiscal too.
Out of the $69.7 billion decline in India’s forex reserves from its early September 2021 peak, $34.6 billion has taken place in this fiscal alone. With the Reserve Bank of India showing willingness to use the reserves to defend the rupee – ensuring “orderly evolution” of the exchange rate with “zero tolerance for volatile and bumpy movements”, to quote RBI governor Shaktikanta Das – a further drawdown to below $550 billion levels cannot be ruled out.
The forex reserves were, after all, accumulated as a buffer against currency volatility, external shocks and sudden stops in capital flows. As Das recently put it, “you buy an umbrella to use it when it rains”.