The Reserve Bank of India, in consultation with the Government of India manages foreign exchange reserves. As the objectives of reserve management are, primarily, liquidity and safety, attention is paid to the currency composition of reserves and duration of investment therefrom, so that a significant proportion can be converted into cash at short notice. The amount of foreign exchange reserves in India is modest when compared to some of the other countries in the region.

Historically, India’s foreign exchange reserve (FER) story, until 1991, was mainly designed to conserve limited FER for essential imports (petroleum goods and food grains), restrict capital mobility, and discourage entry of multinationals. In 1991, India had forex reserves for about two weeks, and we had to go pillar to post, with a begging bowl. India eventually had to transport gold to the Bank of England to get some loan. As on June 2021, India has recorded more than $600 billion of foreign exchange reserves equivalent to about 12 months of imports. India's foreign exchange reserves increased only during the 1990s as a result of measures introduced to liberalize capital inflows under the financial sector reforms undertaken since 1991. The external sector strategy since 1991, though gradualistic in approach, shifted from import substitution to export promotion and had the following key elements – (i) sufficiency of reserves, (ii) stability in the foreign exchange market, and (iii) prudent external debt management. Foreign investment policy also underwent a gradual change to encourage foreign direct investment to India. In 1993, a report was submitted by the High Level Committee on Balance of Payments, chaired by Dr. C. Rangarajan,with Secretary of the Committee was Dr Y V Reddy. The report suggested corrections to the Balance of Payments, stating that the minimum foreign exchange reserves target should be fixed in such a way that the reserves are generally in a position to accommodate imports of about a year plus debt servicing cost and payments. Post the Asian Crisis, Alan Greenspan, an American economist, came up with a view of assessing adequacy of reserves of developing countries, in terms of six months import cover.

Why Countries Accumulate Foreign Exchange Reserves?

The desire to accumulate FER arises for several reasons. The earlier literature focused on the need for reserves to maintain fixed exchange rates and to intervene in the market. More recently, an increasing volume of empirical literature stresses that high FER are held for precautionary purposes. A country’s rating is dependent on the umbrella insurance present in the form of FER. Mostly Dollar (USD), Euro, pound sterling, and Yen dominate these FER. These reserves are kept for transaction motive, and precautionary purposes. Some countries, with high reserves may pursue speculative motives through building sovereign wealth funds.

The rating agencies, when evaluating the state of a country’s economy, consider multiple factors, including reserves. Foreign exchange reserves instill confidence to the markets, both domestic and external, that foreign obligations can always be met. In case of any sudden change in the foreign market due to, let’s say, change in interest rate, FER helps in stabilizing the domestic currency immediately. FER is also important for deterring speculative attacks and suggests that one of the primary ways in which a country can reduce the risk of a currency crisis is by maintaining a substantial level of reserves. A strong Foreign Reserve conveys to the world, industry, speculators and rating agencies that the management of the economy is in safe hands.

Current Scenario

Given the current pandemic, we are aware that across the globe, there is a negative impact on international trade. The current FER India has been built during a time when our current account was in deficit, meaning our imports are more than our exports. In the last few months, India has had a current account surplus. In such circumstances, accumulation of reserves becomes easy. But this isn’t enough. In 2012, the world had a FER worth USD 10 trillion, out of which China had FER worth USD 4 trillion and hence was able to dominate the world market. Thus, FER is important for the economy in global standing.

Today, FER cover of one year of import is inadequate. Earlier, it was assumed that a country would be able to address the crisis in about a year and after that the manufacturing, agriculture and services would normalise . But the current pandemic, which has lasted for almost two years now, has opened new challenges. A lesson that can be learnt is that this concept of FER covering one year of imports can be only applied during normal time for advanced economies. For countries like India, we need export coverage of not less than 17-18 months, to keep the economy & currency stabilized.