What are the benefits of foreign exchange reserves?

India’s foreign exchange reserves fell by $8.062 billion to $580.252 billion in the week ended July 8, according to data from the Reserve Bank of India (RBI).

In the previous week ending July 1, reserves had fallen by $5.008 billion to $588.314 billion.

In the reporting week ended July 8, the decline in reserves was due to a decline in foreign exchange assets (FCA), a major component of overall reserves, and gold reserves, RBI said.

What does it mean?

The total amount of assets held by a central bank in foreign currency is called foreign exchange reserves. Keeping them in adequate amounts is imperative for a variety of reasons – the most important being to maintain a cushion against a collapsing economy. Countries that rely heavily on imports, such as India, should hold large foreign exchange reserves. The Reserve Bank of India (RBI) holds foreign currency in US dollars as it is a widely traded currency around the world. Foreign exchange reserves may include foreign currencies, bonds, treasury bills and other government securities.

On June 5, 2021, RBI’s foreign exchange reserves hit an all-time high of $605 billion, which is enough to meet the 15-month import bill. Reserves were fifth in the world after Switzerland, Japan, Russia and China. Foreign exchange reserves stood at $412.9 billion in March 2019, $459.9 billion in December 2019, $477.8 billion in March 2020 and $585.8 billion in December 2020.

Optimal level of exchange

It is important to maintain an optimal level of foreign exchange reserves to cover import bills over a long period of time. However, some skeptics are of the opinion that the reserves should not exceed a certain threshold. There is a debate around holding more reserves than necessary. They argue that since holding foreign exchange reserves has a cost, they should not exceed a certain level because the higher the reserves, the higher the cost would be.

The RBI, in a report released on June 14, 2021 on the state of the economy, denied claims that foreign exchange reserves are badly needed. “While foreign exchange reserves provide cushions against unexpected external shocks, the levels are often misleading, and a better measure of external vulnerability is an assessment of specific indicators,” the RBI statement read.

The statement further indicates that in terms of projected imports for 2021-22, the reserves provide cover for less than 15 months, while other countries with higher reserves hold them for a relatively longer duration – ranging from 16 months (for China) to 39 months (for Switzerland).

“India’s reserves coexist with a net international investment position of (-) 12.9% of GDP. These factors warrant a pragmatic assessment of reserve adequacy on foreign exchange reserves, including exposure to valuation changes and market risk in a world of heightened global uncertainty,” the statement read.

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