In News:

• India’s foreign exchange (forex) reserves marginally rose by $6 million during the week ended December 7
• According to the Reserve Bank of India (RBI)’s weekly statistical supplement, the overall forex reserves increased to $393.73 billion from $393.71 billion

Explained:

• India’s forex reserves comprise foreign currency assets (FCAs), gold reserves, special drawing rights (SDRs) and India’s position with the International Monetary Fund (IMF).
• Expressed in US dollars, foreign currency assets include the effect of appreciation or depreciation of non-US currencies such as the euro, pound and yen held in the reserves.
• The special drawing rights with the International Monetary Fund (IMF) increased by USD 2.5 million to USD 1.457 billion.
• Forex reserves had touched a record high of $426.028 billion in the week to 13 April 2018. Since then, the forex kitty has been on a slide and is now down by over $31 billion.

Forex Reserves:

• In India, Foreign Exchange Reserves are the foreign assets held or controlled by the country central bank. The reserves are made of gold or a specific currency.
• They can also be special drawing rights and marketable securities denominated in foreign currencies like treasury bills, government bonds, corporate bonds and equities and foreign currency loans.
• Foreign exchange reserves act as the first line of defense for India in case of economic slowdown, but acquisition of reserves has its own costs.
• Foreign exchange reserves facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India
• Reserve bank of India Act, 1934 and the Foreign Exchange Management Act, 1999 set the legal provisions for governing the foreign exchange reserves. Reserve Bank of India accumulates foreign currency reserves by purchasing from authorized dealers in open market operations. Foreign exchange reserves of India act as a cushion against rupee volatility once global interest rates start rising.
  The Foreign exchange reserves of India consists of below four categories
• Foreign Currency Assets
• Gold
• Special Drawing Rights (SDRs)
• Reserve Tranche Position

Why Hold Forex Reserves?

Technically, it is possible to consider three motives for holding reserves:

• Transaction,
• Speculative and
• Precautionary motives
  • International trade gives rise to currency flows, which are assumed to be handled by private banks driven by the transaction motive.
  • Similarly, speculative motive is left to individual or corporates. Central bank reserves, however, are characterized primarily as a last resort stock of foreign currency for unpredictable flows, which is consistent with precautionary motive for holding foreign assets.
  • Precautionary motive for holding foreign currency, like the demand for money, can be positively related to wealth and the cost of covering unplanned deficit, and negatively related to the return from alternative assets.
  • Furthermore, forex reserves are instruments to maintain or manage the exchange rate, while enabling orderly absorption of international money and capital flows.
  • In brief, official reserves are held for precautionary and transaction motives keeping in view the aggregate of national interests, to achieve balance between demand for and supply of foreign currencies, for intervention, and to preserve confidence in the country’s ability to carry out external transactions
  • The objective of holding reserve assets would be influenced by the reconciliation of objectives of the monetary authority as the custodian and the government as principal.
  • There are cases, however, when reserves are used as a convenient mechanism for government purchases of goods and services, servicing foreign currency debt of government, insurance against emergencies, and in respect of a few, as a source of income.

What are the dominant policy objectives in regard to forex reserves in India?

• Maintaining confidence in monetary and exchange rate policies.
• Enhancing capacity to intervene in forex markets.
• Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis including national disasters or emergencies.
• Providing confidence to the markets especially credit rating agencies that external obligations can always be met, thus reducing the overall costs at which forex resources are available to all the market participants, and
• Incidentally adding to the comfort of the market participants, by demonstrating the backing of domestic currency by external assets.