Indian Forex (Foreign- Exchange) reserves touched a historical high of $392.8 Billion, in absolute terms, as on 28.07.2017. Just In case, if you are not able appreciate that fact, we had Forex reserves of $600 million in 1991 which were barely enough to cover three weeks of imports. Though the absolute figure is at historical high level, it can only cover just above 10 months’ worth of imports. At its peak in 2008, just before the Sub-prime crisis hit, we had forex reserves sufficient to cover about 15 months of imports. For a common citizen like you and me, how does it matter if India has a large or small Forex reserves? What would be the ideal forex reserves and why? I would try to answer those questions rather briefly than getting into technicalities.
Let us assume for a minute, in India, every state has its own currency instead of common rupee. If you reside in Mumbai and purchase something from Andhra Pradesh, you have to pay in Andhra Pradesh’s currency. For you, Andhra Pradesh’s currency is the foreign currency. Similarly for them yours is the foreign currency. You may ask, ‘why would I want something from Andhra Pradesh?’ Well, for instance, Andhra Pradesh is one of the largest producers of rice in India and (assume) you don’t produce anything at all. So, to eat rice, you have to import from Andhra Pradesh. Apply the same analogy to countries. We have very limited oil extraction capacities, and to meet domestic oil needs we have to import from oil rich countries, say OPEC (Organization of Petroleum Exporting Countries). Yes, OPEC is ready to supply oil to India. But, how do you pay them? Will they accept rupees? If they accept, that is well and good. But, what if they don’t? We have to make payment either in their currency or in common currency, here the common currency is dollar. Say, OPEC countries are ready to export oil for dollars. But from where do you get the dollars? Like any other good, we have to purchase dollars from open market. Say it is Rs. 64/$, that means, you can purchase a dollar for Rs. 64/-. Can you purchase any number of dollars you want at a rate of Rs. 64 per dollar so that you can buy only at the time of need? No, you cannot.
Here comes the concept of demand and supply. Whenever there is a high demand for a particular product, the price will go up. Here the product is Dollar. If we, India, don’t have enough dollars with us to pay for the imports, we have to buy the dollars from the open market at a disadvantage rate. Foreign exchange is like a barter system, exchanging goods for goods. Here the goods are two different currencies. If you want to buy a dollar from a market, there must be a seller who is ready to exchange dollars with rupees. What if there is no seller of dollars, at least, in exchange of rupees? Country has to default on its payments. That is what we had to face in 1991. Fortunately we had come out of that abyss, thanks to ‘half-lion’ PV Narasimha Rao. Forex reserves are like your savings bank account balances, but, for a country. They are intended to meet the daily needs.
I hope you have understood the concept of foreign exchange and the need for sufficient forex reserves for a country. India is a country with one of the largest forex reserves in the world. In fact, India’s forex reserves are higher than GDP of many world countries. The catch is, the bigger is not always better, at least, in the case of Forex reserves. Forex reserves essentially a way of investing in other countries. It doesn’t make much sense to finance other country needs when our domestic needs are underfinanced. So, what is the ideal level of Forex reserves? Officially, there is no figure as such. Even RBI doesn’t have any target when it comes to Forex reserves. But, larger the reserves the higher the confidence a country carries in the world markets. Ultimately, people who are investing in India would want to repatriate their money back to their homes at some point of time in future. A poor Forex reserve figure doesn’t entice any confidence to the potential investors.
All the big fancy terms aside, for common men like us, what it means to have a greater Forex reserves to us?
Basically, India is an imports based country. Our imports exceed exports by a far margin (technically, we call that as current account deficit). So, many of the things that we use daily (From oil and gold to coal and steel) are being imported into country as either finished product or as raw materials for further assembly and process. So, when we don’t have enough forex reserves to pay the net import bill, we have to buy the currency in open market at a disadvantage price as explained above. That means, we have to pay more for the same amount of items/goods which would lead to increase in the prices of the commodities we use. Which in turn fuels the inflation, causing the general price levels to up and to reduce the purchasing power of the people.
If you were able to buy a coke can for Rs. 25 two years ago and you have to shell out Rs. 30 for the same today, the difference between those two figures is inflation. Inflation simply means, increase in the level of prices of the goods. Assume, your salary remained same for the last two years and inflation has increased by 10% (cumulative) in the last two years. Though you are still earning the same amount, your purchasing power will come down by 10%. You can buy only 90% of the goods which you bought two years back.)
Rupee is a free float currency, means, the value of the rupee is decided by the market forces along with their expectations. Though the value of the rupee is decided by the market forces, RBI keeps a close watch on that. Assume, rupee value has increased from Rs.64/$ to Rs. 50/$ within a day. An exporter who exported goods to US and was to receive $10000 from US importer would be able to receive Rs. 5,00,000/- instead of Rs. 6,40,000/-. That’s straight away loss of Rs. 1,40,000/-. And, India exports about $ 25 billion a month. You do the math, and calculate the loss to the exporters with that kind of steep change in value. To avoid severe fluctuations, RBI does open market operations which means buying and selling of Rupee or dollar to the market participants. If Rupee is depreciating rapidly, RBI sells dollars in exchange of rupees to keep the rupee value stable. Similarly, if rupee is appreciating rapidly, RBI sells rupees to keep the value stable. To perform open market operations and to keep the value of the rupee stable, RBI should have enough reserves. That is exactly where muscle of forex reserves help. However, one should note that the open market operations are for very short term fluctuations. Open market operations can’t become a substitute to fundamental macro-economic factors.
In economics, there is no universal right and universal wrong. For every decision, we have to weigh pros and cons before arriving at a decision. In current scenario, in my opinion, higher forex reserves are advisable. Thanks to rallying markets and Make in India initiative, our forex reserves are raising constantly. We have to have sufficient reserves in case of Fed rate changes and any other adverse global economic scenario which results in capital flight out of our country. (We will discuss the effects of Fed rate change and global economic scenario on India later, as it is not the topic of our discussion.)