Explained: Using Foreign Exchange Reserves

How did the reserves run out so quickly? To answer that, you first have to understand how they got accumulated in the first place. A country typically accumulates foreign exchange reserves when its revenue from the export of goods and services exceeds payments against imports. Current account surpluses lead to an accumulation of reserves, with the central bank mopping up any excess foreign currency entering the country.

The most obvious parallel that can be drawn is that of households or businesses, whose excess of income over expenses or retained earnings adds to their savings or reserves. Just as these savings/reserves are available for use by other households, businesses and the government, current account surpluses in one country can be invested in other countries. In doing so, he becomes a net exporter of “capital”, in addition to goods and services.

The outlier

Table 1 shows the top 12 countries with the highest foreign exchange reserves at the end of 2021. Almost all of them have large and persistent current account surpluses. Take China, whose cumulative surpluses of $2.1 trillion over an 11-year period have helped build an official reserve vault of $3.4 trillion. Or Germany, whose current account surpluses totaling around $3.1 trillion over the period 2011-2021 were mostly exported as capital rather than being accumulated as a reserve.

India is an exception (along with the United States and Brazil) among countries that have accumulated large foreign exchange reserves. Only one of the 11 years – 2020 – recorded a current account surplus in its balance of payments. Its reserves of $638.5 billion in 2021 were despite current account deficits totaling more than $400 billion over the 11 years. Reserves have been built up through the importation of capital; in other words, from the surpluses of others and not of one’s own.

The capital flows attracted to India not only financed its excess of imports over exports, but also contributed to an increase in official reserves. The United States and Brazil have had similar stories, but with larger current account deficits than India and even relative to their reserves. Moreover, foreign exchange reserves and current account balances matter little to the United States, when it owns the reserve currency used in most international transactions.

Sources of accretion

Between March 31, 1990 and March 31, 2022, India’s foreign exchange reserves increased from $3.96 billion to $607.31 billion. Table 2 gives the sources of this increase over four eight-year periods. More than 50% of the $603.35 billion increase occurred in the past eight years, coinciding with the tenure of the Narendra Modi government.

In none of the four periods, however, was the accumulation of reserves the result of exports of goods exceeding imports. On the contrary, the combined merchandise trade deficit over 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 dollars in the “invisible” account of the balance of payments. The invisibles mainly include revenue from the export of software services, remittances from overseas Indians and tourism. In the case of India, these receipts have always exceeded payments for interest on loans, dividends, royalties, license fees, foreign travel and various commercial and financial services.

Invisible surpluses have on the whole contained the country’s current account deficits to manageable levels, some periods (1998-99 to 2005-06) and some years (2001-02, 2002-03, 2003-04 and 2020- 21) record surpluses. Manageable current account deficits combined with capital inflows – averaging $25.2 billion and $68.4 billion respectively over the past 10 years – have led to an increase in India’s foreign exchange reserves in all but five 32 years, from 1990-91 to 2021-22. Those five years were 1995-96, 2008-09, 2011-12, 2012-13, and 2018-19.

In addition to current account deficits and capital flows, there is another source of reserve build-up or depletion: the valuation effect. Foreign exchange reserves are held in the form of dollars as well as non-dollar currencies and gold, the value of which is, in turn, influenced by movements in exchange rates and gold prices. A depreciation of the US dollar or higher gold prices then leads to valuation gains in the existing stock of reserves. A strong dollar or a decline in gold prices likewise lowers the value of the non-dollar portion of reserves.

Where are the reserves going?

India’s merchandise trade deficit stood at $70.8 billion in April-June 2022. This could top $250 billion for the full fiscal year. Net invisible revenue reached a record high of $150.7 billion in 2021-22, compared to $126.1 billion and $132.9 billion in the previous two years. Given the impending recession in the United States and Europe, which could impact software exports, net invisibles are expected to be closer to $140 billion for this fiscal year.

Either way, the current account deficit would top $100-110 billion, beating previous records of $88.2 billion in 2012-13 and $78.2 billion in 2011-12. However, the size of the drawdown on reserves would be a function of capital flows.

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In 2021-2022, net capital inflows amounted to $87.5 billion from April to December. But the last quarter (January-March) saw net outflows of $1.7 billion. With global interest rates and bond yields rising as a result 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 seed funds – don’t look as bright in the current fiscal year.

Of the $69.7 billion decline in India’s foreign exchange reserves from its peak in early September 2021, $34.6 billion took place in this financial year alone. With the Reserve Bank of India showing its willingness to use reserves to defend the rupee – ensuring the “orderly evolution” of the exchange rate with “zero tolerance for volatile and bumpy movements”, to quote RBI Governor Shaktikanta Das – a further decline to less than $550 billion cannot be ruled out.

Foreign exchange reserves were, after all, accumulated as a buffer against currency volatility, external shocks and sudden stops in capital flows. As Das recently said, “You buy an umbrella to use when it rains.”