Context:

• India’s foreign exchange reserves are rising and are slated to hit the $500 billion mark soon amidst the intense COVID-19 pandemic. The level of foreign exchange reserves has steadily increased by 8,400 per cent from $5.8 billion as of March 1991 to the current level.

What are forex reserves?

• Foreign Exchange Reserve indicates the reserves held by RBI in the form foreign currency assets, gold, SDR and reserve tranche. Components of foreign exchange reserve:

1. Foreign Currency Assets– Currencies of foreign countries are held in foreign exchange reserves. Apart from currency it also includes foreign currency deposit held by RBI with foreign central banks and the Bureau of Indian Standards (BIS).
2. Gold Stock of RBI- The RBI has gold stock as a backup to issue currency and to meet unexpected Balance of Payments (BOP) problems. (BOP problem occurs when a nation is unable to pay for essential imports or service its external debt repayments)
3. SDR Holdings– Special Drawing Rights (also called “paper gold”) is a reserve created by the IMF to help countries that have BOP problems. The member countries have to contribute to this account in proportion to their IMF quota. The SDR basket consists of five major currencies of the world – the US dollar, Euro, British Pound, Chinese Renminbi and Yen (Japan).
4. Reserve Tranche-The reserve tranche is a portion of the required quota of currency that each IMF member country must provide to the IMF. It can be accessed by the member country at any time for its own purposes without a service fee.

Objectives of holding Forex reserves:

• The International Monetary Fund says official foreign exchange reserves are held in support of a range of objectives like
  • Supporting and maintaining confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency. 
  • Limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.

 Rising forex reserves despite the slowdown in the economy

The major reason for the rise in forex reserves is the

1. Rise in investment in foreign portfolio investors (FPIs) in Indian stocks and foreign direct investments (FDIs).
2. Fall in crude oil prices has brought down the oil import bill, saving the precious foreign exchange.

Significance of rising forex reserves

• Reserves will provide a level of confidence to markets that a
  • country can meet its external obligations,
  • demonstrate the backing of domestic currency by external assets,
  • assist the government in meeting its foreign exchange needs and external debt obligations and
  • maintain a reserve for national disasters or emergencies.
• The rising forex reserves give a lot of comfort to the government and the Reserve Bank of India in managing India’s external and internal financial issues at a time when the economic growth is set to contract by 1.5 per cent in 2020-21.
• It’s a big cushion in the event of any crisis on the economic front and enough to cover the import bill of the country for a year.
• The rising reserves have also helped the rupee to strengthen against the dollar.
• The foreign exchange reserves to GDP ratio is around 15 per cent.

What does the RBI do with the forex reserves?

• The Reserve Bank functions as the custodian and manager of forex reserves, and operates within the overall policy framework agreed upon with the government.
• The RBI allocates the dollars for specific purposes. For example, under the Liberalised Remittances Scheme, individuals are allowed to remit up to $250,000 every year.
• The RBI uses its forex kitty for the orderly movement of the rupee. It sells the dollar when the rupee weakens and buys the dollar when the rupee strengthens.
• Of late, the RBI has been buying dollars from the market to shore up the forex reserves. When the RBI mops up dollars, it releases an equal amount in the rupees. This excess liquidity is sterilized through issues of bonds and securities and Liquidity adjustment facility (LAF) operations.

Where are India’s forex reserves kept?

• The RBI Act, 1934 provides the overarching legal framework for deployment of reserves in different foreign currency assets and gold within the broad parameters of currencies, instruments, issuers and counterparties.
• As much as 64 per cent of the foreign currency reserves is held in the securities like Treasury bills of foreign countries, mainly the US, 28 per cent is deposited in foreign central banks and 7.4 per cent is also deposited in commercial banks abroad, according to the RBI data.
• India also held 653.01 tonnes of gold as of March 2020, with 360.71 tonnes being held overseas in safe custody with the Bank of England and the Bank for International Settlements, while the remaining gold is held domestically. 

Conclusion:

• Unlike in 1991, when India had to pledge its gold reserves to meet a major financial crisis, the country can now depend on its soaring foreign exchange reserves to tackle any crisis on the economic front. 

Reference:

https://indianexpress.com/article/explained/explained-india-forex-reserves-covid-19-economic-crisis-6448701/