Amidst the COVID -19 crisis, India builds a formidable FX war chest


Recently, India’s foreign exchange reserves touched an impressive all-time high and crossed the USD 500 billion milestone. The significance of this financial firepower is that it reinforces India’s capability to finance imports and repay external debt. Many factors have contributed to this robust build-up, including the recent slump in oil prices, FDI inflows of over USD 73 billion, External Commercial Borrowings (ECBs) by Indian corporates to the tune of USD 53 billion, and active USD purchases by the RBI amounting to USD 45 billion in FY2019-20. The current robust situation is a far cry from 1991 when India was faced with an external sector crisis and forced to pledge its gold to avoid a default. Besides boosting India’s external sector health, the real reason behind the FX war chest is to manage the rupee effectively.

India's gradual ascent in the FX reserves league table

Amidst all the gloom and doom, India’s record-high foreign exchange reserves, which touched a whopping over USD 500 billion, gave reason to cheer. This development catapults India into the league of top 5 nations holding the highest FX reserves with the capacity to cover roughly one year’s imports. The significance of this financial firepower is that it reinforces India’s capability to finance imports and repay external debt. This assurance is an encouraging sign that is expected to attract further foreign investment flows into the country. This positive indicator has not gone unnoticed with certain global rating agencies factoring in India’s FX reserves strength.

India has consistently enhanced its FX pool over the years. There is debate about the opportunity cost to this financial stability i.e., investing in low yield assets like US treasuries to build adequate FX reserves. However, it is learnt that approximately 20-30% of forex are being held in non-USD currencies, which are appreciating against the USD, further hiking up the FX reserve valuation.(Source)

A surge in FX Reserves

Published weekly (every Friday) by the Reserve Bank of India (RBI). Updated monthly by IMA. Updated till June 5th 2020. 

The foreign exchange reserves of India consist of cash, gold, bonds, bank deposits, and financial assets denominated in foreign currencies, i.e., mainly US treasury bonds and institutional bonds.

The growth trajectory of India’s FX reserves

Note: The years in the graph represent the fiscal year, for instance, the year 2009 represents the period Apr'09-Mar'10.

Reasons behind the swelling forex reserves

Many reasons are contributing to this burgeoning trend- both on account of current account and capital account factors. Oil being one of India’s main imports, the sharp decline in global oil prices has resulted in lower import bills for India. The fall in oil prices is expected to be a temporary phenomenon and would return to normal levels once demand resumes. India has capitalized upon the low oil price opportunity and saved to the tune of Rs 50 billion from strategic oil purchase. (Source)

Declining trend of global oil prices

Export-Import scenario

Although exports fell, the lockdown lowered import demand, narrowing India’s trade deficit to record low of USD 3.2 billion in May 2020. Both imports and exports contracted for the third straight month by 51.1% YoY and 36.4% YoY in May. It is also worth noting that overall trade balance (Merchandise plus Services) has gone into surplus in the month of April and May 2020 to USD 0.4 billion and USD 4 billion, respectively.

Foreign investments trend

Other reasons are FII inflows to the tune of over Rs 170 billion into the Indian capital market in June 2020. (Source) Along with the rise in FDI investment by 18.5% in FY2019-20 to over USD 73 billion and ECBs amounting to USD 53 billion by Indian corporates.

Note: The years in the graph represent the fiscal year, for instance, the year 2009 represents the period Apr'09-Mar'10. The data for Total Foreign Portfolio Investment for the year 2020 is upto June 18, 2020.

The real reason behind building a robust FX reserve

While multiple factors have contributed towards building a sizeable FX pool, including RBI’s proactive efforts and timely intervention in the currency markets, the real intention behind this is to effectively manage the Rupee. RBI has bought an estimated USD 45 billion in FY20 to prevent excess Rupee appreciation.

Currency fluctuation is a double-edged sword

It is well known that depreciation or appreciation in the INR exchange rate functions as a double-edged sword. While a certain degree of rupee depreciation ensures higher earnings for exporters, excess depreciation would make oil imports expensive. Vice versa holds true in case of rupee appreciation. In fact, the INR has greatly benefitted from the strong FX build up. Further, considering the current global economic slowdown, a flight of capital away from emerging markets cannot be ruled out. In the event of excessive negative sentiment and panic exit by foreign investors from Indian markets and heavy selling of the Rupees, the FX reserves would come in handy to manage excess rupee depreciation.

The continued interest of foreign investors in India as an investment destination and realising higher export earnings would depend on domestic economic recovery and the emerging global trade order amidst the challenges posed by COVID-19.

Scripting a successful turnaround story: From the 1991 crisis to the current record high

The COVID 19 uncertainty has thrown out of gear economies around the world. Accordingly, in the coming days, foreign investors might adopt a measured, cautious outlook towards emerging economies. Hence a certain degree of currency volatility is given. India’s strategy to further grow its FX reserves and strengthen the external sector metrics is a necessary and welcome step.
India has come a long way since 1991, when our nation faced a FX reserve crisis (USD 5.8 billion in Mar 1991), and it was forced to pledge gold holdings to prevent a default. The lessons learnt from that bitter experience resulted in the subsequent liberalization of the Indian economy in the 1990s. With a comfortable FX pool to cover imports, today in 2020, with over USD 500 billion, the situation is entirely different.

Written by:

Guest Columnist

Sandhya Krishnan

[email protected]