After three consecutive years of rise, India’s foreign exchange reserves declined by around $ 70 billion in 2022 amid rising inflation and interest rates. From $632.74 billion as of January 7, 2022, the reserves declined to $562.851 billion as of December 30, 2022, even as the Reserve Bank of India used its forex arsenal to stabilise the rupee and cushion the capital outflows.
Valuation loss
Market participants attribute two reasons for this decrease in the forex reserves. One of the primary reasons was valuation loss after the US dollar appreciated against major currencies in 2022. The rise in the US currency was due to risk aversion among investors amid the aggressive monetary tightening of the US Federal Reserve and uncertainty surrounding the Russia-Ukraine war last year.
“Close to 55-60 per cent of the decline (in reserves) was because of the valuation impact,” said Anindya Banerjee, vice president (currency derivatives & interest rate derivatives) Kotak Securities Ltd.
Foreign exchange reserves are maintained as a multi-currency portfolio comprising major currencies such as the US dollar, Euro, Pound sterling, and Japanese yen, among others, but are valued in terms of US dollars. When the dollar strengthens, the valuation of other currencies vis-à-vis the US currency declines, leading to notional fall in the overall reserves position, analysts said.
The RBI also keeps the forex reserves in the dollar-denominated assets like the 10-year benchmark securities of the US and UK. Since the yields of these assets rose in 2022, it impacted India’s foreign exchange reserves, they said.
FPI withdrawal
Besides valuation loss, the forex reserves also declined as the Reserve Bank sold dollars in the spot market to smoothen the sudden fluctuations in the rupee’s movement caused by outflows from foreign investors. “In 2022, foreign investors pulled out Rs 1.2 lakh crore from the domestic equity market. FIIs sell their equity investment in the rupee, convert it into the dollar and take the money out. Since there was a shortage in the dollar supply last year, the RBI used its forex reserves to meet the dollar demand of FIIs,” said a treasurer of a state-run bank.
In 2022, FPIs started pulling out after inflation spiked and central started hiking interest rates. The Russian invasion of Ukraine accentuated the FPI withdrawals with the global economic slowdown making inflows tougher, analysts said.
Higher FII outflows led to an over 10 per cent fall in the rupee – making it the worst-performing Asian currency in 2022. As per the latest data, the RBI remained net seller of the US dollar between January and October, 2022. It bought $144.58 billion and sold $199.02 billion in the spot market. On a net basis, the RBI sold $54.44 billion in the spot market.
What is the impact on import cover?
With the depletion of reserves in 2022, the number of months of imports that can be covered through the country’s reserves have also declined. In a report last month, the Reserve Bank said the country’s foreign exchange reserves at $ 564.1 billion as on December 9, 2022, covered 9.2 months of imports projected for 2022-23.
As of January 7, 2022, the foreign exchange reserves provided a cover equivalent to 13 months of import estimated for 2021-22. When the reserves reached an all-time high of $642.5 billion in September 2021, it was equivalent to 15 months of import cover.
Why forex reserves rose in 2019, 2020 and 2021?
Forex reserves surged by $61.38 billion, $119.68 billion, and $48.29 billion in 2019, 2020 and 2021, respectively. A rise in foreign exchange reserves in these two years was due to robust foreign investments, weakening of the US dollar and softening of crude oil prices. FPIs invested Rs 1.01 lakh crore in 2019, Rs 1.7 lakh crore in 2020 and Rs 25,752 crore in 2021 in the domestic equity market.
Why hold foreign exchange reserves?
For almost all economies, whether developed, emerging or developing, holding prudent reserves, in conjunction with sound policies and fundamentals, can bring significant benefits. They reduce the likelihood of balance-of-payments crises, help preserve economic and financial stability against pressures on exchange rates and disorderly market conditions, and create space for policy autonomy, according to the International Monetary Fund (IMF). During 2022, the foreign currency assets (FCA), a major component of the overall reserves, decreased by $71.2 billion.
