Advantages of Forex Reserves

Foreign exchange reserves or forex reserves are also reserve assets, including foreign banknotes, treasury bills, foreign bank deposits, short and long-term foreign government securities, gold reserves, special drawing rights (SDRs), and International Monetary Fund (IMF) reserve positions.

Foreign exchange reserves or forex reserves are stored in the central bank’s account of countries, also known as reserve assets in the capital account of the balance of payment and are probably interpreted as reserve assets under assets by functional category. These forex reserves are used to support liabilities and strengthen countries’ monetary policies. It includes any foreign money held by a central bank, for example, the U.S. Federal Reserve Bank.

Vast foreign exchange reserves or forex reserves are held in U.S. dollars. China is the world’s largest foreign currency reserve holder. Economists largely recommend holding foreign exchange reserves in a currency not directly connected to the country’s currency.

It is common for central banks worldwide to hold significant reserves in foreign exchange. Most of these reserves are held in the U.S. dollar as it is the world’s most traded currency. It is not uncommon for foreign exchange reserves or forex reserves to consist of the British pound (GBP), the Chinese yuan (CNY), the Japanese yen (JPY), and the Euro (EUR).

Forex Reserves

A central bank that chooses to implement a fixed exchange rate policy may face a situation where supply and demand force the value of the currency lower or higher (an increase in demand for the currency would push its value higher and a decrease lower), thus compelling the central bank to use reserves to maintain its fixed exchange rate.

The government is in a safe stance if there are rising forex reserves and the RBI manages to make India’s external and internal economic issues at a time of major contraction, which is supposed to be 23.9% in economic growth.

This helps the government achieve its foreign exchange needs and external debt obligations.

Advantages of Forex Reserves

Appreciation of the rupee: The growing foreign exchange reserves have helped the Indian rupee appreciate and strengthen the currency against the dollar. China is a fitting example because it estimates the yuan’s value to the dollar. When China stockpiles dollars, it raises the dollar value as compared to the yuan, resulting in cheaper Chinese exports than American-made goods and thus increasing sales.

Crisis management: Rising forex reserve serves as a cushion in the event of a balance of payment crisis on the economic pretence. It is ample to cover a country’s import bill for a year. For example, the 1997–1998 East Asian financial crisis emphasised the importance of having appropriate policies at the country level to manage the adequacy of foreign reserves to prevent a foreign exchange crisis. Prior to the crisis, the main paradigm for viewing the sufficiency of forex reserves was based on current account transactions. In other words, foreign reserves should be adequate to support current account transactions with the rest of the world. A widely used measure was the number of months of imports that reserves can cover, with at least three months of imports often used as a guideline; however, no scientific backing was available for the number.

Confidence in the market: Forex reserves provide confidence to markets and investors so that a country can fulfil its external responsibilities. For example, the reduction of crude oil prices has decreased oil import bills, saving valuable foreign exchange. At present, India is challenged by geopolitical risks, particularly the oil shock, which is overwhelming the Indian economy. The government faces a situation wherein oil costs USD 150–200 a barrel for two months because of the war and then subsides once the war ends, and the market will also begin to consider tightening the Fed. Further, we assume that you receive USD 20 billion of FPI outflows or USD 4–5 billion, which has already occurred due to the extreme risk repulsion India is facing. Therefore, the government and RBI expect a USD 30–50 billion forex outflow when the RBI has sufficient forex reserves.

Conclusion

Foreign exchange reserves or forex reserves are also reserve assets, including foreign banknotes, treasury bills, foreign bank deposits, short and long-term foreign government securities, gold reserves, special drawing rights (SDRs), and International Monetary Fund (IMF) reserve positions. There is a surge in investment by foreign portfolio investors and increased foreign direct investments (FDIs). The sharp jump in forex reserves started with the Finance Ministry’s announcement in 2019 to cut corporate tax rates.