09 Jul 2020 21:10 IST

What took India’s forex reserves to historic highs?

One of the major reasons for the increase was the large inflow through foreign direct investments

India’s foreign exchange reserves have been steadily increasing over the past year and hit an all-time high recently. According to the Reserve Bank of India (RBI), the reserves shot up by $59.5 billion in the last fiscal against a reduction of $3.3 billion in the year before.

Notably, India has already added a little over $31 billion in the current financial year. Consequently, the total reserves crossed half a trillion dollars last month for the first-time. At nearly $507 billion, India’s reserves are now the fifth highest in the world after China ($3.1 trillion), Japan ($1.4 trillion), Switzerland ($816 billion) and Russia ($568 billion).

Of the total reserves, foreign currency assets (FCA) account for $467 billion. Value of other components like gold, Special Drawing Rights (SDRs) and reserve position in the International Monetary Fund (IMF) stand at $33 billion, $1.4 billion, and $4.3 billion, respectively.

Dollar influx

One of the major reasons for the increase in reserves was the large inflow through foreign direct investments (FDI). Net inflow of FDI in FY20 was much higher at $43 billion as against $30.7 billion recorded in FY19.

Compared to Foreign Portfolio Investments (FPI), FDI money is much more stable as it is more long-term in nature. More FDI inflows can be considered as an expression of confidence of foreign investors in the long-term prospects of the Indian economy.

On the other hand, the FPI fund flow can be very volatile depending on the expectations of the financial market. While the net FPI outflow in FY20 was $3 billion, it stood at $5.5 billion in FY19 according to the National Securities Depository Limited (NSDL). Notably, March 2020 witnessed a huge sell-off due to the coronavirus scare, recording a net outflow of nearly $16 billion. This trend continued in April and May with net outflow of nearly $2 billion and $1 billion respectively. But the good news is that, June saw a net inflow of $3.4 billion, indicating that the worst might be behind us.

As central banks in advanced economies continue to pump cheap money, more dollars can be expected to head to our shores which can boost the reserves further.

Another factor that contributed to the reserves is External Commercial Borrowing (ECB) by Indian corporates. The ECB for the year 2019-20 more than doubled to $22.1 billion versus preceding year’s $9.7 billion. As per the latest data by RBI, the domestic companies have already raised nearly $2.5 billion in the first two months of the current fiscal.

But unlike FDI, this should be taken with a pinch of salt as these are debt that the companies should pay back. However, until the external interest rate environment stays benign, offshore borrowing could continue. The Covid-19 pandemic has made the case stronger for lower interest rates for an extended period.

Deficit shrinks

Conducive external account also helped the growth in reserves. The current account deficit more than halved last financial year compared to the year before as the trade deficit shrank to $157.5 billion from $180.3 billion. The reason being that imports fell faster than exports. Interestingly, in the final quarter of 2019-20, India recorded a marginal current account surplus of $0.6 billion.

Significantly contributing to the drop in imports were crude oil and related products and precious metals. While the former saw a decline by about 9 per cent, the latter contracted by 16 per cent.

Looking at the latest data, India exported goods worth $19 billion in May this year compared to $30 billion in the same month of the preceding year.

Despite the large inflow of dollars, the rupee has lost a little over 9 per cent in the last one year against the greenback, making it one of the weakest Asian currencies. This could be due to the RBI diverting the dollars towards the reserves. When the central bank adds dollars into its kitty by selling the rupee, obviously the exchange rate is not going to move in favour of the Indian currency.

Once the global economy moves towards the path of recovery, the trade deficit might go up from levels seen in the recent months, weighing on the current account balance. However, the potential inflow through external borrowing, FDI and FPI routes might continue to bring in more dollars, helping reserves.