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The total foreign currencies (of different countries) an economy possesses at a point of time is its ‘foreign currency assets/reserves’.2 The Forex Reserves (short for ‘foreign exchange reserves’) of an economy is its ‘foreign currency assets’ added with its gold reserves, SDRs (Special Drawing Rights) and Reserve Tranche in the IMF.3 In a sense, the Forex reserves is the upper limit upto which an economy can manage foreign currency in normal times if need be.
By December 2016, India’s forex reserves were ate comfortable levels of US$ 360 billion—with a rise of US$ 10 billion since January 2016. This included the gold reserves of US$ 21 billion and SDRs of US$ 5.6 billion (inclusive of reserve tranche of US$ 1.3 billion), as per the Economic Survey 2016-17.
In recent times, there has been a debate over India’s optimum level of the forex reserves. The RBI is aware of the downside risks to the exchange rate, as is reflected by its action of buying the US dollar. Officially, the RBI targets neither a particular exchange rate nor foreign exchange reserves, and maintains such interventions by it to just reduce volatility in the forex market. But in the process of supporting weakening rupee, RBI needs to buy dollar, ultimately, leading to higher forex buid-ups. The Chief Economic Advisor of the Finance Ministry, however, clearly stated the kind of reserve accretion the government is looking at. Citing the example of China, the Economic Survey 2014–15 said India could target foreign exchange reserves of US$750 billion to $1 trillion.
Today, China has de facto become one of the lenders of last resort to governments experiencing financial troubles. China, in its own heterodox and multiple ways, is assuming the roles of both an IMF and World Bank as a result of its reserves. The question for India, as a rising economic and
political power, is whether it, too, should consider a substantial addition to its reserves.
While forex reserves act as insurance when the rupee tends to be volatile against the dollar, there are costs attached to it. When RBI purchases dollars in the spot, it leads to infusion of rupee into the system which leaves inflationary effect on the economy. Since the RBI does not want such actions to create inflationary pressure, so, it converts spot purchases into forwards. This way, it is a direct cost because of the forward premiums. If RBI opts for open market operations (OMOs) to mop up excess liquidity, that also involves costs.
RBI invests these dollars in instruments such as US treasuries, which offer negligible returns, owing to lower yields. But experts say these are unavoidable costs. The returns from rupee assets are much lower compared to returns from dollar assets. But RBI is not into investment management, it is there to maintain stability in the system.
In August 2014, RBI chief Raghuram Rajan agreed foreign exchange reserves came at a cost. India earns next to nothing for the foreign reserves it holds—actually, this way India finances another country when it has a significant financing needs. It is very difficult to state the level of reserves considered adequate by RBI. Though there are costs involved, the costs to benefit cannot be quantified by any model. Globally, there has been no study on the adequacy of reserves. In such an environment, RBI will have to go by experiences.