Forex Reserves Demystified

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Frequently people ask what role a Forex reserve play in country’s economy. Also, other couple of questions are asked by people from various backgrounds. Questions such as ‘What is a Forex reserve?’ or ‘What return does forex reserve give to RBI?’ are quite common on several social media platforms and platforms such as Quora. You will find plethora of questions revolving around Forex reserve. This article will try to demystify the Forex reserves.

Don’t worry this article will try to put everything in layman language and will keep the core workings and other technicalities for some other article.

What is a Forex reserve?

As a common man, here is my understanding of the term Forex reserve. Well obviously, at this moment it won’t be right to dive directly into core workings or deep technicalities of Forex reserve. So, Forex reserve is like a safe deposit or a safe locker where common man puts his gold, diamonds, property papers, insurance papers, financial deeds and business deeds papers, valuable products and some currencies (though this is hardly done these days, except by crooked guys as shown in movies), etc. In case of emergency this safety deposit can be broken and valuables can be redeemed to alleviate the crisis or problem.

From a country’s perspective, Forex reserve could anything from Foreign currencies, gold, foreign Government treasury bonds, foreign institutional bonds, special drawing rights (SDRs), Reserve Tranche positions, etc. In short, any asset(both movable and immovable) recognized by the central bank, which can be easily used for payment to foreign parties can be considered as Forex reserve. At the moment India’s Forex reserve comprises of four types of assets:-

1. Foreign Currency Assets or FCAs
2. Gold
3. Special Drawing Rights (SDRs)
4. Reserve Tranche Positions (RTPs)

We all know what is Foreign Currency Assets. If you are not much aware of FCAs, then this is nothing but foreign currencies held with the central and other banks within the boundary of the country and also in the foreign countries where the banks are operational.

Well Gold is something that can be used in lieu of money or the Fiat currency. Even after abandonment of Gold standard, gold continues to impact the currency markets and majority of the countries across the globe keep a reserve of gold to fight inflation and depreciating currency.

SDRs were introduced by IMF in 1969, when it felt that crisis could arise due to the limitation in usage of gold and dollar to settle the trade and business. It is a kind of artificial currency that is used within the working of IMF. It is used for internal auditing and misc other operations carried out between IMF and member countries.

RTPs is a quota of currency that every member must provide to IMF for countries’ utilization without having to pay service fee to IMF.

As of week ending 17 July 2020, India’s forex reserve stood at $517.63 billion, a rise by $1.275 billion.

What role does Forex reserve plays in the economy of a country?

Forex reserve plays a lot of important role in the economy of a country. Here are some of the important roles:

1. It acts a collateral or safety deposit against the economic slowdown or recession. It can also be called as insurance against economic crisis.
2. Trade balances are settled using Forex reserves.
3. Debts could be cleared/acquired by use of the same.
4. Helps to pay the import bills.
5. Helps to stabilize the currency and thus the economy.
6. Helps the economy at the time of varying interest rates across the globe.
7. Debts can be given to another country.
8. Adds to additional returns in terms of interest earnings, provided interest rates are high across the globe.
9. Provides Liquidity to the market from time to time.

Does Forex gives any return to the country?

Already interest rates in the USA and Europe are very much low as compared to BRICS nation (Russia and India). Only Gold gives some returns on the total Forex reserves comprising of Gold. Baring Gold, due to low interest rates, earnings through interest is very negligible. On contrary some developed countries have negative interest rates, which means that country like India which has acquired vast Forex reserves would be paying the cost to maintain such a huge Forex reserves.

Who is the custodian of Forex reserves and what laws govern Forex reserves in India?

RBI is the custodian of Forex reserves in India and all the major central banks of other nations are major custodian of Forex reserves in respective countries. RBI act along with FEMA Act of 1999, provides the provisions to govern the Forex reserves.

Where is the Forex reserve kept?

Forex reserves are kept across the globe. It is just like an asset which just changes the name of the owner. While some of the Forex Reserves are kept within the boundary of the country, rest are kept in the form of gold, Foreign currency assets, bonds etc. with other major central banks, Bank of international settlements, IMF, loan funding to other nations, investment in properties and assets (movable and immovable) across the globe. Indian banks operating overseas also maintain the Forex reserves under the guidance of the central bank. For example, India keeps the gold with Bank of England as a reserve currency.

How Forex Reserves is built or how Forex reserves is formed?

There are several ways through which Forex reserve is built or formed or acquired whatever you want to call it. Here are some of the ways:

1. FDI inflows — Foreign Direct Investment brings Forex currency assets, along with other foreign assets within the country.
2. FPI inflows — Foreign Portfolio investors invest their money in the Indian markets in the form of stocks, bonds, etc.
3. Interbank trading- RBI along with other Indian banks carry out operations across the globe where they trade foreign currencies especially dollar through the Interbank network.
4. Acquisition through forex dealers — RBI from time to time buys and sells foreign currencies through Overseas forex dealers.
5. Other activities such as investment in real estate, bonds, share markets, etc are also performed by central bank, other banks and government functionaries, which help in building up the Forex reserves.
6. Less imports also helps in building up the large Forex reserves
7. Decline in crude oil means less payment in dollar terms which ultimately leads to massive build up in Forex reserves.
8. Interest payments received for the loans given to other nations also form the Forex reserves.

9. Gold imports also form the Forex reserves.

Any comment, feedback,suggestion is welcome.