India's foreign exchange reserves have recently experienced a positive surge, reaching a near three-month high of $597.94 billion as of November 24, according to data from the Reserve Bank of India (RBI).
This marks the second consecutive week of growth, with the reserves expanding by $2.5 billion in the reporting week.
In this article, ViTWO presents the intricate factors influencing India's forex reserves, with a focus on the role of exports and RBI interventions, shedding light on the optimistic outlook for the nation's economic stability.
The Fluctuating Fortunes of India's Forex Reserves
In mid-July, India's forex reserves stood at an impressive $609 billion, only to dip to $583.5 billion by October 20, reflecting a yo-yo-like behaviour.
The recent rebound to $597.9 billion on November 24 prompts an exploration into the driving forces behind this volatility. A comprehensive analysis reveals that foreign currency assets and gold constitute the primary components of India's forex reserves, with gold making up 7.7% of the current reserves.
The Reserve Bank of India (RBI) plays a pivotal role in managing the value of the Indian rupee against the US dollar. With India heavily dependent on oil imports, a weaker rupee could escalate the cost of these imports.
To counter this, the RBI strategically uses foreign currency assets, especially US dollars, to stabilise the rupee's value. Recent reports suggest that as the rupee faced pressure against the dollar, the RBI engaged in active management, selling dollars and consequently witnessing a dip in forex reserves from $540.2 billion in mid-July to $515.2 billion by October 20.
The Impact of Global Economic Forces on India's Forex Reserves
The rupee's recent challenges were exacerbated by rising returns on US government bonds, reaching 5% in late October.
This prompted foreign institutional investors (FIIs) to sell Indian stocks and move funds to the US, necessitating the sale of rupees for dollars. The resultant pressure on the rupee led to aggressive RBI intervention. However, a shift occurred in November as US bond returns fell to around 4.2%, enticing FIIs to reintroduce funds into India.
In this positive turn, FIIs not only invested in stocks but also purchased bonds, relieving the RBI from tapping into its dollar reserves to defend the rupee.
While India's forex reserves showcase resilience, recent challenges have not gone unnoticed. Aggressive RBI intervention, aiming to prevent sharp depreciation, has significantly reduced India's currency reserves.
Meanwhile, the rupee weakened past the 81-mark against the US dollar, and spot FX reserves dipped to $551 billion, reducing import cover to only 8.4 months.
Both oil and non-oil exports have declined, attributed to weaker global demand and domestic factors such as windfall taxes imposed on petrol/jet fuel exports.
Morgan Stanley's Economic Insights
A report by Morgan Stanley sheds light on the economic landscape, indicating a current account deficit of 3.2% of GDP in 2022. The decline in exports, coupled with elevated imports due to resilient domestic growth, has led to record-high merchandise trade deficits.
The report anticipates a balance of payments deficit above $60 billion in 2022. In response to these challenges, Morgan Stanley predicts a 50 basis points hike in repo rates in September and a 35 basis points hike in December, contributing to a forecasted headline inflation of 6.8% YoY in Q4 2022.
Factors Influencing Exchange Rates
Understanding the factors influencing exchange rates is crucial in comprehending the dynamics of India's forex reserves. Key determinants include:
Inflation: Inflation rates impact currency values. Low inflation enhances a currency's purchasing power, while high inflation leads to depreciation.
Interest Rates: High interest rates attract foreign capital, strengthening a country's foreign exchange rate.
Deficits: Current account deficits, reflecting spending exceeding earnings, contribute to a higher demand for foreign currency, lowering the exchange rate.
Debt: Large-scale infrastructure projects funded by debt can lead to inflation, weakened currency, and increased debt-servicing challenges.
Import-Export: Higher export growth compared to imports strengthens a country's currency, positively influencing exchange rates.
Final Thoughts
India's forex reserves showcase resilience amid global economic challenges, with a recent rebound attributed to a shift in global economic forces and FII investments.
The RBI's strategic interventions, coupled with a nuanced understanding of factors influencing exchange rates, play a pivotal role in maintaining stability. As India faces macroeconomic challenges, a comprehensive approach to managing reserves becomes imperative for sustaining growth and mitigating external pressures.
ViTWO believes that the RBI actively manages the rupee's value, but challenges persist, impacting trade balances and necessitating strategic economic measures. Understanding the intricate dynamics of exchange rate influencers is crucial for anticipating and navigating the future trajectory of India's forex reserves and economic stability.