Why did foreign exchange reserves fall $70 bn in 2022?
Context- After three consecutive years of rise, India’s foreign exchange reserves declined by around $70 billion in 2022 amid rising inflation and interest rates. From $632.74 billion as of January 7, 2022, the reserves declined to $562.851 billion as of December 30, 2022, even as the Reserve Bank of India used its forex arsenal to stabilize the rupee and cushion the capital outflows.
(Credits – RBI)
What are the reasons?
Market participants attribute two reasons for this decrease in the forex reserves.
Valuation loss
- One of the primary reasons was valuation loss, after the US dollar appreciated against major currencies in 2022.
- Foreign exchange reserves are maintained as a multi-currency portfolio comprising major currencies such as the US dollar, Euro, Pound sterling, and Japanese yen, among others, but are valued in terms of US dollars.
- When the dollar strengthens, the valuation of other currencies vis-à-vis the US currency declines, leading to notional fall in the overall reserves position
- The rise in the US currency was due to risk aversion among investors amid the aggressive monetary tightening of the US Federal Reserve and uncertainty surrounding the Russia-Ukraine war last year.
- Close to 55-60 percent of the decline (in reserves) was because of the valuation impact
FPI withdrawal
- The forex reserves also declined as the Reserve Bank sold dollars in the spot market to smoothen the sudden fluctuations in the rupee’s movement caused by outflows from foreign investors.
- FIIs sell their equity investment in the rupee, convert it into the dollar and take the money out. Since there was a shortage in the dollar supply last year, the RBI used its forex reserves to meet the dollar demand of FIIs
What is the impact on import cover?
With the depletion of reserves in 2022, the number of months of imports that can be covered through the country’s reserves have also declined. In a report last month, the Reserve Bank said the country’s foreign exchange reserves at $564.1 billion as on December 9, 2022, covered 9.2 months of imports projected for 2022-23.
As of January 7, 2022, the foreign exchange reserves provided a cover equivalent to 13 months of import estimated for 2021-22. When the reserves reached an all-time high of $642.5 billion in September 2021, it was equivalent to 15 months of import cover.
Why forex reserves rose in 2019, 2020 and 2021?
Forex reserves surged by $61.38 billion, $119.68 billion, and $48.29 billion in 2019, 2020 and 2021, respectively. A rise in foreign exchange reserves in these two years was due to robust foreign investments, weakening of the US dollar and softening of crude oil prices.
Why hold foreign exchange reserves?
For almost all economies, whether developed, emerging or developing, holding prudent reserves, in conjunction with sound policies and fundamentals, can bring significant benefits.
- They reduce the likelihood of balance-of-payments crises (BOP crisis occurs when country doesn’t have enough forex reserves to finance imports)
- Help preserve economic and financial stability against pressures on exchange rates
- Disorderly market conditions, and create space for policy autonomy
Conclusion – Despite recent decline India’s forex reserves are in a comfortable situation. However, cautious optimism is needed to manage short term macroeconomic fundamentals and export promotion should be prioritized as a long term solution.
Source- Indian Express
NEWS- Why did foreign exchange reserves fall $70 bn in 2022?
Syllabus- GS-3; Forex Reserves
