Making sense of forex reserves–ECONOMIC TIMES

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India’s foreign exchange reserves have crossed $500 billion. For some, this is a cause for national pride. For some others, it is a source of irritation: why do we keep such a large hoard abroad, when the domestic economy is in desperate need of investment? Why lend it to the American government, they ask. Both perceptions are deeply flawed.

India runs a current account deficit, most years. So, our forex reserves are very different from the reserves of a country that runs large and perpetual current account surpluses, like China. India’s foreign exchange reserves are unabsorbed capital inflows and, as such, these are liabilities that their foreign owners can take out of the country. However, having a large reserve of foreign exchange is a source of stability and confidence. It is tangible evidence that India will not be in a position where it cannot pay for its imports or service its debt, whether on the government account or otherwise. This reassurance allows foreign investors to pour fresh investment into the country. That said, large foreign exchange reserves are not a sign of great economic health when these arise from capital inflows. It is a macroeconomic identity that the foreign investment that is absorbed in the real economy equals the current account deficit. A country that runs a current account surplus actually exports its savings. When the absorptive capacity of the economy is low, but foreign investors keep pouring dollars into it, either the rupee can appreciate unnaturally or the dollars that are not needed to import goods and services or to acquire foreign assets can add to the foreign exchange reserves. India’s rising forex reserves are a sign of foreign appreciation of India’s growth potential, the RBI’s valiant attempt to keep the rupee competitive for exporters and the real economy’s inability to absorb capital inflows into realised investment.

The obvious thing to do is to raise the level of investment in the economy, significantly above domestic savings. This would raise the rate of growth, keep reserves and the rupee in check.

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