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Understanding foreign exchange

By Prashansa Srivastava

The country’s foreign exchange reserves fell by USD 2.590 billion to USD 399.656 billion in the week ending September 29 due to decline in foreign currency assets, RBI data showed. In the previous week, the reserves decreased by USD 262.3 million to USD 402.246 billion, after touching a lifetime high of USD 402.509 billion in the week ending September 15.

Reasons for decrease

The country’s reserves comprise of foreign currency assets, gold, special drawing rights (SDR) that RBI holds with the International Monetary Fund, and the country’s reserve position with the IMF. India’s foreign exchange reserves are mainly composed of the US dollar in the forms of US government bonds and institutional bonds.

The foreign currency assets, a major component of the overall reserves, decreased by USD 2.565 billion to USD 375.186 billion, the data showed.  The foreign currency assets (FCAs) are assets held by the central bank to pay for its liabilities such as the currency issued, as well as the various bank reserves deposited with the RBI by the government and other financial institutions. The FCAs also include investments in US Treasury bonds, bonds of other selected governments and deposits with foreign central and commercial banks. They are expressed in US dollar terms and include the effect of appreciation or depreciation of non-US currencies such as the euro, the pound and the yen held in the reserves.

Though gold reserves remained unchanged at USD 20.691 billion, the SDR with the International Monetary Fund (IMF) declined to USD 1.502 billion. SDR is a reserve of foreign exchange assets created by the International Monetary Fund in 1969 which comprises of global leading currencies. It can be called a basket of key international currencies and currently consists of the U.S. dollar, the Euro, the Renminbi (Chinese yuan), the Japanese yen and the British pound.

The country’s reserve position with the IMF also declined by USD 15.2 million to USD 2.276 billion, the apex bank said. The reserve position or the reserve tranche position is the proportion of the required quota of currency that each International Monetary Fund (IMF) member country must provide to the IMF, but can designate for its own use. The reserve tranche portion of the minimum quota can be accessed by the member nation at any time, whereas the rest of the member’s quota is typically inaccessible. The members’ quotas are in turn in terms of the SDRs.

Importance of foreign exchange

Foreign exchange reserves act as the first line of defence for India in case of an economic slowdown so as to absorb the distress of the crisis. In these times of extreme market volatility, the reserves are a much-needed buffer for an emerging economy like India. Foreign exchange reserves facilitate external trade and payment and promote orderly development and maintenance of the Indian foreign exchange market. Foreign exchange reserves are traditionally used to back a nation’s domestic currency. Currency – in the form of a coin or a banknote – is itself worthless, merely an assurance that the value of the currency will be upheld. Foreign exchange reserves are alternate forms of money to back that assurance. In this respect, security and liquidity are paramount for a useful reserve investment. They are also an important part of the international investment position of a country.  Foreign exchange can be used to fund infrastructure, pay for external debts and diversify a country’s portfolio.

Most popularly, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. For example, China pegs the value of its currency, the yuan, to the dollar. When China stockpiles dollars, that raises its value when compared to the yuan. That makes Chinese exports cheaper than American-made goods, increasing sales. Countries with a floating exchange rate system also use reserves to keep the value of their currency lower than the dollar. They do this for the same reasons as those with fixed-rate systems. Japan buys U.S. Treasuries to keep its value lower than the dollar. Like China, this keeps Japan’s exports relatively cheaper, boosting trade and economic growth.

However, having too much foreign exchange comes with the opportunity cost of money tied in reserves instead of being invested somewhere where it could have earned a higher return and contributed to increasing domestic productivity.

Featured Image Source: Pexels

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