How high did the forex reserves go after the pandemic? And why have they fallen again?
India’s foreign exchange reserves recorded a drop of $1.23 billion to $623.9 billion for the week ended January 17, 2025, according to RBI data. In the post-COVID years, foreign reserves rose to touch a record high of about $705 billion in end-September 2024, before beginning to decline.
Much of the decline may be attributed to the Reserve Bank of India intervening in the forex markets to sell US dollars. This was because the rupee had been under duress since the end of September due to surge in US dollar and US bond yields on expectation of Donald Trump becoming the next US President. Large foreign portfolio outflows from the equity market increased the pressure on the rupee. The RBI had to sell the dollar heavily to support the Indian currency in the last quarter of 2024.
The decline in dollar holdings has depleted reserves though this has been mitigated by the increase in the value of its other holdings denominated in US dollars. The increase in the value of gold has also helped the reserves.
Overall, India’s forex reserves have dropped about 11.6 per cent since the September high. For context, forex reserves declined about 22% in the fiscal year 2008-09, in the backdrop of the Lehman crisis.
What is a healthy forex reserve level?
One way to measure the health of a country’s foreign exchange reserves is to pit it against its imports. Some economists opine that about 10-12 months’ worth of imports would indicate adequate forex holdings.
Calculating the run-rate for the current financial year from data for December 2024, India’s 12-month imports would come to about $909 billion. That would mean our forex reserves would cover just over 8 months of imports. This is if we include the entire reserves of $623.9 billion. But if we were to take only the foreign currency assets (of $533 billion) – that are seen as more liquid than, for example, our gold holdings – the picture is even less comforting at just over 7 months’ worth of cover.
The Greenspan-Guidotti rule offers another method for measuring the health of our forex reserves. The postulate requires forex reserves to fully cover the country’s short-term external debt (i.e., those with a maturity of one year or less).
As per the report on India’s external debt for the quarter ended September 2024, which came out in December, the ratio of short-term debt to foreign exchange reserves was 18.9 per cent at end-September 2024, which is very comfortable. It is more than likely that the latest figures would still satisfy the Greenspan-Guidotti rule.
What is the IMF’s ARA?
The International Monetary Fund had devised a measurement method to assess emerging markets’ foreign exchange adequacy. The Fund calls it the Adequacy Ratio Assessment for Emerging Markets or the ARA EM. It comprises four components reflecting potential drains on the balance of payments: (i) export income to reflect the potential loss from a drop in external demand or terms of trade shock; (ii) broad money to capture potential residents’ capital flight through the liquidation of their highly liquid domestic assets; (iii) short-term debt to reflect debt roll-over risks; and, (iv) other liabilities to reflect other portfolio outflows.
The Fund notes that reserves in the range of 100-150 per cent of the composite metric are considered broadly adequate for precautionary purposes.
According to a recent report by Nomura, forex reserve holdings are adequate even though RBI has net sold about $89.4 billion since October 2024. It says, “the RBI’s forex reserve adequacy ratio (average of IMF measures under four different forex regimes) has fallen from a recent high of 266 per cent in September 2024, but it is still at about 236 per cent (as per forex reserves data of January 3, 2025).
It notes that “even under a fixed exchange rate regime, India’s reserve adequacy is strong”.
Does it mean that we don’t need to add to the reserves?
QuantEco Research economist Vivek Kumar says India should be highly conservative in measuring the health of our forex reserves. That is, the more reserves there are, the better – for the geopolitical situation is causing uncertainty. “We have not seen this level of uncertainty in geopolitics or geoeconomics for maybe 2-3 decades. In such an environment, it is best to watch all our risk parameters than be selective.”
