Context: Booming in Foreign Exchange Reserve has benefit and issues that need to be addressed.

Booming of foreign exchange reserve

• India has one of the largest foreign exchange reserves: Foreign exchange reserves have gone up by over $160 billion since the beginning of the last fi2020-21 and are currently at about $640 billion. 
• India could soon have reserves worth over $700 billion.

Different usability of foreign exchange reserves  

• Reserves should be used to finance infrastructure needs. 
• Foreign currency can be used to buy foreign goods and services, or assets: Use of reserves would mean that India will be importing a lot of equipment and material for building infrastructure. 
• This is unlikely to be the preferred way and will have a variety of macroeconomic implications.
• Formation of sovereign wealth fund: It would allow India to buy assets overseas.
• Intervention in the currency market as it added to the rupee liquidity in the system and enabled the RBI to push market interest rates lower during the pandemic. 
• Addressing external risks: Tighten monetary policy by the USA could result in tightening of global financial conditions, and capital could flow out from a country like India, at least temporarily. 
• Although India is in a much better position compared to the “taper tantrum” episode of 2013.

Issues with Foreign Exchange Reserve

• Investment in highly liquid assets results into low returns: Returns may have suffered further because of lower interest rates in developed markets.
• It will increase risks and could potentially defeat the purpose of holding reserves.
• India has not built its foreign exchange reserves by running a current account surplus: India regularly runs a current account deficit, which means it is a net importer of goods and services from rest of world. 
• India’s reserves essentially reflect the excess flow of capital, and part of it could get reversed fairly quickly. 
• As per the RBI’s report on foreign exchange reserves, ratio of volatile flows to reserves is over 65%. 
• India’s reserves went up sharply over the last 18 months or so because of higher capital flows. 
• Excessively accommodative monetary policy in advanced economies, particularly the US, led to a higher flow of capital. 
• Fall in currency triggered by large capital outflows can become self-fulfilling and pose risks to financial stability.
• India’s fiscal position: A significant delay in sustainable fiscal path would increase growth risks and affect capital flows.
• Higher reserves can potentially attract more capital flows and make currency management difficult.

Way Forward

• Reserve Bank of India (RBI) should diversify its investment to increase yields. 
• Sustained intervention by the RBI will push up the level of rupee liquidity in the system and increase inflation risks. Continued sterilisation has its own costs.
• India can revisit the kind of foreign flows it needs: Foreign direct investment and equity flows should be preferred to debt. 
• The policy establishment is aiming to get government bonds included in global bond indices. 
• It will increase the flow of debt capital, which is not desirable at this stage, and would make foreign exchange management more difficult. 
• This would also increase India’s exposure to external shocks.

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