India’s foreign exchange reserves rose significantly post-COVID, touching an all-time high of $705 billion in Sept, 2024. They then started to decline, sparking concerns. To help shed light on the situation, businessline’s K Bharat Kumar is joined by Vivek Kumar, economist at QuantEco Research, who provides insights into the factors behind these fluctuations and what they mean for India’s financial health. 

Kumar begins by discussing the evolution of India’s foreign exchange reserves, noting that post-COVID, there was a surge in foreign investments, both direct and portfolio, which boosted the reserves to over $700 billion. This was aided by global economic changes, which initially caused a supply-side shock before leading to demand-side changes. As a result, the country experienced a surge in investment flows, and the reserves saw a dramatic increase. However, as Kumar points out, there has been a recent decline, with the currency reserves (a part of the overall reserves) dropping to around $490 billion by December 2024. 

The conversation also touches on the adequacy of India’s forex reserves in relation to the country’s economic performance and risk appetite. Vivek notes that the concept of “health” in reserves is subjective, dependent on a country’s macroeconomic conditions, ambitions, and risk tolerance. He compares this to an insurance policy: just as different people may have varying needs for insurance coverage, countries need different levels of forex reserves depending on their specific economic situations and experiences with currency volatility. 

Kumar also addresses other models of assessing adequacy, like the IMF’s formula, which combines various traditional metrics with adjusted weights for better accuracy. He concludes that while India’s current reserves might not be at their peak, they are still relatively healthy when considering the context and traditional benchmarks, offering a nuanced understanding of India’s economic resilience. 

Kumar emphasises that if the RBI tries to maintain a fixed exchange rate despite capital mobility, it may lose monetary policy independence, leading to tightened liquidity and higher interest rates. This delicate balancing act is further complicated by external factors such as global economic uncertainty, shifting geopolitical risks, and the slowdown in foreign direct investment (FDI) flows into India.

Host: K Bharat Kumar, Subject expert: Vivek Kumar, Podcast editor: Amitha Rajkumar)

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