Strengthening dollar shrinks foreign reserves across nations

Source: The post is based on an article “Strengthening dollar shrinks foreign reserves across nations” published in The Hindu on 18^th October 2022.

Syllabus: GS 3 – Economic Development

Relevance: declining forex reserves and concerns associated with it

News: The Ukraine crisis and the U.S. Federal Reserve’s tight monetary policy have led to the depreciation of the rupee and other currencies across the world, along with their foreign reserves.

What are the uses of forex reserves?

Forex Reserves including foreign currency assets, gold, Special Drawing Rights, and reserve tranche position are used to absorb shocks during times of crises.

They are a crucial indicator of a country’s economic health and its import capacity.

What has caused the decline in the forex reserves across the world?

The US Federal Bank has increased the rate of interest on dollar which has increased the dollar index by 15% this year while other currencies have declined.

Strong currencies like pound, euro, yen have weakened against the dollar along with the rupee. However, the fall of the rupee has been relatively more moderate. (Chart 1)

The weakening of the currencies has led the intervention of the central bank of the respective countries across the world.

This has led the decline in forex reserves of the countries. Singapore’s reserves saw the sharpest decline in percentage terms while China’s fell the most in absolute terms.

What is the situation of India in forex reserves?

India has the fifth-highest reserves in the world and the rate at which they are depleting is causing concern. Forex reserves in India fell by $97 billion in the last nine months.

This is significantly higher than the decline of reserves during the 2008 global financial crisis ($37.3 billion) and the period of the taper tantrum in 2013 ($16.6 billion).

India’s reserves are mainly formed due to the capital flows (funds through foreign investments, borrowings) and not much from the current account (net income earned through exports of goods and services and remittances).

Therefore, India’s foreign reserves dropped as foreign investment decreased.

The strengthening of the dollar has also declined the value of the euro, pound and yen (also part of India’s foreign reserves) which also led the reduction in India’s reserves. This is called a valuation loss.

The change in India’s forex reserves due to two factors – a) through balance of payments (sum of India’s capital flows and current account deficit) and b) through valuation loss/gain.