Context: Recently, India’s foreign exchange reserves are rising and are slated to hit the $500 billion mark soon. In the last month, it jumped by $12.4 billion to an all-time high of $493.48 billion.
Rising above the 1991 crisis

• Unlike in 1991, when India had to pledge its gold reserves to stave off a major financial crisis, the country can now depend on its soaring Forex reserves to tackle any crisis on the economic front.
• The level of Forex reserves has steadily increased by 8,400 per cent from $5.8 billion as of March 1991 to the current level.

What are Forex Reserves?

• Reserve Bank of India Act and the Foreign Exchange Management Act, 1999 set the legal provisions for governing the foreign exchange reserves.
• RBI accumulates foreign currency reserves by purchasing from authorized dealers in open market operations.
• The IMF says official Forex reserves are held in support of a range of objectives like supporting and maintaining confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency.
• It will also limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed.

Forex reserves of India

• They are holdings of cash, bank deposits, bonds, and other financial assets denominated in currencies other than Indian rupee.
• The reserves are managed by the Reserve Bank of India for the Indian government and the main component is foreign currency assets.
• They act as the first line of defense for India in case of economic slowdown, but acquisition of reserves has its own costs.
• They facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.
• They act as a cushion against rupee volatility once global interest rates start rising.

Where are India's forex reserves kept?

• The RBI Act, 1934 provides the overarching legal framework for the deployment of reserves in different foreign currency assets and gold within the broad parameters of currencies, instruments, issuers and counterparties.
• As much as 64 per cent of the foreign currency reserves is held in the securities like Treasury bills of foreign countries, mainly the US.
• 28 per cent is deposited in foreign central banks and 7.4 per cent is also deposited in commercial banks abroad.
• In value terms, the share of gold in the total foreign exchange reserves increased from about 6.14 per cent as at end-September 2019 to about 6.40 per cent as at end-March 2020.

Structure of the foreign exchange market in India
The foreign exchange market of India consists of several stakeholders. The main stakeholders of the Indian forex market:

• The Reserve Bank of India
• Commercial banks / authorised dealers
• Traders participating and the forex market

Composition of Forex

• Reserve Bank of India Act and the Foreign Exchange Management Act, 1999 set the legal provisions for governing the foreign exchange reserves.
• RBI accumulates foreign currency reserves by purchasing from authorized dealers in open market operations.

The Forex reserves of India consist of below four categories:

• Foreign Currency Assets
• Gold
• Special Drawing Rights (SDRs)
• Reserve Tranche Position

Types of foreign exchange market operations

• Spot market operations (current market): the market which handles the spot transactions or current transactions of foreign currencies are known as spot market. They handle only spot transactions and transactions are of daily in nature.
• Forward Market (or derivative market): Forward Market deals with future delivery of foreign exchange instruments. Forward Market transactions determine the forward exchange rate at which the forward transactions are honored. It deals with instruments such as currency futures, currency swaps, foreign exchange forward, and currency options etc.

Exchange settlement and dealings: the settlement and billings of foreign exchange are facilitated with the help of Nostro accounts and Vostro accounts.

• Nostro account is a foreign currency demand deposit account which is maintained by domestic banks in India with a bank in abroad. The basic meaning of the Nostro account is that our account is with you.
• Vostro account refers to the domestic currency denominated demand deposit accounts maintained by the foreign banks which domestic banks. The basic meaning of the Vostro account is that your account is with us.

Why is Forex rising despite the slowdown in the economy?

• The major reason for the rise in forex reserves is the rise in investment in foreign portfolio investors in Indian stocks and foreign direct investments (FDIs).
• Foreign investors had acquired stakes in several Indian companies in the last two months.
• Forex inflows are set to rise further and cross the $500 billion as Reliance Industries subsidiary, Jio Platforms, has witnessed a series of foreign investments totalling Rs 97,000 crore.
• On the other hand, the fall in crude oil prices has brought down the oil import bill, saving the precious foreign exchange.
• Similarly, overseas remittances and foreign travels have fallen steeply – down 61 per cent in April from $12.87 billion.

What's the significance of rising forex reserves?

• The rising forex reserves give a lot of comfort to the government and the RBI in managing India’s external and internal financial issues at a time when the economic growth is set to contract by 1.5 per cent in 2020-21.
• It’s a big cushion in the event of any crisis on the economic front and enough to cover the import bill of the country for a year.
• The rising reserves have also helped the rupee to strengthen against the dollar.
• The forex reserves to GDP ratio is around 15 per cent.
• Reserves will provide a level of confidence to markets that a country can meet its external obligations, demonstrate the backing of domestic currency by external assets, assist the government in meeting its US dollar needs and external debt obligations and maintain a reserve for national disasters or emergencies.

What does the RBI do with the forex reserves?

• The RBI functions as the custodian and manager of forex reserves and operates within the overall policy framework agreed upon with the government.
• The RBI allocates the dollars for specific purposes. For example, under the Liberalized Remittances Scheme, individuals are allowed to remit up to $250,000 every year.
• The RBI uses its forex kitty for the orderly movement of the rupee. It sells the dollar when the rupee weakens and buys the dollar when the rupee strengthens.

Is there  a cost involved in maintaing forex reserves?

• The return on India’s forex reserves kept in foreign central banks and commercial banks is negligible.
• While the RBI has not divulged the return on forex investment, analysts say it could be around one per cent, or even less than that, considering the fall in interest rates in the US and Eurozone.
• There was a demand from some quarters that forex reserves should be used for infrastructure development in the country. However, the RBI had opposed the plan.
• Several analysts argue for giving greater weightage to return on forex assets than on liquidity thus reducing net costs if any, of holding reserves.
• Another issue is the high ratio of volatile flows (portfolio flows and short-term debt) to reserves which are around 80 per cent. This money can exit at a fast pace.

What are Special Drawing Rights?

• The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves
• The SDR is neither a currency nor a claim on the IMF.
• Initially SDR was defined as equivalent to 0.888671 grams of fine gold, which at the time, was also equivalent to one U.S. dollar.
• After the collapse of the Bretton Woods system, the SDR was redefined as a basket of currencies.
• This basket Includes five currencies—the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling.