Rising forex reserves

The data released last week by the Reserve Bank of India (RBI) showed India’s foreign-exchange reserves increased to an all-time high of $729.3 billion in the week ended August 21. It is reasonable to expect that the reserves will likely witness a significant jump when the data for last week and this week are released. The increase over the past few weeks has been driven by the swap schemes announced by the RBI in June, including for Foreign Currency Non-Resident (Bank), or FCNR (B), deposits. Given the strong flows under the FCNR (B) window, the RBI decided to prematurely end the scheme, a month ahead of schedule (August 31). The scheme for external commercial borrowing and overseas foreign-currency borrowing will continue as announced. The RBI has added about $47 billion to its reserves since the swap scheme was announced on June 5. 

A higher level of foreign-exchange reserves, sufficient to cover about 11 months of imports, will provide enormous comfort to policymakers. It is worth noting that the rupee came under pressure with the beginning of the Iran war. Since India depends on imports for most of its crude-oil requirement, economists expected the current account deficit (CAD) to expand substantially to over 2 per cent of gross domestic product (GDP) this financial year, compared to about 0.6 per cent in 2025-26. Since India was already facing outflows on the capital account, the rupee came under pressure despite the central bank’s defence. Although economists have scaled down CAD projections, the broader uncertainty has not abated, and crude-oil prices remain elevated. The United States (US) and Iran remain engaged in brinkmanship, with unpredictable consequences. 

Thus, in the given uncertain global environment, higher foreign-exchange reserves will definitely help maintain external stability. The rupee, for instance, has stabilised over the past few weeks and recovered some of the lost ground. However, it is worth noting that higher reserves should not be used to prop up the rupee against fundamentals because this could affect external competitiveness and might end up widening the CAD. The latest reading (July) on the index for the real effective exchange rate showed that the rupee had depreciated about 8 per cent in real terms over the past year and was undervalued to a similar extent. Some amount of undervaluation will help reduce the CAD and make Indian assets more attractive to foreign investors. It must also be kept in mind that capital flows under the swap scheme will provide relief only in the short to medium term. 

Besides the uncertainty in West Asia, India must also be prepared for shifts in global financial conditions. Longer-term bond yields in the US are moving up and are expected to rise further. US Federal Reserve Chairman Kevin Warsh reiterated the central bank’s commitment to attain the 2 per cent inflation target in his much-awaited speech last week. The inflation rate in the US has been above target for over five years and might require policy tightening, which will push up bond yields. Borrowing costs are rising in the US also because of rising public debt and sustained investment in artificial-intelligence capacity building. Thus, continued tighter financial conditions would affect capital flows. The risk of low returns on artificial-intelligence investment, which is now partially being financed by debt, could also pose threats. Therefore, Indian policymakers must adjust not only to potentially tighter global financial conditions but also to possible large-scale disruption.