Why forex reserves are important for any growing economy?

Why forex resrves are important for any growing economy?
Why Forex reserves are important for any growing economy?

What are forex reserves?

Forex reserves also known as foreign exchange reserves are a country’s resources. They are a country’s assets in the central bank of the respective country. The denomination is not local currency.  These financial assets are in foreign currency. Usually, it is in US dollars, given that it is the most traded currency. Occasionally, they are also in British Pounds, Japanese Yen, Euros or Chinese Yuan etc. These reserves may comprise bonds, treasuries, currencies, gold reserves and special drawing rights with the International monetary fund. Forex reserves play the role of monetary security.

Their importance

For any growing economy, capital is extremely essential. Capital refers to financial assets. It is important for productivity, employment, production, tools etc. Often, the heart of economic development is called capital accumulation. Foreign exchange reserves play the role of capital in the economy. In case the domestic currency value drops, they are used as backup funds by the government. Forex reserves are vital at times of crisis especially economic or financial ones. They come to the rescue at times when there are restraints on borrowing from overseas.

They also help maintain liquidity. Foreign exchange reserves also aid in providing support during international transactions. Sudden disturbances in the capital flow can cause vulnerability. Having foreign exchange reserves limits this. It can be said that the more the foreign exchange reserves the better financial security a country has. Forex reserves also help in strengthening the local currency. They act as cushions to any unusual external shocks.

How do reserves grow or fall?

The increment or decrease in foreign exchange reserves is based upon the countries Balance of payment (BOP). It is an accounting or record of all the international transactions made by a country at a specific time period. When there is an increase in the BOP of a country its forex reserves increase. When there is depreciation in the BOP foreign exchange reserves of a country drop.

 Forex reserves of India. 

China is leading with most foreign exchange reserves in the world. Following China is Japan and then Switzerland. India secures fourth place. As per records, India has 608.081 billion dollars in forex reserves till June 2021. In the case of India, the Reserve bank of India plays the role of the central bank. In 1991 India suffered from an Economic crisis known as the Balance of payment crisis. Since then, India’s reserves are rising steadily.  There are multiple reasons for this increase.

High foreign capital flow through foreign direct investment (FDI) and foreign portfolio investment (FPI). Another reason is due to COVID-19 there has been a decrease in the capital outflow. Yet another reason is the drop in crude oil prices that in turn brought down oil import bills. The United States of America holding liquidity infusions also rose India’s forex reserves. Major acts regarding foreign exchange include the Foreign exchange management act of 1999 (FEMA) and the reserve bank of India act 1934.

Downsides to forex reserves

Certainly, these reserves are of utmost significance. However, we cannot ignore the little problems that lie with them. One of the problems being of inflation. In the case of inflation forex reserves may lose value as the value of currencies is not fixed. Inflation erodes its value. Another problem is operation. These markets work 24/7 which sometimes becomes difficult to manage. So as to administer them algorithms are applied. That is because it is not humanly possible to work all day and night.

With the coming of globalisation, it becomes important for countries all around the world to know about foreign exchange reserves and everything that is associated with it. Forex reserves hold immense power to either devalue the local currency if there are no reserves. On the other hand, reserves may give an upper hand to a country.

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