Foreign Reserves Explained in Simple Terms

What is a Foreign Reserve

Foreign Reserve is a foreign currency hold by country’s central banks (RBI) and also by major financial institutions to meet their international payment obligations or in other words to influence their exchange rate. And also includes sovereign,commercial debts,during imports,to intervene in the foreign currency market during high volatility. Usually commodities such as gold and oil will be priced in the reserved currency, making other countries also to hold the currency to pay for these goods. Countries who held foreign reserves will not have to exchange their currency for the current reserve to purchase any goods.

How does the RBI buys foreign currencies

If a foreign investor wants to buy a Indian stock.The investor should pay in rupees to buy a stock,he’ll approach a bank for converting his currencies which in turn bank should find a buyer of the foreign currency. If buyers are in demand ,the demand for the foreign currency will drop and the exchange rate falls. To maintain price-stability ,the RBI buys the foreign currency from banks and print rupees accordingly.

Purposes apart from maintaining Exchange rate

• Impact on inflation
• Fiscal Deficit
• RBI Balance sheet – The balance sheet will have extra assets(foreign currencies bought) and extra liabilities(equivalent rupees printed)

Composition of Foreign reserves

India’s foreign exchange reserves comprise foreign currency assets, gold and special drawing rights where foreign currency assets are invested in instruments abroad possessing high credit rating and no risk. Reserves are held and managed by RBI and the composition of the reserves are not disclosed to the public in India. Foreign currency assets include sovereign bonds, treasury bills and short term deposits in global banks in addition to cash accounts. Deployment is based on safety,liquidity and returns.

Indicators of adequacy of foreign reserves

In general the adequacy of reserves was measured in level of imports. Apart from imports the adequacy is measured in percentage of short term debt reserves, ratio to GDP, ratio of broad and reserve money, size of the current account deficit and capital flow variations.

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