Jobs, growth, import stability and buoyancy in equity markets: Contribution of high forex reserves

Growth, employment generation, asset creation, increased valuation in equity markets are some of the reasons why a common man should rejoice at the news of foreign exchange reserves reaching record highs in India.

Even as the killer Covid virus tears through the country, foreign exchange reserves has risen at a furious pace rising to record levels surpassing $600 billion touching $604 billion on June 4. Mainly helped by a surge in the flow of dollars from foreign investors to take advantage of a fast-rising equity market, the torrent was also assisted by a rise in foreign direct investment even in these trying times.

Blessing on most counts

A high forex reserve has been usually considered a blessing for emerging economies that have been traditionally starved of capital.

There are reasons why high foreign exchange reserves are welcomed in countries such as India.

Jobs and growth

The first reason is obviously growth. The foreign direct investment (FDI) component of forex reserves is something that all governments look forward to.

According to the figures of Department for Promotion of Industry and Internal Trade, the FDI flow in the country between April and December 2020 stood at Rs 3,83,000 crore. Incidentally, the FDI in the entire country in 2019-20 was Rs 3,53,558 crore and that in 2018-19 was Rs 3,09,867 crore.

Thus, even in the Covid-hit year, the FDI in the first nine months was 108% of that of the entire preceding financial year.

The common man is most impacted by FDI that helps create physical assets on the ground such as factories, machinery and companies that employ people and generate income and generates cascading effect on the economy.

“Income levels go up which in turn raise standards of living,” said investment expert Nilanjan Dey, Director, wishlist Capital Advisors.

“This FDI figure shows that foreign investors are increasingly reposing their confidence in India,” said Subhasish Roy, deputy director general of MCC Chamber of Commerce and Industry.

Buoyant markets

However, the same cannot be said for portfolio investments in the country.

While portfolio investments can trigger buoyancy in price of equities and can generate profits for individual investors and companies in the short run, it can also lead to fast exit of capital and can erode the hard-earned money of millions of retail investors who are lured to a fast-rising market.

Essential imports

For a country that imports a lot of its essential goods such as crude oil that keeps its economy moving, high forex serves are essential. If the country has low reserves that affects crude imports, it can trigger a rapid rise in the prices of petrol and diesel in the domestic market, which, in turn, would lead to high inflation, affecting everyone – especially the poor in the country.

The same logic goes for all imports. Without a healthy forex reserve, the prices of all essential imports would rise, putting a lot of people in misery.

The Reserve Bank also uses the forex reserves to fine tune the exchange rates of the rupee against the dollar.

In March 1991, India had forex reserves of $5.8 billion, less than 1% of what the country has today. The country had to pledge gold reserves to pre-empt a financial crisis.

Since the 1990s

Interestingly, for many emerging economies, the flow of capital inflows rose in and since the 1990s compared to a dearth in the earlier decades when scarcity of foreign capital gave sleepless night to policymakers. In fact, many government now spend a lot of time formulating strategy on how to manage largescale capital inflows to generate higher rates of investment and growth.

Economists often point out that high inflow of foreign capital may not be an unmixed blessing. In fact, in some countries a glut of capital inflow led to “fast monetary expansion, inflationary pressures, real exchange rate appreciation, financial sector difficulties, widening current account deficits, and a rapid build-up of foreign debt.”

The South East Asian crisis of 1997-98 left painful lessons that a quick flight of capital can hurt an economy in many way. financial integration and globalisation can cut both ways. Quick and substantial reversals can even trigger recessions.