India's Diplomacy Has Another Tool: Forex Reserves

India's strategy of building large foreign currency reserves is aimed more at enhancing its international diplomacy than ensuring domestic macroeconomic stability.As of May 17, India had forex reserves of $645.5 billion, the highest among SAARC countries, insulating the domestic economy from adverse market conditions. These substantial buffers also enable India to assist other countries in withstanding external shocks through currency swap lines, according to the RBI's monthly bulletin."If India is able to lend its excess reserves to these economies on a short-term basis, it makes diplomatic sense. It is probably part of India's goal to become the leader of the Global South," said Dhiraj Nim, an economist at ANZ Research.A swap line is an arrangement between the central banks of two countries where the providing central bank loans its currency against the counterparty's currency as collateral.The purpose of a swap line is to allow central banks to exchange currencies with each other to maintain a liquid and stable currency market. These swap operations carry no exchange rate or other market risks, as transaction terms are set in advance."While central banks can provide local currency to domestic financial institutions to address any stress from local currency liquidity, their ability to extend support by providing foreign currency is constrained by the forex reserves they hold," the Reserve Bank of India said in its latest monthly bulletin.However, there is a caveat.A large part of India's foreign currency reserves is not "earned reserves," Nim said, but is largely a function of the extent of foreign flows into India that the central bank absorbs.This means that these foreign currency assets will need to be repaid at some point.."They have absorbed net international liabilities coming in the form of FDI and FPI and converted them into FX assets. This has given them more confidence in terms of handling external shocks and has helped them maintain currency competitiveness gradually," Nim said.To facilitate the currency swap system, a Global Financial Safety Net of $18 trillion has been set up. This system comprises institutional arrangements and mechanisms that provide precautionary support against crises and extend liquidity support to avoid balance of payments crises.Of this, currency swap arrangements account for about $2.8 trillion, according to the RBI's bulletin. This has provided India with the comfort and leverage to extend more swap support to other countries..Since the establishment of the SAARC framework, the RBI has provided swap lines worth $6.1 billion. These lines help neighboring countries during their time of need. For example, consider India's assistance during the Sri Lankan financial crisis.In 2022, Sri Lanka faced severe economic and political turmoil, grappling with high inflation and unsustainable levels of depleted foreign reserves. The RBI's currency swap lines with the Central Bank of Sri Lanka were instrumental in helping the country survive.Sri Lanka accounts for 62% of the RBI's overall swap lines, according to the bulletin.In recent years, risk-aversion sentiment has prevailed globally, with investors and governments seeking safe havens to protect the value of their assets.India's foreign exchange reserves account for 60–65% of its net international investment position, indicating a decent risk-taking capacity, Nim said."This number may be much lower for other emerging market economies in Asia. The lower the metric is, the more susceptible you are to external shocks," he added.In 2022, Japan and India renewed their bilateral swap agreement of up to $75 billion. Another swap line arrangement that India is part of is the BRICS contingent reserve arrangement..RBI's New Record: How Dividend Payout More Than Doubled And What's Next?

India's Diplomacy Has Another Tool: Forex Reserves

India's strategy of building large foreign currency reserves is aimed more at enhancing its international diplomacy than ensuring domestic macroeconomic stability.

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India's Diplomacy Has Another Tool: Forex Reserves

India's strategy of building large foreign currency reserves is aimed more at enhancing its international diplomacy than ensuring domestic macroeconomic stability.

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