• How does Forex reserve increase in India in spite of High current account deficit???

    Current account balance specifies the difference between the inflows and outflows of the foreign exchanges and depends on the import and export with the other countries. If import is higher than export, then it is termed as current account deficit and on the contrary it is termed as current account surplus.

    Countries likeChina,Taiwan,JapanandRussia, having huge current account surplus, can easily increase their forex reserves by earning more foreign currency by exporting much more than import. But forIndiawith huge expected current account deficit of nearly 3.5% of GDP in FY 2010-11, it is really surprising how it has been increasing its forex reserves continuously since 1991.

    India’s total import is much higher than the total export mainly because of very high crude oil import. This trade imbalance results in higher trade deficit and current account deficit. With this high current account deficit,Indiahas been able to manage to increase its forex reserves continuously.India’s forex reserves increased from just USD 5.83 billion at the end of FY 1990-91 to nearly USD 305 billion at the end of FY 2010-11. This is 52 times increase in just 20 years.

    In this write up, we will analyze the reason behind this dream run of forex reserves in spite of current account deficits.

    • The trade deficit considers only the trade of goods, materials and manufactured products. It does not consider any kind of services like software, consultancy and other miscellaneous services.
    • Indiais having huge trade deficit because of higher import than export. This results in high current account deficit.
    • At the same time,India’s service related export is much higher compared to its import.Indiais the world’s biggest IT services exporter. This results in high service related current account surplus.
    • If we match both of them, then current account surplus gained from the services trade almost negates the impact of current account deficit resulted from trade deficits.

    Now even if the service export reduces the overall current account deficit, where from the forex reserves coming?

    Here come the other capital inflows in the other forms like FDI, FII, ECB, NRI deposits etc.

    • FDI stands for Foreign Direct Investment, usually done for long term investment purpose.
    • FII or Foreign Institutional Investments are used to invest in stocks, portfolios, mutual funds etc. normally for short term.
    • ECB or External Commercial Borrowing, which the domestic companies use to raise money from outside investors at lower interest rates.
    • NRI deposits which is a source of capital inflow inside the country.

    All these capital inflows are used to increase the total foreign capital inside the country. Foreign currency flows inside the country through these routes and later converted to domestic currency Rupee to invest or use inside the country. RBI buys these foreign currencies and sells Rupee to the sellers, thus increases the forex reserves.

    In last 20 years,Indiahas attracted total capital inflows of nearly USD 440 billion which is mainly used to build these huge forex reserves of USD 305 billion after deducting the current account deficit.

    India will continue building its forex reserves as

    • The healthy capital inflow in terms of FDI, FII and ECB are going to continue because of Indian growth story andIndia’s attractiveness as a nice investment bet to the foreign investors.
    • The foreign investors have high confidence in investing inIndiabecause of high domestic consumption potential.
    • The service sector export is expected to continue its dream run led by the IT/BPO services and consultancy services to attract more foreign capital inside the country.

    This is howIndiahas built its huge forex reserves and continues to increase it in the immediate future.

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