The Making of India’s Forex Fortress

Part 2: Three decades after the 1991 crisis, India’s record Forex reserves have transformed the country from a crisis-prone borrower into an economy with a formidable external shock absorber.

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Three decades ago, India had so few dollars that it had to pledge gold to avert a balance-of-payments crisis. Today, it sits on a foreign-exchange war chest of more than US$700 billion. The journey from near-bankruptcy to external resilience is one of the quieter successes of India’s economic reforms and one of the clearest examples of why central-bank prudence matters.

As India’s economy liberalized and attracted large foreign capital inflows during the 2000s and 2010s, the RBI faced the challenge of managing these inflows without destabilizing domestic liquidity or undermining export competitiveness. Its response was a strategy of “silent reserve accumulation”. Large capital inflows created upward pressure on the rupee as investors converted dollars into local currency. Left unchecked, a sharply appreciating rupee could have weakened exports and encouraged imports. To prevent this, the RBI regularly intervened in the forex market, purchasing surplus dollars and adding them to its reserves. This approach helped steadily build a strong reserve buffer without disrupting broader macroeconomic stability.

Unlike some export-led economies that used reserves to maintain an artificially undervalued currency, the RBI has viewed forex reserves primarily as a safeguard against external shocks, capital outflows, currency speculation and global financial volatility. Accordingly, RBI interventions in the forex market have focused on smoothing excessive fluctuations and maintaining orderly market conditions, rather than defending any specific exchange-rate level.

Building the Fortress

India’s forex reserves have grown from a few tens of billions of dollars in the early 2000s to over US$700 billion by 2026. Rather than remaining idle, these reserves are actively managed by the RBI with three priorities: safety, liquidity and return. The bulk is held as Foreign Currency Assets (FCAs) invested in highly rated sovereign securities, while gold holdings have been steadily increased to enhance diversification and serve as a hedge during periods of global uncertainty. In addition, Special Drawing Rights (SDRs) and India’s reserve position with the IMF provide supplementary sources of international liquidity. This diversified reserve portfolio has strengthened India’s ability to withstand external shocks.

When the collapse of Lehman Brothers in 2008 triggered a global flight to safety, emerging markets witnessed sharp capital outflows and intense demand for dollar liquidity. India faced outflows of nearly US$26 billion, while the rupee depreciated from about Rs. 39 to Rs. 48 per US dollar.

Unlike in 1991, however, India entered the crisis with forex reserves sufficient to cover eight to nine months of imports. This strong reserve buffer enabled the RBI to inject dollar liquidity, stabilize forex markets and prevent disorderly currency movements. Crucially, India weathered the crisis without seeking emergency assistance from multilateral institutions. The episode underscored the strategic importance of robust forex reserves, which acted as an effective shock absorber and insulated the economy from a much deeper downturn.

The Taper Tantrum

The 2013 “Taper Tantrum” was India’s most severe external-sector challenge since the 1991 BOP crisis. Triggered by signals from the US Federal Reserve that quantitative easing would be scaled back, global capital rapidly exited emerging markets. With a CAD of nearly 4.8% of GDP and high inflation, India was among the so-called “Fragile Five” economies. Investor sentiment deteriorated sharply, causing the rupee to slide from around Rs. 55 to nearly Rs. 69 per US dollar within four months.

In response, the RBI launched the FCNR(B) swap scheme, offering banks an attractive swap facility to mobilize long-term NRI dollar deposits. The initiative attracted nearly US$34 billion in inflows within weeks, replenished reserves, stabilized the rupee and restored investor confidence. The episode demonstrated how innovative policy measures and a strong institutional response could effectively counter external shocks and safeguard macroeconomic stability.

The COVID-19 pandemic in 2020 triggered severe disruptions across global financial markets, leading to volatile capital flows, a sharp rise in demand for dollar liquidity and a stronger US dollar. For India, however, the crisis did not evolve into a BOP emergency as it had in 1991. Decades of prudent external-sector management and sustained reserve accumulation had created a substantial forex buffer. Equipped with ample reserves, the RBI was able to inject liquidity, stabilize financial markets and contain excessive currency volatility. As a result, India absorbed the external shock without compromising macroeconomic stability.

Geopolitical tensions in West Asia and Brent crude prices above US$100 per barrel have put significant pressure on India’s import bill and external balance. At the same time, heightened global risk aversion has triggered substantial capital outflows, with FIIs selling a record Rs. 1.07 trillion of Indian equities.

Unlike the crises of 1991 and 2013, however, India entered this period with a forex reserve buffer of about US$700 billion. Leveraging this strength, the RBI intervened actively in the forex market, reportedly supplying around US$26 billion in March 2026 alone to curb excessive volatility. Although the rupee depreciated sharply, financial markets remained orderly and stable.

A New Dollar Lifeline

Furthermore, the RBI revived the FCNR(B) scheme in 2026 to strengthen foreign-currency inflows and alleviate structural liquidity pressures in the domestic financial system. Building on the success of the 2013 initiative, the redesigned framework offered broader participation and greater certainty on hedging costs, making it more attractive for market participants. The scheme encouraged banks, public-sector enterprises and quasi-sovereign institutions such as REC, PFC and EXIM Bank to raise funds through External Commercial Borrowings and NRI deposits.

Beyond boosting forex inflows, the initiative delivered a significant macroeconomic benefit by enabling large borrowers to access offshore funding, thereby reducing pressure on domestic liquidity and credit markets. The response was overwhelmingly positive, attracting sizable inflows and reinforcing investor confidence in India’s macroeconomic fundamentals. Reflecting its strong demand and effectiveness, the RBI closed the scheme well before the originally announced deadline, underscoring its success as a targeted liquidity and external-sector management tool.

The benefits of large forex reserves extend well beyond import cover. A strong reserve position enhances India’s sovereign credibility, reassuring investors and rating agencies of the country’s ability to meet external obligations even during periods of global financial stress. It also helps lower forex risk premiums, reducing borrowing costs for Indian businesses and improving their global competitiveness.

Managing such large reserves, however, requires careful liquidity management. When the RBI purchases dollars, it injects rupee liquidity into the banking system, which can create inflationary pressures. To neutralize this effect, the RBI undertakes sterilization operations. As capital inflows surged, the Market Stabilization Scheme (MSS) was introduced in 2004 under Governor Y.V. Reddy, allowing the government to issue special securities solely for absorbing excess liquidity. Although sterilization entails a fiscal cost, it is widely viewed as a necessary insurance premium for preserving macroeconomic stability and protecting the economy from external shocks.

Despite India’s record forex reserves, the rupee can still depreciate because the RBI does not target a specific exchange rate. Instead, it focuses on maintaining competitiveness and macroeconomic stability. Since India’s inflation is often higher than that of its major trading partners, gradual nominal depreciation helps prevent the rupee from becoming overvalued and hurting exports.

Moreover, India’s key imports, such as crude oil, electronics and gold, are largely price-inelastic, so an artificially strong rupee would not significantly reduce import demand. Consequently, the RBI uses its reserves primarily to smooth excessive volatility and contain speculative pressures during periods of stress, rather than defend a particular rupee level. In this sense, forex reserves act as a financial shock absorber, helping the economy withstand external disruptions while allowing the currency to adjust to underlying economic fundamentals.

Over the past 35 years, India’s forex-management framework has undergone a remarkable transformation, evolving from crisis-driven survival to a position of strength and resilience. The benefits of record reserves are visible in lower borrowing costs for Indian firms, greater resilience to large capital outflows and enhanced financial stability during periods of global uncertainty.

Most importantly, robust reserves provide the RBI with invaluable policy flexibility. Rather than being forced to react to external shocks, the central bank can independently pursue domestic monetary and financial stability objectives.

(The writer is a Chartered Accountant with a leading Mumbai-based company. Views personal.)