Earlier this week, the Reserve Bank of India (RBI) said India’s foreign exchange reserves “remain adequate to provide cushion against external shocks”. The central bank’s assurances are crucial: so far in March, a net $12.1 billion worth of Indian shares have been sold by foreign investors – the highest monthly figure ever. This has dragged down the rupee to a new record low almost every other day.At their current levels – $710 billion as on March 13 – the forex reserves are not far from the record of $728 billion that was hit at the end of February. However, this figure requires a lot of unpacking.India’s forex reserves have four components: foreign currency (FX) assets, gold, Special Drawing Rights (SDRs), and the Reserve Tranche Position with the International Monetary Fund (IMF).SDRs are a buffer of sorts for IMF members, who can exchange it for currency when they are in trouble. The value of SDRs is based on a basket of five currencies – the US dollar, the euro, the Chinese renminbi, the Japanese yen, and the pound sterling. As of March 13, India’s SDR holdings were worth $18.7 billion. The reserve tranche position with the IMF is akin to an emergency line of credit. India’s reserve position is worth $4.8 billion.As such, the real heft in India’s forex reserves only comes from holdings of FX assets ($556 billion) and gold ($131 billion). However, selling gold for the RBI is a last resort – like it was the case during the Balance of Payments (BoP) crisis of 1991; the central bank can’t sell its gold on a day-to-day basis to defend the rupee. As such, FX assets are the realistic measure of the RBI’s ability to defend the rupee on a continued basis. However, even that figure requires adjustments.Dual rupee defenceThe RBI can stop the rupee from falling in two ways.The first involves the central bank selling FX in the ‘spot’ market. This reduces the forex reserves immediately and helps the currency strengthen or not weaken further. But defending the rupee this way has an inadvertent impact on the domestic financial system: when the RBI sells FX, it gets rupees in return. This reduces rupee availability – or liquidity – in the Indian financial system and drives up interest rates.Story continues below this adAlso in Explained | Difference between LPG and LNG, and why West Asia war affected LPG supply moreWhich is why the central bank also sells FX in the ‘forward’ market: it gets the desired result – the rupee is defended – but not the undesirable indirect impact on interest rates. How? Because the RBI doesn’t have to immediately deliver the FX, but at a future date, rupee liquidity is not tightened.As per latest data for the end of January, the RBI had net sold $68 billion of FX in forwards. This figure has likely increased in the last two months considering the rupee has been under severe pressure in March. However, the RBI’s FX assets must be adjusted for these forward sales. Even if one conservatively assumes the figure to have remained at $68 billion, the FX assets number reduces to under $500 billion.“The RBI may need to keep an eye on net FX adequacy,” HSBC said this week, adding that the number of months of goods imports that reserves can cover is approaching 2013 levels – “when India was last under BoP stress”.Preserve reserves or rupee?According to Bernstein analysts, the RBI’s defence of the rupee “will not help” at a time when global conditions are working against it and foreign investors are pulling money aggressively. This is true: since October 2024 – when markets began expecting Donald Trump to return to the White House for a second term – and until January this year, the RBI net sold $94 billion of FX in the spot market. And yet, the rupee has fallen from 84-per-dollar to almost 94.Story continues below this ad“Hence, in the event these hostilities persist, we think it is only a matter of time before 97-98 levels for the Rupee are breached,” Bernstein analysts added.Former RBI governor Shaktikanta Das often said forex reserves is the umbrella that must be used on a rainy day. But at what point does the umbrella not stop India from getting drenched? According to economists, if the West Asia war continues, the RBI will have “no choice but to let the currency depreciate”.“To navigate a longer-duration crisis RBI will need to let the INR depreciate in a controlled manner, ensuring that FX reserves are preserved. This change in FX reserve management is already visible with USDINR (exchange rate) moving upwards over the last few days,” Gaura Sen Gupta, Chief Economist at IDFC First Bank, said on Wednesday.Longer the war goes on, longer energy prices will stay elevated. This will increase India’s import bill. At a time when foreign investors are pulling money out of India, a higher import bill will mean an even greater exit of FX from India – which will put further pressure on the rupee.