From UPSC perspective, the following things are important :
Prelims level : Impossible trinity
Mains level : RBI functions
- A currency defence will also impose costs on the economy.
Why in news?
- Legally, the Reserve Bank of India is mandated to target an inflation rate. But with the global economic environment taking a turn for the worse, the central bank has also been targeting the exchange rate. This could prove to be a costly mistake.
What is a simple definition for inflation?
- Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country.
What is exchange rate?
- An exchange rate is a rate at which one currency will be exchanged for another currency. Most exchange rates are defined as floating and will rise or fall based on the supply and demand in the market. Some exchange rates are pegged or fixed to the value of a specific country’s currency.
What is monetary policy?
- Monetary policy is the control of the quantity of money available in an economy and the channels by which new money is supplied. Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry and sector-specific growth rates influence monetary policy strategy.
What is fixed exchange rate in simple words?
- A fixed exchange rate is a regime applied by a government or central bank that ties the country’s official currency exchange rate to another country’s currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency’s value within a narrow band.
What is a simple definition of capital?
- Capital is a broad term that can describe anything that confers value or benefit to its owners, such as a factory and its machinery, intellectual property like patents, or the financial assets of a business or an individual.
What is meant by the impossible trinity?
- Many economists think of possible policy responses to capital flows in terms of the so-called “impossible trinity,” or “policy trilemma”, according to which, with an open capital account, a central bank cannot simultaneously exercise monetary control and target the exchange rate.
A currency defence will impose costs on the economy?
- Little economic gain: Some may believe that a stronger currency gives the impression of economic stability and generates confidence in the economy. But there is an inherent contradiction between artificially propping up the rupee and the country’s growth prospects. Very little economic gain will accrue from turning the currency’s value into a political issue.
- Inflation should be tackled through monetary policy: Understandably, a depreciating currency leads to concerns over higher imported inflation. But inflation should be tackled through monetary policy, while exchange rate management should be linked to growth. Not the other way around.
Significance of currency defence for foreign exchange reserves
- Decline by 10 per cent: A large part of the current relative strength of the rupee vis-à-vis other currencies is due to the sale of dollars by the RBI it has lost more than 10 per cent of its foreign reserves in the space of about nine months.
- Why country needs foreign exchange: A developing economy needs foreign exchange to finance its international transactions for both the current account (goods and services) and capital account (assets) transactions.
- Cost involved: The benefits of this stock are obvious, but there are also costs associated with the holding of these.
We should follow Tenfold Path to manage Exchange Rate Volatility rather monetary policy path
(1) Selling dollars
- The first course of action has been selling dollars in the spot forex market.
- This is fairly straightforward, but has limits as all crises are associated with declining reserves.
- While this money is meant for a rainy day, they may just be less than adequate.
- The idea of RBI selling dollars works well in the currency market, which is kept guessing how much the central bank is willing to sell at any point of time.
(2) NRI deposits
- The second tool used is aimed at garnering non-resident Indian (NRI) deposits.
- It was done in 1998 and 2000 through Resurgent India bonds and India Millennium Deposits, when banks reached out asking NRIs to put in money with attractive interest rates.
- The forex risk was borne by Indian banks.
- This is always a useful way for the country to mobilize a good sum of forex, though the challenge is when the debt has to be redeemed.
- At the time of deposits, the rates tend to be attractive, but once the crisis ends, the same rate cannot be offered on deposit renewals.
- Therefore, the idea has limitations.
(3) Let oil importers buy dollars themselves
- The third option exercised often involves getting oil importing companies to buy dollars directly through a facility extended by a public sector bank.
- Its advantage is that these deals are not in the open and so the market does not witness a large demand for dollars on this account.
- It is more of a sentiment cooling exercise.
(4) Let exporters trade in dollars
- Another tool involves a directive issued for all exporters to mandatorily bring in their dollars on receipt that are needed for future imports.
- This acts against an artificial dollar supply reduction due to exporter hold-backs for profit.
(5) Liberalized Exchange Rate
- The other weapon, once used earlier, is to curb the amount of dollars one can take under the Liberalized Exchange Rate Management System.
- This can be for current account purposes like travel, education, healthcare, etc.
- The amounts are not large, but it sends out a strong signal.
(6) Forward-trade marketing
- Another route used by RBI is to deal in the forward-trade market.
- Its advantage is that a strong signal is sent while controlling volatility, as RBI conducts transactions where only the net amount gets transacted finally.
- It has the same power as spot transactions, but without any significant withdrawal of forex from the system.
(7) Currency swaps
- The other tool in India’s armoury is the concept of swaps.
- This became popular post 2013, when banks collected foreign currency non-resident deposits with a simultaneous swap with RBI, which in effect took on the foreign exchange risk.
- Hence, it was different from earlier bond and deposit schemes.
- Most preferred options by the RBI
- Above discussed instruments have been largely direct in nature, with the underlying factors behind demand-supply being managed by the central bank.
- Of late, RBI has gone in for more policy-oriented approaches and the last three measures announced are in this realm.
(8) Allowing banks to work in the NDF market
- First was allowing banks to work in the non-deliverable forwards (NDF) market.
- This is a largely overseas speculative market that has a high potential to influence domestic sentiment on our currency.
- Here, forward transactions take place without real inflows or outflows, with only price differences settled in dollars.
- This was a major pain point in the past, as banks did not have access to this segment.
- By permitting Indian banks to operate here, the rates in this market and in domestic markets have gotten equalized.
(9) Capital account for NRI deposits
- More recently, RBI opened up the capital account on NRI deposits (interest rates than can be offered), external commercial borrowings (amounts that can be raised) and foreign portfolio investments (allowed in lower tenure securities), which has the potential to draw in forex over time.
- Interest in these expanded contours may be limited, but the idea is compelling.
(10) Settlement in Rupees
- RBI’s permission for foreign trade deals to be settled in rupees is quite novel; as India is a net importer, gains can be made if we pay in rupees for imports.
- The conditions placed on the use of surpluses could be a dampener for potential transactions.
- But the idea is innovative and could also be a step towards taking the rupee international in such a delicate situation.
- Clearly, RBI has constantly been exploring ways to address our forex troubles and even newer measures shouldn’t surprise us.
- The RBI (which is in charge of monetary policy) should focus on containing inflation, as it is legally mandated to do.
- The government (which is in charge of the fiscal policy) should contain its borrowings.
- Higher borrowings (fiscal deficit) by the government eat up domestic savings and force the rest of the economic agents to borrow from abroad.
- Policymakers (both in the government and the RBI) have to choose what their priority is containing inflation or being hung up on exchange rate and forex levels.
- If they choose to contain inflation (that is, by raising interest rates) then it will require sacrificing economic growth. So be prepared for that.
Q.What do you understand by the term impossible trinity? How should RBI respond to manage currency exchange rate? Discuss.