From UPSC perspective, the following things are important :
Prelims level : Forex reserves, BoP
Mains level : Balance of Payment/Trade
A recent report by the RBI shows that India received support of $17.86 billion in August 2021 by way of Special Drawing Rights (SDRs) has helped cushion the worsening current account deficit.
What are Special Drawing Rights (SDRs)?
- SDRs, created by the IMF in 1969, are an international reserve asset and are meant to supplement countries’ reserves.
- Adding SDRs to the country’s international reserves makes it more financially resilient.
- Providing liquidity support to developing and low-income countries allows them to tide over the balance of payments (BOP) situations like the one India has been experiencing due to the pandemic and the one it faced earlier in 1991.
- SDRs being one of the components of foreign exchange reserves (FER) of a country, an increase in its holdings is reflected in the BOP.
What are the key components of BOP?
The BOP divides transactions of a country with the rest of the world into two accounts:
- Current Account: It consists of net trade of exports and imports of products and services, net earnings on cross-border investments and net transfer payments.
- Capital Account: It constitutes a country’s transactions in financial instruments i.e. assets and liabilities constituting of direct investment, portfolio investment, loans, banking capital, and other capital.
What does the SDR support signify?
- Pandemic impact: Countries worldwide are going through one of the worst health and economic crises, and India has been no exception.
- Domestic business underperformance: It is also indicative of the fact that the domestic business environment is failing to attract foreign direct investment.
Is dependence on SDR a matter of concern?
A BOP dependent on an SDR-dependent capital account surplus to cushion the country’s widening current account deficit is not a comfortable position to be in.
- Compulsion for reforms: Importantly, IMF support comes with a baggage of conditions as was the case in 1991—the support came with the condition that India initiates big-ticket economic reforms.
- Sovereign decisions: Any democratic country would be more comfortable with sovereign rights to design its policy strategy.
Back2Basics: Foreign Exchange Reserve
- Foreign exchange reserves are important assets held by the central bank in foreign currencies as reserves.
- They are commonly used to support the exchange rate and set monetary policy.
- In India’s case, foreign reserves include Gold, Dollars, and the IMF’s quota for Special Drawing Rights.
- Most of the reserves are usually held in US dollars, given the currency’s importance in the international financial and trading system.
- Some central banks keep reserves in Euros, British pounds, Japanese yen, or Chinese yuan, in addition to their US dollar reserves.
India’s forex reserves cover:
- Foreign Currency Assets (FCAs)
- Special Drawing Rights (SDRs)
- Gold Reserves
- Reserve position with the International Monetary Fund (IMF)
Significance of these reserves
- Import support: Holding liquid foreign currency provides a cushion against such effects and provides confidence that there will still be enough foreign exchange to help the country with crucial imports in case of external shocks.
- USD reserves: All international transactions are settled in US dollars and, therefore, required to support India’s imports.
- Exchange rate regulation: More importantly, they need to maintain support and confidence for central bank action, whether monetary policy action or any exchange rate intervention to support the domestic currency.
- Cushion against inflation: It also helps to limit any vulnerability due to sudden disturbances in foreign capital flows, which may arise during a crisis.
Initiatives taken by the government to increase forex
- Self reliance: To increase the foreign exchange reserves, the GoI has taken many initiatives like Atmanirbhar Bharat, in which India has to be made a self-reliant nation so that India does not have to import things that India can produce.
- Duty remission: The government has started schemes like Duty Exemption Scheme, Remission of Duty or Taxes on Export Product (RoDTEP), Nirvik (Niryat Rin Vikas Yojana) scheme, etc.
- FDI and EoDB: Apart from these schemes, India is one of the top countries that attracted the highest amount of Foreign Direct Investment, thereby improving India’s foreign exchange reserves.