Monetary Policy Committee Notifications

India’s Tenfold Path to manage Exchange Rate Volatility

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Rupee-Dollar relation

Mains level : Issues with Rupees depreciation

The RBI is prepared to sell a sixth of its foreign exchange reserves to defend the rupee against a rapid depreciation after it plumbed record lows in recent weeks.

Must read:

[Burning Issue] Global Trade in Rupees

Is there a forex crisis underway?

  • And the way in which India has tackled foreign exchange crises over the years has been quite profound.
  • A forex crisis can be loosely defined as one where the rupee starts depreciating rapidly or when forex reserves slide precipitously.
  • Ever since India’s reforms of 1991-92, the external sector has been liberalized, with even full capital account convertibility being considered at one point.

In the rupee’s context, let’s look at options that have been used in the last three decades or so:

(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.

 

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