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RBI and the rupee: To break a free fall or not to

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Foreign exchange reserves

Mains level : Paper 3- Depreciation of rupee

Context

The Indian rupee has been in free fall. Some commentators have pointed out that it has fallen less against the US dollar than a lot of other currencies.

Significance of 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.
  •  The larger the stock, the more its reassuring value.
  • Typically, because of their “liquid” nature, the returns on these are low.

How RBI manages the foreign exchange reserves?

  • How country accumulates foreign exchange reserves? A country can accumulate reserves by running current account surpluses that is, keeping its total expenditure below its gross national product, and/or by interventions in the foreign exchange markets.
  • India (usually) runs a current account deficit.
  • Its reserves are then accumulated solely through “sterilised” interventions.
  • When foreign entities want to invest in Indian assets (stocks and debt), the RBI gives them rupees in exchange for foreign exchange.
  • Mindful of the fact that this may cause a surge in inflation, the RBI then sells government bonds, sucking out the additional rupees.
  • The foreign exchange reserves rise, and are matched by an increase in government bonds outstanding.

How outflow of foreign financial capital affects foreign exchange reserves?

  • When capital inflows were taking place, the RBI accumulated foreign exchange and allowed some currency appreciation.
  • As long as capital flows were strong, foreign reserves kept piling up and the currency (in real terms) was strong.
  • Depreciation of rupee: In recent months, we have witnessed an outflow of foreign financial capital, with reserves falling and the rupee depreciating.
  • International capital flows tend to be pro-cyclical, that is, they move with the world economic activity.
  • Unlikely to increase export: A depreciation of our currency is unlikely to see our exports rise very much because the world income levels are down.
  • Inflation: What this depreciation will cause is imported inflation and bankruptcies.

Analysing the RBI’s role

  • Allowed outward remittances: The RBI threw caution to the winds and allowed outward remittances in foreign currency by Indian residents, with almost no questions asked (up to $2,50,000 annually). 
  • The RBI could have had a much larger supply of foreign exchange had they not generously handed out foreign currency to be frittered away.
  • While they have not restricted outward remittances, they are trying to shore up reserves by making FCNR (B) and FRE deposits more attractive.
  • It is not in any individual’s interest to bail out the RBI.
  • The RBI has also committed to using reserves to ensure an orderly depreciation.
  • Futility of RBI’s intervention: If the world financial markets want a depreciated rupee, the RBI’s intervention would not be able to prevent it.
  • But in spite of this, the RBI, with its commitment to inflation targeting, would try to prevent a depreciation (because it causes the price of imported goods to rise).
  • Possible impact on the poor: Having too open a capital account policy was always fraught with risks.
  • When countries are confronted with a crisis, the IMF is asked to provide assistance.
  • But assistance from IMF would involve a “structural adjustment”, including cutting back on subsidies for the poor and vulnerable.

Conclusion

We are standing at the edge of a precipice, but, hopefully, the world will pull back in the nick of time. If not, it would be the chronicle of a death foretold.

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Back2Basics: FCNR(B) Account

  • An FCNR ( Foreign Currency Non-resident) account is a type of term deposit that NRIs can hold in India in a foreign currency.
  • FCNR (A) was introduced in 1975 to encourage NRI deposits.
  • The Reserve Bank of India (RBI) guaranteed the exchange rate prevalent at the time of a deposit to eliminate risk to depositors.
  • In 1993, the apex bank introduced FCNR (B), without exchange rate guarantee, to replace FCNR (A).
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