From UPSC perspective, the following things are important :
Prelims level : Foreign exchange reserves
Mains level : Paper 3- Depreciation of rupee
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.
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.
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).