Forex: Problem of Plenty

  • India’s forex reserve is reaching the $400 billion mark on the back of a stronger rupee against the US dollar.
Key points:
  • In 2013, the Reserve Bank of India (RBI) was struggling to save the rupee from a free fall and was compelled to raise emergency foreign currency deposits from non-resident Indians.
  • Today’s concerns are with respect to appreciating currency and the problems the central bank is facing in managing the strong rupee.
  • Strong foreign inflows contributed to a rise by over $23 billion so far in the current financial year.
  • A recent report by Edelweiss Securities Ltd stated that continuous interference by the RBI brought India close to getting in the currency manoeuvring watch list of the US.
  • The accommodative monetary policy in the developed world and the global financial system is flush with cheap money and investors are in a desperate search for yield.
  • For example, $1 billion worth of bonds issued by the government of Iraq were oversubscribed and sold at a lower than expected yield.
  • Rupee has been appreciated by about 6% since the beginning of this year, despite persistent intervention by the RBI
  • Non-intervention or insufficient intervention would result in further appreciation of the rupee and affect India’s competitiveness.
  • The external competitiveness is not exclusively dependent on the exchange rate. Therefore, there is no harm in suppressing volatility if possible, and giving businesses a more stable economic environment.
  • The present liquidity situation is making things more difficult for the RBI.
  • The banking system has excess liquidity of around Rs3 trillion and currency market intervention will increase this.
  • Even though there is no imminent threat of high inflation, persistent surplus liquidity can affect monetary policy operations.
  • The yields on foreign assets are much lower than government bonds and sterilized intervention is in effect a switch in central bank holdings from rupee to dollar securities.
So how can the central bank deal with this problem of plenty?
  • Work on government instrument like market stabilization scheme bonds and continue to build reserves.
  • But, the cost would keep rising, as higher reserves would attract more flows, which will reduce the currency risk for foreign investors.
  • The other option is to reassesses the kind of foreign funds it wants.
  • India’s external debt is at about 20% of gross domestic product, and about 37% of this is commercial borrowing.
  • Policy rationalization on this front can ease the pressure on both the RBI and the rupee.

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