Issues with high FOREX – UPSC GS3

Problems for Indian economy: (Make a diagram)
  • Low output;
  • Increase in Public debt;
  • High Inflation;
  • Low demand; and
  • Increased forex reserves.
  • India’s Forex has crossed $600 billion. Now India has 5th largest foreign exchange reserves in the world. India’s Gold reserves are largest.
Reasons for rise in forex reserve:
  • Decline in import bill: Due to weaker demand and lower crude oil prices.
  • Strong capital flows: 
    • Resulted in the balance of payments surplus;
    • Foreign portfolio investors, bought Indian stocks worth about $7 billion in November.
    • This is also because of maintenance of the near-zero interest rates by the US Federal Reserve.
How useful is this increase in foreign exchange reserves?
  • Cover for imports: If we consider the projected imports for 2021-22, the current level of reserves provides cover for less than 15 months. It is lower than for other major reserve holders – Switzerland (39 months); Japan (22 months); Russia (20 months); and China (16 months).
  • External debt: As of December 2020, total external debt of India is $563.5 billion. It was 104% of our foreign currency assets of $541.6 billion on 1 January 2021.
  • Net International Investment (NII): Between December 2019 and 2020, NII position of India has improved. Foreign exchange reserves get counted as assets in counting net international investment position. NII is the difference between a country’s stock of foreign assets vis-a-vis foreigners’ stock of the country’s asset.
Problems associated with the excess flow of foreign currency:
  • Affects the inflation-targeting: Excess rupee liquidity in the market due to the intervention of RBI to absorb excess foreign currency will affect the central bank’s inflation-targeting mandate
  • Increase in bond yield and cost of money: This happens if RBI absorbs excess liquidity from the system caused due to the absorption of excess foreign currency.
  • Rupee appreciation: This will affect India’s external competitiveness and potentially create longer-term imbalances in the economy.
  • Charges of currency manipulation on RBI: If RBI intervenes to prevent rupee appreciation.
Steps taken by RBI: RBI takes regular steps for diversification of forex reserves by:
  • Scaling up operations in forex swap and repo markets
  • Acquisition of gold and
  • Exploring new markets/products
Reasons for Variation in Forex Reserves: Variation in India’s forex reserves is primarily due to:
  • RBI’s intervention in the foreign exchange market to smoothen exchange rate volatility
  • Valuation changes due to the movement of the US dollar against other international currencies in the reserve basket
  • Movement in gold prices
  • Interest earnings from the deployment of foreign currency assets and
  • The inflow of aid receipts.
Factors on which External Sector Stability Depends: The overall stability of the external sector depends on the following components of the balance of payments:
  • Exports and imports of goods and services
  • Remittances (transfers)
  • Income in the current account,
  • The size of net capital flows and
  • External debt.
Way Forward:
  • Coordinated monetary and fiscal efforts: Government and the RBI should work on prudent policy options to deal with the situation.
  • Restrict the flow of external debt capital: The stock of external commercial borrowing is over $200 billion.
Conclusion: India needs to improve its competitiveness to revive growth and exports.
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