India’s tenfold path to manage exchange rate volatility

Source: the article “India’s tenfold path to manage exchange rate volatility” published in the Live Mint on 21^st July 2022.

Syllabus: GS 3 Issues and Challenges pertaining to growth and development of the Indian Economy

Relevance: Indian Rupee Depreciation; macroeconomic condition; Monetary policy measures

News: In recent months, India has witnessed the depreciation of the Indian rupee to a record level.

What are the tools in the RBI’s monetary and forex policies to handle the situation?

(A) Instruments of direct nature:

(1) To sell dollars in the spot forex market. The idea of the RBI selling dollars works well in the currency market, which keeps guessing how much the central bank is willing to sell at any point in time.

(2) To promote non-resident Indian (NRI) deposits. For example, the RBI outreached to NRIs to put in their money in the Resurgent India bonds and India Millennium Deposits with attractive interest rates, in 1998 and 2000.

Limitations: The idea entails forex risk when the debt is redeemed. For example, the rates tend to be attractive at the time of deposits, but the same rate cannot be offered on deposit renewals once the crisis ends.

(3) To get oil importing companies to buy dollars directly from a public sector bank. The deals are not in the open. Therefore, the market does not witness a large demand for dollars on this account.

(4) A directive can be issued for all exporters to mandatorily bring in their dollars on receipt within a set time period. This prevents an artificial dollar supply reduction due to exporters holding -back the profit.

(5) Curbing the amount of dollars that one can take under the Liberalized Exchange Rate Management System for current account purposes like travel, education, healthcare, etc.

(6) The RBI can deal in the forward-trade market. It controls volatility because the 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) The RBI can use the concept of swaps. In this, the banks collected foreign currency non-resident deposits with a simultaneous swap with RBI. Hence, it was different from earlier bond and deposit schemes. The same idea has been used though without deposits being raised. It involves a sale-purchase transaction in which dollars are provided to banks with a commitment to buy back after, say, 3 years.

(B) Nowadays, the RBI uses more policy-oriented approaches, and the last three measures announced are in this realm.

(2) The RBI allowed the banks to work in the non-deliverable forwards (NDF) market. This is a largely overseas speculative market. Here, forward transactions take place without real inflows or outflows, with only price differences settled in dollars. Due to this measure, the rates in this market and in domestic markets have gotten equalized.

Second, the RBI has opened up the capital account on NRI, external commercial borrowings, and foreign portfolio investments, which has the potential to draw in forex over time.

Third, the RBI has given permission for foreign trade deals to be settled in rupees. India is a net importer. Therefore, gains can be made if we pay in rupees for imports.