External stability – new challenges can emerge in currency management

Source-This post on External stability – new challenges can emerge in currency management has been created based on the article “External stability” published in ‘Business Standard” on 14 March 2024.

UPSC Syllabus- GS Paper-3-Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Context- India’s economic management has witnessed stability on the external front.

What is an external sector of the economy?

All economic activities of an economy which take place in foreign currency fall in the external sector such as balance of payment, export, import, foreign investment, external debt, current account, capital account, exchange rates etc.

Read more- RBI and the net-zero transition

What is the RBI’s stated policy to manage external sector?

The stated policy of the RBI is that it does not target any level in the currency market and intervenes only to check excess volatility.

The International Monetary Fund (IMF) in its country report in December 2023 termed India’s exchange rate regime stabilized arrangement instead of floating

What is the importance of a stable external front?

1) A stable external front provides policy space domestically

2) It allows the government to run a large fiscal deficit.

What are the reasons for the stability and strength exhibited on the external front by India?

1) There is an improvement in overall macroeconomic management and the growth outlook.

2) Role of RBI– India received large capital flows during the covid pandemic. Rise of dollar reserve may have appreciated the rupee which would have affected India’s tradable sectors.
However, the RBI intervened in the currency market and accumulated foreign exchange reserves worth about $120 billion in 2020. The reserve accumulation proved useful in stabilizing the currency at the time of global tightening.

What is the significance of intervention and accumulation of reserve by RBI?

1) It protects external stability in times of stress.

2) Sustained interventions and accumulation of reserves can attract higher foreign flows because it reduces the currency risk for both foreign investors and domestic borrowers.

3) It can affect both fiscal and monetary policy operations.

4) There are expectations of rate cuts in the USA. This may result in higher flows to emerging markets like India. Further, Indian government bonds are also being included in global bond indices, which will increase flows. In the backdrop of these events, there is a need for intervening in the market to prevent appreciation of the rupee.

Question for practice

Highlight the role played by RBI to maintain the stability of external sector?