RBI and the rupee: To break a free fall or not to

Source: This post is based on the article “RBI and the rupee: To break a free fall or not to” published in the Indian Express on 30th July 2022.

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

Relevance: Macroeconomic conditions; Rupee Depreciation  

News: The Indian rupee has depreciated by around 7% against the U.S. dollar, since the start of the year.

What is the significance of forex reserves?

A developing economy needs foreign exchange to finance its international transactions for both the current account (goods and services) and capital account (assets) transactions.

Foreign exchange reserves also signal its ability to meet potential obligations. The larger the stock, the more its reassuring value. But due to the reserves “liquid” nature, the returns on these are low.

How did India so far build its forex reserves and what is happening now?

A country can accumulate reserves by running current account surpluses, and/or by interventions in the foreign exchange markets. India usually runs a current account deficit — in this century, it ran a surplus only in 2020-21. Its reserves are then accumulated solely through “sterilised” interventions.

When foreign entities want to invest in Indian assets, the RBI gives them rupees in exchange for foreign exchange. To prevent inflation, the RBI then sells government bonds to suck out the additional rupees.

Thus, the Forex reserves rise, along with the increase in government bonds outstanding. The accumulation of foreign reserves limits the appreciation of the currency.

Present condition: In recent months, India has witnessed a reversal of this process — there is an outflow of foreign financial capital, with reserves falling and the rupee depreciating.

What are the impacts of RBI’s decision to pile up forex reserves?

When capital inflows were taking place, the RBI accumulated foreign exchange and allowed some currency appreciation. This caused the following, a) Reduced exports, b) import-competing sectors gave way to cheap imports, especially from China, c) those engaged in “carry trades” continued without bothering about the exchange risk, d) India’s external commercial borrowings have also increased, e) The rich bought properties abroad and sent their children to study in foreign universities.

What does the RBI need to do while the rupee is depreciating?

The RBI has committed to using reserves to ensure an orderly depreciation. If the world financial markets want a depreciated rupee, then the RBI should not throw forex reserves to prevent it.

But the RBI, with its commitment to inflation targeting, would try to prevent a depreciation (because it causes the price of imported goods to rise).