Reserves: The RARE model in India

Relevance: Foreign Exchange reserves in India and issues related to it

Synopsis: India should do away with the prevailing RARE model of reserves in a phased manner.

Context

The foreign exchange reserves in India are close to $620 billion. Recently, a parliamentary panel and the Union Minister Nitin Gadkari observed that the Reserve Bank of India (RBI) is possibly holding excessive reserves.

RARE model

RARE stands for Reserves for Atmanirbharta, Ratings, and Exchange rate stability. However, the first two of the three objectives are not explicit; only the third is.

Reasons behind huge forex reserve by RBI

RBI maintains a huge forex reserve under the RARE model.

1. First, to supplement the policy of Atmanirbharta. There has been an emphasis on atmanirbharta (self-reliance). It is about pushing exports and discouraging imports. This policy is keeping the current account deficit in check.
   • But given the large capital inflows, there is a need for the RBI to absorb the extra dollar inflow and increase its reserves. And, purchases of foreign currencies by the RBI keep the rupee on an average at a low level.
2. Second, to achieve decent international ratings: The fiscal situation in India is quite weak, which is why the international ratings of the Indian sovereign are consistently very low. In fact, if the RBI was not holding a very large amount of reserves, the ratings could have been lower still.
3. Third, to maintain exchange rate stability. If the dollar fluctuates significantly, the RBI can buy or sell dollars to ensure stability. Large reserves can avoid a collapse in the external value of the rupee.

Why India needs to relook RARE model?

• Sustaining the rupee at a low level for long may not end well. In Japan, the policy of low yen was brought to an abrupt end through the Plaza Accord with the US in 1985. Hence, we need to be careful with any important “disequilibrium” price. India is already on the US list of possible currency manipulators.
• India now has flexible exchange rates and inflation targeting. Flexible exchange rates facilitate adjustment, and inflation targeting prevents prices and the exchange rate from going out of control.
• In order to be able to settle our obligations in the future, we should have adequate assets, not huge amount of liquid assets in form of huge forex.

Measures

• There is need to raise the tax-GDP ratio and provide for a tax on sudden and large capital flows that can cause negative externalities.
• India can buy additional credit in normal times. The availability of credit line on reasonable terms has improved over time. So, there is no pressing need for large reserves.

Terms to know

• Plaza accord