The overvalued rupee: Managing exchange rate volatility and forex reserves

Source– The post is based on the article “The overvalued rupee: Managing exchange rate volatility and forex reserves” published in the Business Standard on 27th October 2022.

Syllabus: GS3- Indian Economy

Relevance– External economy

News- The article explains the need for higher foreign reserves for India.

What factors explain the need for higher foreign reserves?

To prevent any sharp appreciation/depreciation of the rupee to provide a stable environment for domestic and foreign investment.

India should be prepared for economy-wide shocks such as the Covid-19 epidemic and unusual interest rate and fiscal decisions of central banks and governments of large economies. This in turn means that India should have enough stock of foreign reserves.

The overvaluation of the rupee has been driven by the interests of Indian importers, people who remit forex abroad and Foreign Institutional Investors (FIIs). The INR tends to become overvalued due to higher domestic nominal interest rates. It is the reason enough to let the rupee slide by gradual accumulation of dollars whenever there were opportunities.

Total factor productivity in India had to be much higher than in the US or western Europe if the INR were not to depreciate. The reason is higher nominal interest rates in INR debt instruments compared to the lower interest rates in G7 currencies.

Interest rates by central banks of major economies have been raised.

The US dollar is appreciating against all other major currencies.

Why US dollar has gained importance?

The US government is looking with suspicion at countries which have sustained a current account surplus of 2%. It is against the excessive accumulation of foreign reserves in dollars by central banks. India is also in a list of potential currency manipulators.

Dollar is likely to be the dominant reserve currency for at least another 10 years. It should be given a dominant weighting in estimating the six-currency real effective exchange rate (REER) of the rupee against the dollar, euro, pound sterling, yen, and China’s renminbi.

What should be potential forex in future?

Moody’s rating for India is Baa3, which is just about investment grade. The current account deficit projection for 2022-23 is around 3.5% of GDP.

Indian consumer price inflation was at 7.4% in September 2022.

Brent crude oil price per barrel was at $93 on October 25. It May persist around this level till uncertainties related to the conflict in Ukraine persist.

India’s short-term debt, with residual maturity of less than one year, was $267.7 billion at the end of March 2022.

All things considered, it would be prudent for India to raise its FX reserves to at least $700 billion by December 2024.