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RBI and Forex reserve

Relevance for UPSC

GS 3: Mobilization of Resources, Growth & Development


Why in news?


  • India’s forex reserves dropped by $4.854 billion to $532.664 billion as of September 30, according to the Reserve Bank of India (RBI).
  • There is a widespread misconception that the Reserve Bank of India (RBI) has been depleting India’s foreign exchange (forex) reserves to defend the rupee.


What is happening?


  • The Indian rupee has been witnessing a steady decline this year, losing almost 4% against the U.S. dollar since the beginning of 2022.
  • India’s forex reserves have also dropped below $600 billion, plunging by about $45 billion since September 3, 2021, when forex reserves stood at an all-time high of $642 billion.


What are foreign exchange reserves (FOREX)?


  • Forex reserves are assets maintained by monetary authorities to check the balance of payments, deal with the foreign exchange rate of currency and to maintain financial market stability.
  • The RBI Act, 1934 and the Foreign Exchange Management Act, 1999 govern the foreign exchange reserves.
  • India’s forex reserves can be broken into four categories.
    • Foreign currency assets
    • Gold
    • Special drawing rights
    • Reserve Tranche Position
  •  The main purposes of maintaining forex reserves are
    • To ensure that the RBI has backup funds if the rupee rapidly devalues or becomes altogether insolvent
    • To check the rupee depreciation by selling the dollar in the Indian money market
    • To support our imports since all international transactions are settled in US dollars
    • To limit any vulnerability because of a sudden disruption in foreign capital flows, which could happen during a crisis
    • To establish a good image for the country at the international level thus helping in attracting foreign trade.


What determines the rupee’s value?


  • The value of any currency is determined by demand for the currency as well as its supply.
  • When the supply of a currency increases, its value drops.
  • On the other hand, when the demand for a currency increases, its value rises.
  • In the wider economy, central banks determine the supply of currencies, while the demand for currencies depends on the amount of goods and services produced in the economy.
  • In the forex market, the supply of rupees is determined by the demand for imports and various foreign assets.
  • So, if there is high demand to import oil, it can lead to an increase in the supply of rupees in the forex market and cause the rupee’s value to drop.
  • The demand for rupees in the forex market, on the other hand, depends on foreign demand for Indian exports and other domestic assets.
  • So, for instance, when there is great enthusiasm among foreign investors to invest in India, it can lead to an increase in the supply of dollars in the forex market which in turn causes the rupee’s value to rise against the dollar.


What is the status of forex reserves in India?


Most foreign exchange reserves are held in U.S. dollars, with China being the largest foreign currency reserve holder in the world.

  • Current status of reserves

    • India’s foreign exchange reserves stood at $532.66 billion in September 30, the lowest level since July 2020.
    • This has come at a time when the Indian rupee breached the key 82 per dollar level.
    • The Indian currency has weakened nearly 10% so far this year, with the central bank defending the rupee via dollar sales that have depleted its forex reserves.
  • Why such a decline in reserves?

    • The RBI has attributed the fall in the forex reserves to a fall in the foreign currency assets (FCA), which is a major component of the overall reserves.
    • RBI has said that about 67% of the decline in reserves during FY2022 is due to valuation changes arising from an appreciating US dollar and higher US bond yields.


What is the role of RBI in forex reserves?


  • One part of the Reserve Bank of India’s (RBI) mandate is to intervene in the foreign exchange market, which it does through sales or purchases of dollars in order to curb excessive volatility in the rupee.
  • It dominates the market as a regulator, a player and a jury.
  • The RBI Act stipulates that the Central Government orders the rate at which the RBI shall buy or sell forex to banks. This rate in turn, will be governed by India’s obligations to the International Monetary Fund (IMF).
  • So, the forex market is regulated by the RBI with impregnable exchange control regulations.


Where does the real problem lie?


Valuation Change

Two-thirds of the decline in foreign exchange reserves are largely due to the valuation changes arising from an appreciating US dollar.

Import/export policy

  • If the RBI sells 1 billion dollars in the market and a bank buys these dollars to remit them abroad for an importer customer.
  • Then the funds would have gone abroad anyway since the importer, holding an import licence, can remit funds abroad as a matter of right.
  • So, 1 billion of forex reserves depletion is caused not because of the RBI’s intervention but because of the import licence granted by the Ministry of Commerce.

Twin deficits

  • India’s twin deficits, trade and current accounts, are matters of concern.
  • There is a need to entangle the trade control regulations (flow of goods/services) and exchange control regulations (flow of funds in exactly an equal and opposite direction).

Foreign Currency Assets (FCAs)

  • The drop in the reserves for the week that ended on September 30 was on account of a dip in the Foreign Currency Assets (FCAs), a major component of the overall reserves.


Way forward: Is the Indian Economy moving positively?


  • There has been an accretion of USD 4.6 billion to the forex reserves in Q1:2022-23 on a balance of payments (BoP) basis.
  • Other external indicators like net international investment position and short-term debt also indicate lower vulnerability.
  • In fact, India’s external debt to GDP ratio is the lowest among major emerging market economies (EMEs).
  • In this tumultuous global environment, India’s external financing position remains comfortable despite the widening of the current account deficit (CAD) to 2.8 per cent and the trade deficit to 8.1 per cent in Q1:2022-23.
  • Similarly, the banking sector has posted six-year lows on non-performing assets (NPAs) and slippage ratios, while capital to risk-weighted assets ratio (CRAR) and provision coverage ratio (PCR) have moved up.
  • India also sees strong credit growth at 15 per cent in September 2022. The total resource flow to the corporate sector so far is five times that of last year’s mobilisation, mainly by way of bank credit, CPs and FDI.

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