fbpx

RSTV- The Big Picture : Can India Leverage its Forex Wealth?

  • IASbaba
  • October 22, 2017
  • 0
The Big Picture- RSTV
Print Friendly, PDF & Email

Can India Leverage its Forex Wealth?

Archives

TOPIC: General Studies 3

  • Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

India’s forex reserve crossed the 400 billion dollars mark strengthening the hopes that India will be able to withstand an expected reduction in stimulus by the US central bank later in the year. This is a long way since reserves bottomed out at USD 275 billion in August 2013, at the worst point of the Fed taper tantrum. The reserves stock has increased on the back of strong foreign portfolio inflows, net investment flows and a narrower current account deficit.

The forex surged by 6.2 billion dollars which is likely to help the rupee volatility that may be seen on exodus of foreign funds on India’s debt and equity markets. Foreign investors have pumped in more than 1 lakh crore rupees in Indian debt and equity market in last one year.

This in one sense is the validity and success of the economic reform process that began in the wake of the BoP crisis in 1990-91 when the reserves had fallen to less than $1 billion.

It also portrays the good quality of overall macroeconomic management, especially of the external sector, in the post-reform years.

Why higher reserve needed?

India is a supply constrained economy. There is always current account deficit. Now it is 2.5% of GDP in first quarter of 2017-18. Lot of forex reserve is required to meet India’s demand. The export-import ratio has stagnated. The global market is still volatile. India will not be able to increase export trajectory as demand may remain subdued. Geopolitical conditions are constantly being strained and there are risk to global growth. That’s why reserve at this juncture is needed.

What high reserves mean?

It is an insurance against any kind of external shock which can impact the rupee as India runs a current account deficit.

It exports far less than it imports. Moreover, the current account deficits are financed by capital flows which are most difficult in nature. It is described as hot money and can reverse any time. There is a loss of confidence or increase in risk aversion in the west.

It took a decade to move from 300 million dollar reserve to 400 million dollars. The increase in reserve is due to increase in portfolio investments, equity and investments in debt market.

There is now higher degree of import coverage of 13 months of imports. This gives confidence in the Indian currency. This is attracting it as a good investment source and there is increase in FDI. All these advantages can be wiped away if there is a foreign currency crisis. There is no proof to the contrary that a huge amount of reserve can withstand against a major currency crisis.

This is unlike china which has 3 trillion dollars reserve which it has earned the surpluses coming from higher exports and lower imports, India is borrowing and accumulating it from portfolio capital inflows and therefore there is a cost it incurs. These reserves are accumulated from the surpluses of the capital account. So there is a cost incurred by holding these reserve.

Volatility in rupee

Rupee prices keep fluctuating all the time. Sometimes we need more rupees to buy one unit of foreign currency and sometimes we need fewer rupees to buy one unit of foreign currency.  This change in rupee price is known as rupee appreciation or depreciation

Appreciating rupee– when value of rupee increases (becomes expensive) and fewer rupees can buy one unit of foreign currency. Also called as strengthening of rupee as now INR is worth more than foreign currency. (Import is favourable)

Depreciating rupee– when rupee value decreases (becomes less expensive) and more rupees can buy one unit of foreign currency. Also called as weakening of rupee as now INR worth is less than foreign currency. (Export is favourable)

Appreciating rupee brings other kind of problems- the exports aren’t increasing at all. Instead of leveraging the reserves that are rising, there should be composition of the reserves. Much of the money has come through the debt route with 2017 having inflow of 1 lakh crore compared to Rs. 45000 crore in 2016. However, rupee appreciation and depreciation is not entirely related to export growth. When rupee was appreciating in 2004-05 and 2006-07, the export growth was more than 25%. These are the global demand conditions on which export of the country is based on.

There is need to take a hard look at exchange rate policy not from export perspective but a rapidly appreciating rupee always endangers and carries the seed of macro-economic instability. It happens because the more rupee appreciates, the imports become cheaper. Over time, the trade deficit on structural basis, the difference between merchandise exports and imports have continuously expanded for more than a decade. The more the imports takes place, the wider is the CAD. The moment portfolio capital investment comes to a sudden stop, there will be a reversal. Here forex will help to check the path of depreciation. But eventually is unsustainable as seen in 2011, 2012 and 2013.

If there is an exchange rate policy where the rupee is getting stronger, the tradeable import sector is easy to import. So the tradeable import sector is facing competition from manufacturing side and foreign exchange management side. If the exchange rate policy is relaxed and RBI can moderate it, things would be better and there would be better quality of forex reserve.

China and India

They are significant differences between China and India. When China started liberalising, they followed export led growth model of industrialisation in late 1970s.

The key difference is china managed to relax the FDI rules and managed to attract FDI into the exporting sectors and therefore was able to generate substantial surpluses. Through same mechanism, it was able to lift out its surplus labour from agriculture into industry and thereby achieve reduction in poverty. India has been much slower in opening up and liberalising FDI flows. Moreover, even after liberalisation, there is less FDI in exporting sectors.

India also embarked upon opening its capital account side in parallel to trade liberalisation whereas china never gave up much control on capital account but it now it has begun to relax the capital account a bit.

Conclusion

Forex reserves are likely to increase further in the coming years, although the accumulation being driven by current account surplus may not happen soon. Nonetheless, the focus henceforth will possibly be on the quality of portfolio management of reserves, especially on the risk-return profile and performance of foreign currency assets (FCA).

Demonetisation has had effect on the liquidity. There has been monthly 30% rise of non-oil non-gold import from February. Hence RBI has a major currency management challenge.

Also, there is a need for domestic demand to build up to encourage investments. The stagnation in IT services, its export is not a favourable circumstance for India. And thus, domestic demand is one way forward to sustain the macro economic conditions.

Connecting the dots:

  • India’s high forex reserve is due to India’s economic policy post BoP crisis. Do you agree with the statement? Discus.
  • Critically analyse how current account deficit affects India’s economic growth.

 

For a dedicated peer group, Motivation & Quick updates, Join our official telegram channel – https://t.me/IASbabaOfficialAccount

Search now.....