India’s forex reserves exceeded $640 billion in end-October 2021, having risen by more than $72 billion in six months from $588 billion. Since then, forex reserves are continuously declining. The reserves are down to less than $600 billion now.
The Reserve Bank of India’s (RBI) stated policy and strategy is to allow the Rupee to float freely but to maintain orderliness and stability in the forex market.
The RBI has spent more than $45 billion in the last six months to serve its policy objective. Yet, the Rupee’s nominal value has depreciated from Rs 74.9 to a dollar on 31 October 2021 to Rs 77.7 on 19 May 2022.
RBI's Three Policy Objectives
The global economy is in a flux. The US and other major economies are raising policy rates and contracting their balance sheets in view of the unprecedented inflation. Factors like the COVID-19 pandemic and the Russia-Ukraine war, and the ensuing sanctions and trade realignment, are putting pressure on currencies all over the world.
The currency waters are choppy and the undercurrent for Rupee is quite weak. While our forex reserves are still quite healthy, the road ahead for the Rupee looks dicey. The Rupee is under some serious pressure.
The RBI has three policy objectives with internal contradictions.
Indian politicians like a ‘strong Rupee’, which, in practice, implies that the Rupee’s nominal value in terms of US dollars should appreciate or at least remain stable and not depreciate. Collated with political preference, the RBI’s policy objective is thus to keep the nominal value of the Rupee stable, or if the Rupee has to appreciate or depreciate on account of fundamental factors, to ensure that it happens in an orderly and gradual manner.
India came very close to defaulting on its international obligations in 1991 but learnt a very valuable lesson – large forex reserves are the insurance against any speculative raid on the currency. The RBI wants to maintain as large forex reserves as possible.
Movement in forex reserves and Rupee-Dollar exchange rates do impact the domestic money supply, which, in turn, affects domestic prices and interest rates. For some time, the RBI has also been selling and buying dollars to raise profits for surplus distribution to the government.
Inherent contradictions in these three objectives complicate the RBI’s policy and actions operationally at times. It is doing so currently.
India’s Vulnerabilities Have Come to Fore
India has a large international economy. We imported goods worth $612 billion and services worth $145 billion in 2021-22. Our imports are almost entirely denominated and paid for in US dollars, which is the de facto international settlement currency.
India required $750 billion in US dollars to pay for these imports. It exported goods worth $420 billion and services of $250 billion in 2021-22. The export earnings of $670 billion still left a foreign trade deficit of $87 billion.
India runs a trade deficit almost every year. Whether you blame our excessive dependence for energy resources or electronics imports, or our love for gold, our trade account remains structurally in deficit.
India received foreign investment flows of $80 billion in 2020-21, but they plummeted to only $22 billion in 2021-22. Portfolio investments, the most volatile component, were $38 billion in 2020-21 but turned into an outflow of $15 billion in 2021-22. Perceptions about the opportunity to make profits, movement in exchange rates, etc, influence foreign investors.
Loans and NRI deposits also have the same incentives. NRI deposits declined by about $3 billion in 2021-22. Commercial borrowings inflows are also declining – $5 billion in March 2022 as against $9 billion in March 2021.
There is considerable structural volatility in capital flows as well.
The stock of all capital flows is reflected in the overall investment position. In end-December 2021, India had international assets of $926 billion (investments of $293 billion and forex reserves of $633 billion). However, India’s external liabilities were $1284 billion (FDI $514 billion, portfolio investment $277 billion, trade credit $113 billion, commercial loans $204 billion, NRI deposits $144 billion and other assets $32 billion).
India had an international investment deficit of $358 billion at the end of December 2021.
Keeping Rupee Strong Comes With a Cost
India’s $600-billion forex reserves are an assurance that India will take care of the deficit in imports and exports, make sure that repayments of loans and interest are made in time and foreigners can repatriate their investments whenever they like. Forex reserves also keep speculators away.
Forex reserves, however, are maintained at a cost.
India’s outstanding external debt was $630 billion at the end of December 2021. India’s foreign exchange reserves were also of the same order at $634 billion at that time.
Indian borrowers paid on an average 5% interest on their outstanding foreign debt. India deploys its forex reserves in foreign central banks and other institutions, and roughly earned a 1.5% return in 2021.
When India pays 5% and earns 1.5%, it costs India 3.5%. This is the cost of maintaining the forex reserves. For $633 billion, it cost India $22 billion in 2021-22. This cost was higher than the entire expenditure on building national highways.
Taming Inflation and Checking Capital Outflows
India is witnessing a very high order of inflation currently – more than 15% in WPI and about 8% in CPI. FPIs have been net sellers of more than $25 billion in equity and debt in the calendar year 2022 so far.
RBI’s forex policy can contribute to containing inflation and altering the behaviour of foreign investors to encourage them to bring in more capital than take it out.
This will, however, require a change of mindset about a 'strong Rupee'. The RBI does not care about the domestic nominal value of the Rupee. Likewise, we should stop worrying too much about the Rupee’s nominal dollar value.
The RBI does not control global inflation, supply of dollars or its federal fund or other interest rates. The central bank can, however, use its forex reserves to calibrate the demand and supply of US dollars for rupees to manage the current account deficit.
Expectations about the movement of the Rupee’s exchange rate and the relative interest rate differential determine the attitude of foreign investors, Indian diaspora and traders. If the RBI ensures that domestic interest rates, including on government bonds, move to neutralise the increase in US interest rates and enough US dollars are supplied to take care of the trade deficit and other foreign exchange demands, there are good chances that the rush of capital outflow would also subside.
How Wheat Export Ban & Coal Decision Can Complicate Matters
Certain decisions of the government are likely to complicate matters in forex markets. The diktat to compulsorily blend imported coal with domestic coal might lead to a desperate rush to import coal at whatever cost. The decision to ban the export of wheat is likely to hurt exports. Global energy prices are likely to stay high in the foreseeable future.
The RBI has been quite late in recognising the inflation crisis in India. It has started raising interest rates but is well behind the curve. The compulsion to keep domestic interest rates low for financing large government borrowing programmes will come in the way of a reversal of capital outflows.
Choppy waters may continue to rock the Rupee boat for some time. Rs 80 to a dollar by the end of the calendar year does not appear to be a far-fetched possibility.
(The author is Chief Policy Advisor, SUBHANJALI, author of 'The $10 Trillion Dream' and Former Finance Secretary, Government of India. This is an opinion article and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)