Relevance: GS-3: Indian Economy, mobilization of resources, changes in industrial policy and their effects on industrial growth.

Key Phrases: Foreign exchange reserves, Foreign Currency Assets, Gold, Special Drawing Rights, International Monetary Fund, Demand, Supply, U.S. Federal Reserve, Higher inflation, Fixed Rate, Floating Exchange Rate, and Maintain Liquidity.

Context:

• The Indian rupee hit an all-time low against the U.S. dollar during week ending 15 th May, weakening past the 77 rupees to a dollar mark and selling at 77.63 against the dollar on 12th May. Many analysts expect the rupee to weaken further in the coming months to hit the 80 rupees to a dollar mark. In fact, the International Monetary Fund expects the rupee to weaken past the 94 rupees to a dollar mark by FY29.

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 a 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’s causing the rupee to lose value against the dollar?

• Since March this year, the U.S. Federal Reserve has been raising its benchmark interest rate causing investors seeking higher returns to pull capital away from emerging markets such as India and back into the United States. This, in turn, has put pressure on emerging market currencies which have depreciated significantly against the U.S. dollar so far this year.
• Moreover, India’s current account deficit, which measures among other things the gap between the value of imports and exports of goods and services, is expected to hit a 10-year high of 3.3% of gross domestic product in the current financial year. This means that India’s import demand amid rising global oil prices is likely to negatively affect the rupee unless foreign investors pour sufficient capital into the country to fund the deficit. But foreign investors are unlikely to plough capital into India when investment yields are rising in the U.S. Yields on U.S. 10-year Treasuries, for instance, have risen from around 0.5% in mid-2020 to over 3% earlier this month.
• The rupee has consistently lost value against the U.S. dollar for several decades now. A major reason for this has been the consistently higher domestic price inflation in India. Higher inflation in India suggests that the RBI has been creating rupees at a faster rate than the U.S. Federal Reserve has been creating dollars. So, while capital and trade flows gain a lot of attention in discussions on the rupee’s value, the difference in the rates at which the U.S. Federal Reserve and the RBI regulate the supply of their currencies may play a much larger role in determining the value of the rupee over the long run.

Why forex reserve is important for a country?

• First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. A good example is China, which pegs the value of its currency, the yuan, to the dollar. When China stockpiles dollars, it raises the dollar value compared to that of the yuan. That makes Chinese exports cheaper than American-made goods, increasing sales.
• Second, those with a floating exchange rate system use reserves to keep the value of their currency lower than the dollar. They do this for the same reasons as those with fixed-rate systems.
• A third and critical function is to maintain liquidity in case of an economic crisis. For example, a flood or volcano might temporarily suspend local exporters' ability to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the central bank can exchange its foreign currency for its local currency, allowing them to pay for and receive the imports.
• A fourth reason is to provide confidence. The central bank assures foreign investors that it's ready to take action to protect their investments. It will also prevent a sudden flight to safety and loss of capital for the country. In that way, a strong position in foreign currency reserves can prevent economic crises caused when an event triggers a flight to safety.
• Fifth, reserves are always needed to make sure a country will meet its external obligations. These include international payment obligations, including sovereign and commercial debts. They also include financing of imports and the ability to absorb any unexpected capital movements.
• Sixth, some countries use their reserves to fund sectors, such as infrastructure.

Way Forward:

• The forex reserves will be an essential policy tool for achieving external stability in such an eventuality. Over the years, India has incurred significant opportunity costs by holding its forex reserves in relatively low-yield, liquid assets.
• Analysts believe that, over the long run, the rupee is likely to continue to depreciate against the dollar given the significant differences in long-run inflation between India and the U.S. At the moment, as the U.S. Federal Reserve raises rates to tackle historically high inflation in the country, other countries and emerging markets, in particular, will be forced to raise their own interest rates to avoid disruptive capital outflows and to protect their currencies.
• As interest rates rise across the globe, the threat of a global recession also rises as economies readjust to tighter monetary conditions.

Source: The Hindu

Mains Question:

Q. Why are forex reserves important for a country? Why is there a fall in India’s foreign exchange reserves? Critically Examine.