India’s Forex Reserves and United States’ Concerns

In recent months, India’s total Forex reserves are hovering around USD 400 Billion and India is at sixth position in terms of Forex reserves. In the second week of October, the US treasury said that it would closely monitor the RBI’s policies as there is an increased scale and persistence of dollar purchases. Some fundamental questions are addressed in this article.

What are Foreign Exchange Reserves?

Foreign exchange reserves or Forex Reserves are reserve assets in the in the balance of payments, held by a country in foreign currencies. They are part of the capital account.  Every country in the world tries to hold significant foreign exchange reserves and in most developing, they are in US dollars, which is most global traded currency. Other currencies in which the Forex are held include British pound sterling, Euro; Chinese Yuan and Japanese Yen.

What is composition and status of India’s Forex Reserves?

India is now at sixth position in Forex reserves ranking behind China (3,053 billion reserves), Japan ($1,188 billion), Switzerland ($743 billion), Saudi Arabia ($489 billion) and Taiwan ($441 billion). The Foreign exchange reserves of India consists of below four categories

1. Foreign Currency Assets
2. Gold
3. Special Drawing Rights (SDRs)
4. Reserve Tranche Position in the IMF

Generally, Forex reserves are managed by the Central Bank of the country, so in India they are maintained by RBI.  The legal provisions for governing the foreign exchange reserves are guided by Reserve Bank of India Act and the Foreign Exchange Management Act, 1999.

Currently, India is also top holder of foreign exchange reserves among countries with current account deficit.

What are Fixed Exchange Rate System and Floating Exchange Rate System?

In fixed exchange rate system government decides the conversion rate. When market forces determine the rate then it is called floating exchange rate.

Fixed Exchange Rate System

• It is also known as Pegged exchange rate. Before 1970s most of the countries follow this type of system.
• In this system currency value is officially fixed by the government or monetary authority and not determined by market forces. Only a very small deviation from this fixed value is possible.
• Here a currency’s value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

Gold Standard System, where each country committed itself to convert freely its currency into gold at a fixed price, was an example of fixed exchange rate system.

Floating Exchange Rate System

In this system, the rate of exchange is determined by forces of demand and supply of foreign exchange market. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange. In this system central bank do not intervene in the foreign exchange market. It is also known as flexible exchange rate system.  Currently, most of the countries, including India are following floating exchange rate system.

What is Importance of Foreign Exchange Reserves?

Foreign exchange reserves facilitate external trade and payment and allow orderly development and maintenance of foreign exchange market in India. Foreign exchange reserves of India act as a cushion against rupee volatility once global interest rates start rising. Foreign exchange reserves act as the first line of defense for India in case of economic slowdown, but acquisition of reserves has its own costs. Holding the currencies of other countries as assets allows the government or the regulator to keep their currencies stable and reduce the economic risks of a falling currency.

Foreign currency Assets forms the major component of all reserves. Foreign currency assets include US dollar, euro, pound sterling, and Japanese yen etc. The level of Forex reserve is expressed in US dollars. Hence India’s Forex reserve declines when US dollar appreciates against major international currencies and vice versa.

US is concerned over RBI’s aggressive dollar buying. Why it hurts them? Can this hurt India also?

In 2013, India’s rupee, while continuously depreciating against US dollar, had reached to its lowest level. Since then, the RBI’s foreign-currency purchases have been aggressive and this has led the country to mop up total reserves to be USD 400 billion. While sharp fall in rupee was curbed, in recent months, it is the sharp gain in rupee that is hurting not only India but also US. It is hurting India because an overvalued INR would keep exports expensive and hurt competitiveness of the exports. The increasing forex reserves of India give an impression to US that either its dollar is depreciating or India / RBI is aggressively manipulating the currency markets. United States has only expressed concerns and has not so far placed India in its watch list for potential currency manipulators. The US treasury has kept upper limit of US dollar buying at 2% of its GDP; and India is right now at 1.8% and RBI is still seen aggressively buying USD.

What may follow if India crosses 2% red line?

India may be placed in US treasury’s watch list and it can trigger sanctions if the country is satisfying three conditions to be called a currency manipulator:

• It is persistently intervening in currency markets
• It is running a significant trade surplus with the US
• It is running a large current account surplus overall.

We note here that right now there are five countries in this watch list viz. China, Japan, South Korea, Germany and Switzerland but none of them fulfils all of these conditions to be called a currency manipulator. At present, India is running a USD 25 billion trade surplus with United States. Further, India has a current account deficit and not surplus and this means that it does not seem that India will have to face major issues.

Topics for Exam

Prelims

Composition of India’s Forex; Fixed and Floating Regimes; Impacts of rising / falling rupee on India’s exports and imports.

Mains

Explain the role of RBI in management of foreign exchange and Forex reserves. How this particular function may affect India’s bilateral relations with other countries? (GS-III)