Rupee in the red, case of the forex blues

A country holds foreign exchange reserves for several reasons. These include ensuring self-insurance and holding sufficient liquidity buffers against external shocks and crises.
Rupee in the red, case of the forex blues

The rupee has been in the red for some time now, having depreciated by more than 10.5% since January 2022. This has led to a severe case of forex blues, with doomsday predictions on India’s macroeconomic stability and concerns about India’s return to the 1991 days.

A country holds foreign exchange reserves for several reasons. These include ensuring self-insurance and holding sufficient liquidity buffers against external shocks and crises. Foreign exchange reserves also help preserve the currency’s value when market conditions—especially those unrelated to the country’s fundamentals—lead to sudden, massive capital outflows and cause the rupee to depreciate.

During the infamous ‘taper tantrum’ episode, India witnessed a sudden and deep depreciation of the rupee in 2013. The accumulation of foreign exchange reserves by the Reserve Bank of India (RBI) not only preserves the currency’s value but also boosts confidence in the central bank’s ability and commitment to the timely discharge of external obligations. The country’s ability to cover its import requirements is prime among such obligations.

We looked at India’s historical experience with its foreign exchange reserves to address concerns about reserve availability as a cover for India’s imports. The “reserve cover of imports”—a crucial external liquidity indicator—refers to the number of months a country’s reserves can finance its imports if all external inflows cease. This also reveals the country’s vulnerability to our external sector. The conventional rule, based on the recommendation of the High Level Committee on Balance of Payments (Chairman: Dr C Rangarajan) in 1993, is for the country to maintain a reserve cover to allow at least three months’ worth of imports.

We used RBI data for our analysis of India’s crisis periods.

In the worst-case scenario, in 1990, India had forex reserves worth only $3,962 million, sufficient to cover only about two months’ worth of our imports ($21,219.2 million) at the time. The rupee, pegged to a basket of currencies from 1975 to the early 1990s, was moved away from such pegged exchange rates, and India adopted a managed float exchange rate system. At the same time, to counter the massive drawdown in the foreign exchange reserves, to instill confidence in the investors and to improve domestic competitiveness, India initiated a two-step downward exchange rate adjustment by 9%
and 11% between July 1 and 3, 1991 as part of its economic reforms. As a result, the rupee fell from Rs 17.5 in 1990 to Rs 26 to a dollar in 1992.

A second critical moment in India’s external sector vulnerability came during the Global Financial Crisis in 2008–09, when India’s forex reserves fell by 18%—from $311,885 million in April 2008 to $255,160 million in April 2009. The rupee also fell by 11%—from Rs 43.5 in 2008 to Rs 48.4 in 2009. Such a devaluation of the rupee allowed the forex reserve depletion to be within limits, with the reserve cover for imports being 10.2 months.

During the taper tantrum of 2013, a third critical moment witnessed forex reserves dipping by a mere 4.3% during the crucial months of May to August 2013, from $287,897 million to $275,492 million.
In fact, over the calendar year 2013, there was a next to negligible change in forex reserves, with the forex reserves amounting to $295,508 million in January 2013 and $293,877 million in December 2013.

The RBI had allowed the rupee to fall, thereby bringing about equilibrium in the Balance of Payments. The rupee fell by 13.8%—from Rs 54.85 on January 4, 2013, to Rs 62.41 in January 2014. In the current scenario, amidst the Russia-Ukraine crisis and the Fed tightening episode, the rupee has fallen by about 10.5% till date. India’s forex reserves, on the other hand, too have fallen by about 10% from $606,475 million on April 1, 2022, to $545,652 million on September 16, 2022.

We used the import data for April-June 2022 (imports of $191,524 million) to project the imports for all four quarters of 2022–23 (at $766,096 million). India’s forex reserves in September 2022 would still cover about 9.2 months of such projected imports, much higher than the ideal reserve cover for imports of 3 months.

There are myths surrounding the ‘preciousness’ of foreign exchange reserves and the equation of the rupee-dollar exchange rate to national pride. It is important to bust such myths. India’s foreign
exchange reserves comprise mainly foreign currency assets—major currencies such as the US dollar, Euro, Pound sterling, Japanese yen, etc., valued in terms of US dollars.

Forex reserves also include gold, Special Drawing Rights, and the reserve tranche position in the International Monetary Fund. Such Foreign Currency Assets (FCA), accounting for 88% of overall forex reserves while providing a cushion for import cover, involve costs since they earn no interest for the RBI. One has to assess the costs of holding such assets against the benefits of maintaining confidence.

Our analysis highlights the challenges of exchange rate management for the RBI. It can either defend the rupee by selling dollars in the market and reducing its forex reserves or maintain its forex reserves and allow the rupee to go through a free fall. A third option, of course, is that it manages both judiciously as it has been doing during this round of the crisis.

However, in the realm of forex management, by no means can one have their cake and eat it too.


Professor, Economics and Executive Director, Centre for Family Business & Entrepreneurship at Bhavan’s SPJIMR

(Views are personal)


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