Problems for Indian economy: (Make a diagram)
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Low output;
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Increase in Public debt;
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High Inflation;
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Low demand; and
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Increased forex reserves.
Status:
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India’s Forex has crossed $600 billion. Now India has 5th largest foreign exchange reserves in the world. India’s Gold reserves are largest.
Reasons for rise in forex reserve:
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Decline in import bill: Due to weaker demand and lower crude oil prices.
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Strong capital flows:
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Resulted in the balance of payments surplus;
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Foreign portfolio investors, bought Indian stocks worth about $7 billion in November.
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This is also because of maintenance of the near-zero interest rates by the US Federal Reserve.
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How useful is this increase in foreign exchange reserves?
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Cover for imports: If we consider the projected imports for 2021-22, the current level of reserves provides cover for less than 15 months. It is lower than for other major reserve holders – Switzerland (39 months); Japan (22 months); Russia (20 months); and China (16 months).
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External debt: As of December 2020, total external debt of India is $563.5 billion. It was 104% of our foreign currency assets of $541.6 billion on 1 January 2021.
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Net International Investment (NII): Between December 2019 and 2020, NII position of India has improved. Foreign exchange reserves get counted as assets in counting net international investment position. NII is the difference between a country’s stock of foreign assets vis-a-vis foreigners’ stock of the country’s asset.
Problems associated with the excess flow of foreign currency:
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Affects the inflation-targeting: Excess rupee liquidity in the market due to the intervention of RBI to absorb excess foreign currency will affect the central bank’s inflation-targeting mandate
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Increase in bond yield and cost of money: This happens if RBI absorbs excess liquidity from the system caused due to the absorption of excess foreign currency.
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Rupee appreciation: This will affect India’s external competitiveness and potentially create longer-term imbalances in the economy.
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Charges of currency manipulation on RBI: If RBI intervenes to prevent rupee appreciation.
Steps taken by RBI: RBI takes regular steps for diversification of forex reserves by:
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Scaling up operations in forex swap and repo markets
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Acquisition of gold and
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Exploring new markets/products
Reasons for Variation in Forex Reserves: Variation in India’s forex reserves is primarily due to:
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RBI’s intervention in the foreign exchange market to smoothen exchange rate volatility
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Valuation changes due to the movement of the US dollar against other international currencies in the reserve basket
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Movement in gold prices
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Interest earnings from the deployment of foreign currency assets and
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The inflow of aid receipts.
Factors on which External Sector Stability Depends: The overall stability of the external sector depends on the following components of the balance of payments:
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Exports and imports of goods and services
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Remittances (transfers)
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Income in the current account,
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The size of net capital flows and
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External debt.
Way Forward:
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Coordinated monetary and fiscal efforts: Government and the RBI should work on prudent policy options to deal with the situation.
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Restrict the flow of external debt capital: The stock of external commercial borrowing is over $200 billion.
Conclusion: India needs to improve its competitiveness to revive growth and exports.