Forex: Problem of Plenty

India’s forex reserve is reaching the $400 billion mark on the back of a stronger rupee against the US dollar.

In 2013, the Reserve Bank of India (RBI) was struggling to save the rupee from a free fall and was compelled to raise emergency foreign currency deposits from non-resident Indians.

Today’s concerns are with respect to appreciating currency and the problems the central bank is facing in managing the strong rupee.

Strong foreign inflows contributed to a rise by over $23 billion so far in the current financial year.

A recent report by Edelweiss Securities Ltd stated that continuous interference by the RBI brought India close to getting in the currency manoeuvring watch list of the US.

The accommodative monetary policy in the developed world and the global financial system is flush with cheap money and investors are in a desperate search for yield.

For example, $1 billion worth of bonds issued by the government of Iraq were oversubscribed and sold at a lower than expected yield.

Rupee has been appreciated by about 6% since the beginning of this year, despite persistent intervention by the RBI

Non-intervention or insufficient intervention would result in further appreciation of the rupee and affect India’s competitiveness.

The external competitiveness is not exclusively dependent on the exchange rate. Therefore, there is no harm in suppressing volatility if possible, and giving businesses a more stable economic environment.

The present liquidity situation is making things more difficult for the RBI.

The banking system has excess liquidity of around Rs3 trillion and currency market intervention will increase this.

Even though there is no imminent threat of high inflation, persistent surplus liquidity can affect monetary policy operations.

The yields on foreign assets are much lower than government bonds and sterilized intervention is in effect a switch in central bank holdings from rupee to dollar securities.

Work on government instrument like market stabilization scheme bonds and continue to build reserves.

But, the cost would keep rising, as higher reserves would attract more flows, which will reduce the currency risk for foreign investors.

The other option is to reassesses the kind of foreign funds it wants.

India’s external debt is at about 20% of gross domestic product, and about 37% of this is commercial borrowing.

Policy rationalization on this front can ease the pressure on both the RBI and the rupee.