Forex Reserve and Rupee Exchange Rate - UPSC Current Affairs

Probable Mains Question

Analyze the role played by the Forex Reserve in a developing country like India. 

Context 

During the last few days, India’s forex reserves as well as the rupee's exchange rate (vis a vis the US dollar), both fell quite sharply.

About Exchange Rate 

• Indian firms and individuals buy and sell goods and services to and from various countries. For doing these transactions, there is a need for exchange of currencies. 
• For trade between India and America, transactions make Indians seek and buy dollars. Similarly, they make Americans seek and buy rupees.
• For example; 
  • Consider that at the beginning of all the trades, for every rupee demanded in the market, there is a demand for a US dollar. The exchange rate between the two currencies would be 1.
  • Over time more dollars are demanded than the rupee because Indians import more from the US than what the Americans import from India. In such a situation, the dollar would appreciate against the rupee. The dollar’s exchange rate with the rupee would change from 1 to 10.
  • If this trend continues, the rupee will keep becoming weaker and weaker and its exchange rate will keep falling (say, to Rs 50 to a dollar).
• When Americans (foreigners in general) demand more rupees than the dollars demanded by Indians, the rupee’s exchange rate will appreciate. When the reverse happens, the rupee’s exchange rate will depreciate.

Also Read: The Need for Space Sustainability 

Impact of Change in Exchange Rate on Traders 

• Indians who import stuff from the US will be at a loss because, with each passing year, the rupee buys less and less of an American product (which is priced in US dollars).
• But those Indians who export stuff (for example; mangoes) to the US would enjoy this “depreciation” in the rupee’s value. Because the rupee’s depreciation makes India’s mangoes cheaper and more affordable to US customers. This often leads to the Americans buying more mangoes from India as against some other competing country.

What is a Forex Reserve?

• Forex reserves are foreign currency assets held by the central banks of countries. 
• Other than foreign currencies, these assets include, foreign marketable securities, monetary gold, special drawing rights (SDRs) and reserve position in the IMF. 

Enhance your UPSC Mains 2022 preparation with a related video lecture on the topic Nominal Exchange Rate by Vivek Singh Sir, our faculty for Economy:

Role of Forex in Such situations 

• If the relative demand of rupee and dollar fluctuates wildly, then the rupee’s exchange rate too will fluctuate wildly. Such sharp and repeated fluctuations will destroy firms and individuals’ plans.
  • For example; An Indian importer placed an order to buy something worth $100 only to realize that by the time of payment, the exchange rate had doubled. At the level of companies, even small variations can sink an enterprise. 
  • Similarly, students preparing to study in the US can have a big impact. A sharp depreciation of the rupee can make their study plans unviable or at least exorbitant.
• Here the RBI and forex reserves play their role;
  • For an emerging economy such as India, which is trying to build its economy by increasingly creating a niche for itself in the global market, the exchange rate mustn’t appreciate to such an extent that it hurts India’s exporters.
  • For example; Suppose in a particular year, foreigners demanded rupees more than Indians demanded dollars. That is, there was a relative excess of dollars in comparison to the rupees in the forex market.
  • In such situations, the RBI buys the excess dollars from the forex market using the rupee. This exchange reduces the presence of dollars and increases the presence of the rupee in the forex market, thus holding back the rupee from becoming stronger (or appreciating) against the dollar. The dollars bought by the RBI become India’s forex reserve.
• RBI controls the appreciation of rupee because a weaker rupee benefits India’s exporters and how a stronger rupee will hurt India’s attempt to become a global exporting hub.

Following table illustrates the forex reserves of various countries;

China’s forex reserves are much more than most of the developed economies. China has been soaking up foreign currencies from the forex market and thus either allowing its currency to stay weak (or become weaker) or to avoid it from becoming too strong. China does so because it wants its exports to be attractive in the global market.

Strategic Importance of Forex Reserve

Forex reserve provides import cover in contingency situations.

• In situations when India is at war and it could not export all that it typically did for 4 months. All the dollars that would have otherwise come into India as repayment for those exports would never come.
• However, necessary imports cannot be stopped such as petroleum, fertilizers, and other essentials etc. To buy these items and to repay loans there is a need for dollars. 
• In such situations, the forex reserve comes to rescue and covers the import cost of the country for a few months. 

Conclusion 

For a developing economy such as India, a gradually weakening rupee is economically beneficial. The point of forex reserves is two-fold: to smoothen fluctuations in the exchange rate and to provide some strategic import cover. Merely accumulating forex reserves is not an end in itself; it is neither the ultimate measure of an economy’s success nor something that comes without a cost.

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