Foreign Exchange Reserve: India’s Trade, Reserves, and Exchange Rates

Introduction

All economic activities of an economy which take place in foreign currency fall in the external sector such as balance of payment, export, import, foreign investment, external debt, current account, capital account, exchange rates etc.

Foreign Exchange Reserve

• Assets denominated in a foreign currency that are held on reserve by a central bank. 
• Reserve Bank of India Act and the Foreign Exchange Management Act, 1999 set the legal provisions for governing the foreign exchange reserves.
• Composition of Forex [UPSC 2013]: 
  • Foreign Currency Assets, Gold Reserves, Special Drawing Rights (SDR), Reserve Position in IMF (In Descending Order)
• Special Drawing Rights (SDR)
  • An international reserve asset, created by the IMF in 1969; 
  • It is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.
  • Value of the SDR: It is based on a basket of five currencies: Dollar, Euro, Renminbi, Yen and Pound Sterling.
• Reserve Tranche: 
  • A Reserve Tranche is a portion of the required quota of currency each member country must provide to the IMF that can be utilized for its own purposes without a service fee or economic reform conditions.[UPSC 2020]
• India is the 6th largest Foreign Exchange Reserve holder in the world (Economic Survey 2022-23)
• Remittances into India
• • India is the largest recipient of remittances in the world receiving US $ loo bn in 2022 (Economic Survey 2022-23).
  • The United States of America being the biggest source, accounting for over 20% of all Remittances.

Foreign Exchange Reserves and Remittances: Significance, Composition, and Trends

• Definition: The market in which national currencies are traded for one another is known as the foreign exchange market.
• Foreign Exchange Rate
  • Foreign Exchange Rate (Forex Rate) is the price of one currency in terms of another; Enables comparisons of international costs and prices.
• Various Exchange Rate Mechanisms
• Fixed Exchange Rate
  • The complete intervention of the Authority (government or central bank) in the determination of the currency exchange rate.
• Devaluation: 
  • In a fixed exchange rate system, when some government action increases the exchange rate (thereby, making domestic currency cheaper)
• Revaluation: 
  • When the Government decreases the exchange rate (thereby, making domestic currency costlier) in a fixed exchange rate system
• Floating Exchange Rate
  • Market forces (demand and supply) determine the value of currency .
  • No role of authority
• Depreciation of Domestic Currency: An increase in exchange rate implies that the price of foreign currency (dollar) in terms of domestic currency (rupees) has increased. 
• Appreciation of Domestic Currency: In a flexible exchange rate regime, when the price of domestic currency (rupees) in terms of foreign currency (dollars) increases.

• Managed Floating Rate 
• • Exchange rate is largely determined by market forces. 
  • In a crisis, central banks may intervene to stabilize the exchange rate.
  • India has been operating on a managed floating exchange rate regime since march 1993

• Pegged Float Exchange Rate
  • A currency is pegged to international hard currency.
• Nominal Effective Exchange Rate:  
  • It is the exchange rate of one currency against a basket of currencies, weighted according to trade with each country (not adjusted for inflation); 
  • Increase/decrease in NEER indicates the appreciation/depreciation of Rupee against the weighted basket of currencies of its trading partners. [UPSC 2022]
• Real Effective Exchange Rate:   
  • Weighted average of nominal exchange rates, adjusted for inflation;  
  • It is calculated based on NEER; 
  • Captures inflation differentials between country and its major trading partners and reflects the degree of external competitiveness; 
  • An increase in a nation’s REER is an indication that its exports are becoming more expensive. 
  • Higher the inflation higher will be divergence (difference between) NEER and REER.  [UPSC 2022]
• Changes in Exchange Rate
  • Interest Rate Differential: Difference between interest rates between countries; 
    • Impact of Domestic Interest Rate Rise on Currency Appreciation: A rise in domestic interest rates often leads to an appreciation of the domestic currency (lower exchange rate), assuming no restrictions exist on purchasing foreign government bonds.
  • Domestic Income Increase: Increase in consumer spending; Demand for foreign goods would increase thus increasing the demand for foreign exchange (increase in exchange rate) which in turn depreciates the domestic currency.
• Purchasing Power Parity (PPP) 
• • Exchange rates are calculated by comparing the prices of the same basket of goods and services in different countries; 
  • In terms of PPP dollars, India is the third largest economy in the world. 

Net International Investment Position (NIIP)

• Measures the total stock of external financial assets and liabilities. Assets owned by residents in other countries – Assets owned by non-residents within India. 
• Expressed both in absolute value as well as % of GDP.
• Higher the ratio of NIIP to GDP, the more vulnerable an economy becomes to the developments in international markets; 
  • Positive NIIP: Indian residents own more assets abroad as compared to assets owned by non-residents; 
  • Negative NIIP:  Indian residents own less assets abroad as compared to assets owned by non-residents.
• Sovereign Wealth Fund: 
  • It is the fund of foreign currency that is meant to be invested in global assets like, shares, bonds, energy assets etc. 
  • It diversifies the income, and secures external accounts.

Conclusion

• The country has witnessed growth in exports, driven by sectors like IT, pharmaceuticals, and automotive, contributing to foreign exchange earnings and economic stability. 
• However, there are persistent issues such as trade imbalances, fluctuating global demand, and geopolitical tensions affecting exports and imports. 
• Efforts to diversify export markets, improve trade infrastructure, and enhance competitiveness will be crucial for sustaining growth and stability in India’s external sector.