The rupee and foreign reserves: The larger story

It is argued that we should let the rupee find its own level - more so, when many other currencies are depreciating against the dollar. The low values of these currencies, however, are not sustainable

The price of a dollar is now around Rs 82. This is in the aftermath of the Fed policy in the US this year to raise the federal funds rate sharply from 0.25 per cent in March to 3.25 per cent in September. Other factors like oil prices have not helped either. The Reserve Bank of India (RBI) did intervene and the foreign exchange reserves fell by $104.93 billion by September 23 this year from an all-time high of $642.45 billion on September 3, 2021. But this depiction hides more than it reveals. We need to consider three aspects.

First, besides the dollar assets, some reserves are held as assets denominated in euro, yen, etc. This policy of diversification is, ex-ante, good. It so happened ex-post that these other currencies have all depreciated substantially and so the RBI incurred a “loss”. However, if much of the depreciation of these other currencies is not permanent, and I will come to why this is plausible, the accounting loss can get reversed eventually. So far, so good.

Second, to the extent that the RBI was holding medium-term or long-term bonds in its portfolio of reserves, it suffered a loss after the Fed raised interest rates. But it is not clear why the RBI was holding or continuing to hold such bonds at a time when it was apparent that the interest rates would rise. The value of its reserves fell due to higher yields. This is a loss for the country.

Third, reserves have got depleted in actually fighting the fall of the rupee. Though this aspect is well known, it is not widely well understood. Only one third of the change in reserves is due to the fight to protect the rupee. Another way to see this is that just 5.4 per cent of the level of reserves at their peak has been used to fight the fall of the rupee. It should have been far more. Why? 

Ignoring the short-term fluctuations, the rupee depreciates almost every year against the dollar. This is primarily because inflation is typically much higher in India than in the US. But currently it is the opposite. The inflation rate in India at present is actually a little less than that in the US. So, ideally the rupee should have appreciated a bit though only temporarily. But this did not happen. On the contrary, the rupee depreciated and it did so substantially. However, this is not an equilibrium. In fact, to the extent that the excess has happened, there can be a tendency for a reversal after causing some damage in the interim. 

 Going forward, the rupee may appreciate slightly. At least, the rupee could for a while depreciate less than it would have otherwise. This is the plausible outcome in the coming months or quarters after the speculative and momentum trades are over. And, this is with a small use of reserves to fight the fall of the rupee. Had the RBI intervened more aggressively, we may have been able to avoid the large depreciation. And, such intervention is consistent with flexible inflation targeting as the policy regime.

It is true that the level of reserves with the RBI would have been reduced by a much larger amount with the suggested policy. But the basic role of foreign exchange reserves — as distinct from the role of a sovereign wealth fund — is that these are supposed to be used when the rupee falls precipitously! In any case, even now the reserves are large enough to cover about 65 months of possible current account deficits; the alternative metric of nine months of imports can be misleading.

It is sometimes argued that we should let the rupee find its own level in the market — more so, when many other currencies are depreciating against the dollar and India needs to protect its share of exports. This argument is indeed valid, if the fall of the other currencies is somewhat permanent. But this is unlikely. In which case we may as well have a relatively stable rupee, all things considered.

The reason why the low values of other currencies are not likely to be permanent lies in the fact that eventually the purchasing power of a currency matters (even as the interest rate changes can rule in the short-term). So, the low values of many currencies, as in the case of the rupee, are not sustainable. A stark example is the yen; it is trading at around 145 to a dollar. 

This column has discussed accounting, portfolio choice, and the actual very limited use of reserves to arrest the fall of the rupee. But there are other policies as well. That is, however, another story.

The writer is visiting faculty, Indian Statistical Institute, Delhi Centre. gurbachan.arti@gmail.com