Forex reserves & rupee’s exchange rate

The Reserve Bank of India recently announced a host of measures to boost forex inflows and push the value of rupee.

• The steps include doubling the borrowing limits for companies from overseas to $1.5 billion, temporarily removing interest-rate cap for banks to attract deposits from NRIs and relaxing rules for foreigners to invest in local-currency bonds.

Forex reserves:

• Forex reserves are regarded as the health meter of a country.
• These reserves are assets like foreign currencies, gold reserves, and treasury bills, among other things, maintained by a country’s central bank or other monetary authority, which checks the balance of payments, deals with the foreign exchange rate of currency and maintains financial market stability.
• RBI Act and the Foreign Exchange Management Act, 1999 govern the foreign exchange reserves.
• It can be broken into four categories.
  • The first and largest component is foreign currency assets — it constitutes about 80% of the total portfolio.
  • India invests heavily in US treasury bills and about 75% of the country’s foreign currency assets are invested in dollar denominated securities.
  • Then comes the investment in gold, and special drawing rights from the IMF.
  • And the last is the Reserve Tranche Position.

The purpose of the foreign exchange reserves:

• To ensure that the RBI has backup funds, if the rupee rapidly devalues or becomes altogether insolvent.
• If the value of the rupee decreases due to an increase in demand for foreign currency, then the RBI can and does sell the dollar in the Indian money market so that rupee depreciation can be checked.
• A good stock of forex establishes a good image for the country at the international level as trading countries can be sure about their payments, thus helping in attracting foreign trade.

Exchange Rate:

• The price of one currency in terms of the other is known as the exchange rate.
• A currency’s exchange rate vis-a-vis another currency reflects the relative demand among the holders of the two currencies.
• The exchange rate tells us how much of a currency (e.g. Rupee) is required to purchase one unit of another currency (e.g. Dollar).
  • For example, if the rupee’s exchange rate “falls”, it implies that buying American goods would become costlier.

How an exchange rate is determined?

• In a free market, the exchange rate is determined by the supply and demand for currencies, i.e. rupees and dollars.
  • For example, in case Indians demand more dollars in comparison to the demand of rupees in America, the value of rupees will depreciate.
• Other than the market forces, central banks (RBI, in the case of India) also play a role in determining the exchange rate.