Analysis of India's Forex Reserves Policy
The unexpected nature of global political and economic developments, as highlighted in Oscar Wilde’s play, is a fitting backdrop for discussing India’s approach to foreign exchange reserves in the wake of Donald Trump's presidency and potential protectionist policies.
Potential Trade War and Economic Impact
- Higher tariffs: Expected to disrupt multilateral trade, affecting not only China but also allies like Canada, Mexico, and BRICS members.
- US Dollar Strengthening: Likely to impact India's trade deficit and inflows, as investors may seek safer havens.
Role of Forex Reserves
- Purpose: Primarily to finance the Current Account Deficit (CAD), which is the excess of imports over exports.
- Additional Benefits:
- Provide insurance against sudden shocks or reversal in inflows.
- Reduce BoP crises likelihood and preserve economic stability.
Challenges with Holding Large Reserves
- Opportunity Cost: Reserves must be invested in low-yield avenues like US Treasury bills, yielding less than Indian securities.
- Limited Assurance: Large reserves do not guarantee resilience, as evidenced by the dollar's weaponization post-Russia-Ukraine war.
Current Reserve Policy Debate
- Import Cover Strategy: Traditional approach focused on maintaining three months of import cover.
- Exchange Rate Volatility: Post-reform, focus shifted to smoothening exchange rate fluctuations.
- Intervention Effects: Despite interventions, the rupee's depreciation suggests a need to reassess reserve use.
Policy Alternatives
- Reserves Composition: Consider holding more gold and less US dollars.
- Rupee Depreciation: Evaluate the benefit of allowing the rupee to reflect its Real Effective Exchange Rate (REER) instead of using reserves to support it.
In conclusion, the notion of being prepared for unexpected global shifts calls for a thorough review of India's forex reserves policy to ensure it aligns with contemporary economic challenges.
