Need for Appropriate Use of Foreign Exchange Reserves
December 30, 2020
Today, there is an opportunity for the government to revive efforts to ensure the stability of foreign exchange reserves and exchange rates in the country, because even if they start withdrawing, we will have sufficient buffer of FER to support the government endeavor. — Dr. Ashwani Mahajan
Developing countries, which are on the path of development, usually face scarcity of foreign exchange. The demand for foreign exchange is much more, due to the import of capital and intermediate goods required for development and there are limited possibilities for export. They also have to face shortage of foreign currency due to the obligation of payment of principal and interest on the debt accumulated due this reason.
In 1991, India had to deal with similar situation. The situation had reached to such a point that the country did not have Foreign Exchange Reserves (FER) sufficient for even one week’s imports. But we never faced the same situation after that. Recently foreign exchange reserves have reached more than $ 575 billion, breaking all previous records.
It is indeed a great achievement for the country. This in a way provides relief and solace to the policy makers because there is hardly any threat of any default in the payment for our imports or repayment of debt. Significantly, today our foreign exchange reserves have reached the equivalent of 15 months imports.
How Foreign Exchange Reserves Increased?
Although the foreign exchange reserves have been increasing continuously for a long time, there is a special reference to the recent increase in foreign exchange reserves. During the Corona era, when countries around the world are struggling with the problem of declining GDP and decreasing exports, our foreign exchange reserves in India are increasing. Foreign exchange reserves have grown by more than 100 billion in the last eight months. The reason for this is that on the one hand there has been a huge reduction in imports after April and on the other hand, huge amount of foreign investment has been attracted towards India. Between April and November, portfolio investment of about $ 19 billion and FDI of more than $ 23 billion has been received. The import of oil was reduced due to the lockdown. Similarly, the import of electronics and gold has also decreased significantly. Due to the declining oil prices as well as the declining volumes, oil imports between April and September this year have been only $31.9 billion, against $65 billion during the same period last year. Between April and October last year, gold worth $ 17.6 billion was imported, which has been reduced to only $ 9.2 billion during the same period this year. Between April and October last year, imports of electronic goods were $ 34.7 billion, which has come down to only $28.6 billion this year.
It may be noted that the lack of foreign exchange reserves also causes devaluation of the country’s currency. Everyone knows that the exchange rate, that is, the price of foreign currency in terms of domestic currency (rupees), depends on the demand and supply of foreign exchange. Increasing foreign exchange reserves are indicative of excess supply of foreign exchange in the country, vis-a-vis its demand. Naturally, with comfortable position of FER, not only the constant devaluation of our rupee has come to an end, rupee has rather started appreciating. Exchange rate, which reached 77 rupees per dollar in April 2020, is now around 74 rupees per dollar.
Need for Make Appropriate Use of FER
Although foreign exchange reserves give us a sense of comfort, that there will be no further devaluation of our currency; and the country will be at ease in foreign payments. But we have to understand that growing foreign exchange reserves also entail a significant cost. Gold is the only reserve in foreign exchange reserves, whose value keeps increasing in the long run. But there is usually no monetary benefit from increasing reserves of foreign currencies. Most of our foreign exchange reserves are invested in foreign central banks, which usually receive interest at the rate of zero to 0.5 percent only. But the reasons for which foreign exchange reserves are increasing, such as portfolio investment, are those investments that make foreign investors earn 25 to 30 percent or more. Similarly, foreign direct investors also earn huge amounts and repatriate their returns to their respective countries.
Both increase and decrease in foreign exchange reserves mainly depend on foreign investment. It is generally observed that Foreign Direct Investment (FDI), especially in green field projects is more stable than Foreign Portfolio Investment (FPI). This is so because FDI is for the long run. Simultaneously, new technology also comes with this type of foreign investment. It doesn’t only do away with the scarcity of resources; it also increases employment and production. Proponents argue that all measures should be adopted to attract foreign investors.
But it has to be understood that not all foreign investment is the same. Portfolio investments, in particular, are highly uncertain and volatile. This causes uncertainty not only in the stock markets but also in foreign exchange reserves and exchange rates. Due to this, the country’s currency keeps devaluing without any fundamental reason. On the other hand, there is a class in the country, which supports this devaluation. This type of uncertainty and volatility has to be stopped.
How to Stop Volatility?
Today the situation is that portfolio investors invest mostly in the share markets, because their objective is basically to profit from the volatility of the share markets. This is proven fact that this volatility is also created by these portfolio investors only. They first push the share prices up by bringing in huge investment and lure other investors to invest in these shares. Then they suddenly offload these shares at their peak and cause share prices to dip low. The gainers are obviously these FPIs and the losers are domestic investors. In the process when they take their investment to their home countries, it causes deprecation of Indian rupee. This process is continuously repeated.
Since the country was struggling with shortage of foreign exchange, therefore, government did not want to take any risk that would dissuade portfolio investors. Hence the government was not prepared to take any action, which would displease them. But today when our foreign exchange reserves are comfortable due to various reasons and due to the efforts of self-reliance by the country, there is every possibility of reduction in imports and opportunities of foreign investment are also increasing. Therefore, now we can make some such efforts, which can discipline the portfolio investors.
In this regard, a minimum lock in period can be imposed on them. Also, when they withdraw their amount, some tax must be levied on them, what in theory is called ‘Tobin Tax’. Apart from this, many other measures can be imposed on their withdrawal. Last year, the government proposed taxing portfolio investors earning more than Rs 2 crore annually. Portfolio investors pressurized the government by withdrawing their investment. This was a kind of blackmailing. In such a situation, the government rolled back its decision under their pressure.
Today, there is an opportunity for the government to revive efforts to ensure the stability of foreign exchange reserves and exchange rates in the country, because even if they start withdrawing, we will have sufficient buffer of FER to support the government endeavor. This will be the appropriate policy for the long run. And since now we have comfortable FER position, this is an appropriate time as well to put new rules in place, which may include Tobin Tax, minimum lock in period and tax on their earnings. If we fail to discipline these FPIs now, the country will continue to suffer from the volatility caused by them.