An unnecessary debate is on currently over whether the RBI is right in using the forex reserves to defend the rupee. The Indian currency has been under tremendous pressure since last October when foreign investors began pulling out funds due to the US Federal Reserve tapering its stimulus measures. The expansion in trade deficit due to surge in commodity prices has worsened the external account balance further, necessitating regular interventions in the forex market. But the 11 per cent decline in foreign exchange reserves since last October is not a cause for undue concern since the RBI has been quite prescient about accumulating reserves in periods when foreign portfolio inflows flooded the country. The RBI Governor Shaktikanta Das is right in saying, “After all, this is the very purpose for which we had accumulated reserves when the capital inflows were strong. And, may I add, you buy an umbrella to use it when it rains!” 

Among the principal objectives of foreign exchange reserves are to help manage an orderly movement in the currency in periods of extreme duress. With all emerging economy currencies depreciating sharply versus the dollar in recent months, there seems to be no harm in using the forex kitty to shore up the currency. Ratios used to measure adequacy of reserves indicate that there’s no reason for alarm yet. External debt of India is well under control. Of the total debt of $620.7 billion towards the end of March 2022, debt of the government and central bank accounted for only a fifth. The ratio of forex reserves to external debt was 97.8 per cent, showing that there would be no difficulty in servicing this debt. The ratio of short-term debt to total debt was also not too alarming at 19.6 per cent. The ratio of volatile capital flows (including cumulative portfolio inflows and outstanding short-term debt) to reserves has remained in a range around 60 per cent over the last two years. While the import cover has been declining fast due to the large increase in imports as well as the decline in reserves, the depths touched in 2013 have not been reached yet. The central bank however needs to coax more of the corporate borrowers to hedge their external borrowings. The recent Financial Stability Report revealed that 44 per cent of external commercial borrowings are unhedged. These positions can result in large losses when the rupee turns volatile. 

The pressure on the rupee is likely to continue and the Centre and the RBI are working in tandem, through both monetary and fiscal measures, to ease the conditions for the currency. Besides the recent hikes in policy rate, the RBI has also given banks the flexibility to solicit more NRI deposits, relaxed the rules for FPI investments in debt securities and for external commercial borrowings and allowed settlement of external trade in rupees. The Centre, on its part, has hiked import duty on gold in a bid to dis-incentivise imports and reduce the trade gap. Policymakers will have to use all the tools in their arsenal to control the volatility in the rupee. It will be good if the task of the regulator is not made harder through fear-mongering which can create panic in the currency market, exacerbating the volatility.