The Reserve Bank of India announced measures to ease forex inflows. This explainer helps us understand the measures and objectives behind them.
What are forex inflows and why are they needed?
One of the major factors of a country’s growth is higher savings. Savings are channelised into investments, which help drive the growth of an economy. If the domestic savings rate is low or the investment rate is higher than the savings rate, foreign exchange savings can be used to bridge the gap. Foreign exchange savings are nothing but net inflows of foreign capital.
The Indian economy was liberalised in 1991 and efforts were made to attract forex inflows. There are various categories of forex such as Foreign Direct Investment (FDI), Foreign Portfolio Investment (FPI), NRI deposits, and External Commercial Borrowings (ECB). The government and the Reserve Bank of India welcome equity flows such as FDI and FPI, but are cautious about debt inflows because heavy overseas borrowings are a strong factor in an external crisis.
What is the need to promote foreign exchange inflows now?
Global central banks, most notably the US Federal Reserve, have started increasing policy rates to temper inflation, which has accelerated sharply across economies. There is also growing uncertainty over the global economy. Higher interest rates and safety factors are leading global funds to pull their investments from developing countries and place them in developed countries, especially the US.
The outflow of funds leads to higher demand for the dollar and thereby, local currency depreciation. While a depreciating currency helps a country’s exports, it makes imports more expensive and feeds inflation. A depreciating currency could also lead to financial instability, as was seen during the South East Asian and Latin American crises. While steady depreciation of a currency can be managed, sudden and quick depreciation creates problems.
To prevent any sudden depreciation, the authorities opt for two policies. First, by selling foreign exchange reserves, and second, by promoting and encouraging foreign inflows.
How is India placed currently?
The RBI said July 6 that conditions are stable on the external account front. The current account deficit is modest and capital flows, barring FPI flows, are stable. India has forex reserves worth $593 billion, which is equivalent to about 10 months of imports. The rupee has depreciated by 4.1 percent against the dollar during the current financial year, as of July 5. The RBI said the level of depreciation is modest relative to the currencies of other developing economies.
Still, there have been concerns over FPI outflows, rupee depreciation and loss of forex reserves. FPI outflows have touched almost $30 billion since January. As a result, the rupee depreciated to Rs 79 against the dollar in July from Rs 74 in January.
To curb exchange rate volatility, the RBI sold dollars and bought rupees. India’s forex reserves declined to $593 billion in July from $635 billion in January.
Now, the RBI has turned to easing capital inflows. The central bank said the measures are intended “to further diversify and expand the sources of forex funding so as to mitigate volatility and dampen global spillovers.”
What measures has the RBI taken?
First, the RBI has made it easier for banks to attract fresh deposits from NRIs and foreigners. The RBI exempted banks from maintaining the Cash Reserve Ratio and Statutory Liquidity Ratio on both foreign currency and rupee deposits. Interest rate norms on such deposits have been relaxed.
Second is FPI investment in government debt and corporate bonds. Foreign investors now have more choices and options for investing in bonds.
Third, the RBI allowed money borrowed from abroad by Authorised Dealer Category I (AD Cat-I) banks to be lent for wider uses in addition to export finance. This measure will enable foreign currency borrowing by a larger set of borrowers who may find it difficult to directly access overseas markets.
Fourth, the limit on eligible companies borrowing from banks under the automatic route has been raised to $1.5 billion from $750 million.
All the measures are timebound – the first three applicable until October 31 and the fourth until December 31.
Will these measures help?
This is not the first time that the RBI has taken measures to attract more capital inflows. The central bank took similar measures during the 2008 global financial crisis and the 2013 taper tantrum crisis. These measures boost short-term confidence.
Capital inflows are more a function of real economy drivers such as productivity and potential growth. This has been seen since the 1991 reforms, where growth drivers of the Indian economy led to a rise in capital inflows. The potential of the Indian economy attracted foreign investments and India started generating surpluses on the forex account, leading to a rise in forex reserves.
The import cover of reserves steadily increased to 17 months in 2020-21 from two months in 1990-91.
For sustained and long-term capital inflows, the government must keep initiating reforms and welcoming long-term foreign investments.
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