Economics

Simply Put: Why India is on US currency monitoring list

Details :

The news:

  • In a recent report to Congress, the US treasury department put India on a watch list of countries with potentially questionable foreign exchange and macroeconomic policies.

 

New summary:

About the report:

  • The US treasury department releases a semi-annual report on ‘Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States Treasury’ and delivered it to Congress.
  • The report highlights the currency practices adopted by major trading partners of the US.
  • It found that six major trading partners warrant placement on the ‘Monitoring List’ for their currency practices. Five of these countries — China, Germany, Japan, Korea and Switzerland — were already on the list, India has been added this year.
  • Once a country is added to the monitoring list, it will remain on it for at least two consecutive reports.

 

Why India has been added to ‘Monitoring List’?

  • There are three pre-conditions:
    1. A trade surplus of over $20 billion with the US.
    2. Persistent foreign exchange purchases of 2% plus of the GDP over 12 months.
    3. A current account surplus of 3% of the GDP.
  • India meets two of three criteria laid out for inclusion in the monitoring list for the first time in this report.
  • India’s trade surplus with the US in 2017—$23 billion—was higher than the $20 billion benchmark used for assessment.
  • And net purchase of foreign currency was 2.2% of GDP, higher than the 2% cut-off. So India excessively purchased dollars in recent time through one-sided intervention in foreign exchange markets.
  • India did not meet the third criteria, which is having a current account surplus of at least 3% of GDP. India’s current account is in deficit.

 

How do central banks intervene and why?

Central banks intervene in the foreign exchange market to:

  • Reduce volatility in the exchange rate– They intervene to ensure that their currencies are neither overvalued nor undervalued.
    • If the currency is overvalued, it can hurt a country’s competitiveness in exports while an undervalued currency will have an impact on inflation.
    • For instance, when the currency is appreciating, a central bank intervenes in the market by buying foreign exchange — say, the USD or Euro or any other currency — which leads to an increase in the supply of the local currency and in turn lowers its value.
    • To combat depreciation of the currency, the central bank sells foreign exchange. It is also done to manage expectations in the forex market.
  • Build foreign exchange reserves or to manage these reserves.
    • India’s central bank — the RBI has intervened in the market to build the country’s reserves especially after 2013 when the rupee came under attack.
    • Through excessively purchasing dollars in recent time, India’s reserves have risen.

 

Intervention by RBI:

  • Prior to 2013, intervention for several years had generally been less frequent, and when it had occurred, it had been broadly symmetric i.e. RBI engaged in both purchases and sales of foreign exchange at various points in the midst of volatile global financial markets.
  • To curb volatility:
    • The RBI has noted that the value of the rupee is broadly market-determined, with intervention used only during “episodes of undue volatility”.
    • In 2017, the rupee gained, mainly due to good foreign direct investment and portfolio investment inflows. This led to intervention by the central bank to sterilize dollar flows.
    • So as per RBI’s stated policy, it intervenes in the forex market in recent times to curb undue volatility.
  • Building Forex reserve another factor:
    • However, India has generally been a net purchaser of foreign exchange since late 2013, when the RBI sought to build a stronger external buffer in the wake of large emerging market outflows globally.
    • Frequent intervention by the central bank in the foreign exchange market means that India has increased its purchases of foreign exchange over the first three quarters of 2017.
    • Accordingly, forex reserves rose and are currently at an all-time high of nearly $425 billion. Of this, foreign currency reserves were $399.776 billion.

 

Why the RBI increasing Forex reserve?

  • Learning from the ‘taper tantrum’ in 2013, where the US first indicated that it would be normalizing monetary policy, it would be only fair for RBI to be mindful of the need to increase forex reserves to guard against sudden outflows.
  • Also RBI wants to ensure sufficient reserve as India’s external debt is rising and to import cover for longer duration.
    • Currently RBI’s forex reserves are inadequate: import cover, at 11 months, is running well below the pre-global financial crisis level of 14 months, share of portfolio investments has jumped to 120% of forex reserves from pre-crisis level of 70%.
    • At the end of 2013, foreign currency reserves were $268 billion, or 2.3 times short-term external debt, 6 months of import cover, and 14% of the GDP.

 

What does the report mean for India?

  • For the country, this could be a reputational risk, especially given the context of US President Donald Trump’s rhetoric of imposing trade barriers.
  • Experts believe the probability of India being tagged as a currency manipulator is low. This is because even China, which is known for its exchange rate management, is still only in the monitoring list despite a massive trade surplus with the US and a large current account surplus.

 

What does this mean for the rupee?

  • While the report has no impact on the rupee, RBI may become cautious about intervening in the market, especially when there is a surge in inflows.
  • Currently, the rupee is in depreciating mode and hence there is no need for RBI to intervene.
  • External volatility, with a rise in US bond yields, oil prices, geopolitical concerns and a threat of trade war, has led to the dollar strengthening and the rupee weakening.
  • Slowing inflows into local financial markets and the widening current account deficit have also contributed to the weaker rupee.
  • In its most recent analysis, the IMF maintained its assessment that the rupee is moderately overvalued. The RBI’s most recent annual report assessed the rupee to be “closely aligned to its fair value over the long term”.

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