Why do exchange rates become volatile?
A simple explanation is that when the supply and demand of the currencies concerned change rapidly, the exchange rate also varies. The present scenario of rupee devaluation can be explained by a simple diagram:
Poor supply of dollar --> increased demand for dollar --> dollar appreciation --> rupee depreciation
Similarly, the opposite action works when there is an appreciation of the value of the rupee. There has been a lot of debate if RBI should use its forex reserves to control the exchange rate. RBI has sold dollars in the recent past which has resulted in a decrease in forex reserves; but should this be done more aggressively is the question.
How can forex reserves be used to monitor the exchange rate?
India’s foreign exchange reserves are currently over $250 billion. By controlling the supply of currencies, RBI can in effect control the exchange rate. RBI can buy or sell US dollars through open market operations to depreciate or appreciate the value of the rupee respectively. Let’s explain how forex reserves can be used in the present situation:
RBI sells dollars from forex reserves and buys rupee --> Dollar supply increases in the market and rupee supply falls --> Forex reserves go down --> Value of rupee increases as supply is scarce
On the contrary, if the value of the rupee needs to be depreciated to make Indian exports competitive, then RBI can perform the following action:
RBI buys dollars and sells rupee --> Dollar supply falls and rupee supply increases --> Forex reserves go up --> Value of rupee depreciates as supply is high
If there is a situation when forex reserves are plenty, RBI can use this mechanism for a longer duration to monitor the exchange rate.
Should forex reserves be used to monitor the exchange rate?
Recently the World Bank Chief Economist Kaushik Basu cited that India should use its forex reserves to control the rupee volatility, as the present situation is very different from the 1991 crisis. However, the multiplicity of inter-connected factors in using forex reserves to monitor the exchange rate makes it a complicated process.
The current scenario of rupee devaluation is caused by a variety of factors - India’s growth prospects, inflation in the country and policy actions by the developed world. Further, the impending increase in crude oil prices can cause a further dent in the import bill of the country. As a result, using forex reserves to stabilize the exchange rate may not be the best of options.
Although this can bring about a short-term support, India needs a more long term approach to support its exchange rate - active policy measures to stem inflation, fundamental change in reforms and policies and means to bring down the Current Account Deficit of the country. #gettingyourich