On April 13, the US Treasury Department delivered to Congress the semi-annual Report on Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States Treasury, which 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. The US move and the higher rise in March trade deficit created nervousness in the foreign exchange market on Monday, with the rupee falling 29 paise against the US dollar to close at 65.49, a more than six-month low.
What does the report say?
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. Despite a sharp drop-off in purchases in the fourth quarter, net annual purchases of foreign exchange reached $56 billion in 2017, equivalent to 2.2% of the GDP. The pick-up in purchases came amidst relatively strong foreign inflows, both of FDI and portfolio investment. Notwithstanding the increase in intervention, the rupee appreciated by over 6% against the dollar and by more than 3% on a real effective basis in 2017. India had a significant bilateral goods trade surplus with the US, totalling $23 billion in 2017, but the current account is in deficit at 1.5% of the GDP and the exchange rate is not deemed to be undervalued by the IMF.
So India met two of the three criteria for the first time in this report — having a significant bilateral surplus with the US and having engaged in persistent, one-sided intervention in foreign exchange markets. US Treasury Secretary Steven T Mnuchin says in the report, “We will continue to monitor and combat unfair currency practices, while encouraging policies and reforms to address large trade imbalances.”
How do central banks intervene and why?
Central banks intervene in the foreign exchange market to reduce volatility in the exchange rate and often to build foreign exchange reserves or to manage these reserves. They intervene to ensure that their currencies are neither overvalued or 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. 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. Since then reserves have risen.
Why has the RBI been buying dollars?
The US report says 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. Prior to 2013, intervention for several years had generally been less frequent, and when it had occurred, it had been broadly symmetric, as for example during 2007 and 2008, when the RBI engaged in both purchases and sales of foreign exchange at various points in the midst of volatile global financial markets. The RBI has noted that the value of the rupee is broadly market-determined, with intervention used only during “episodes of undue volatility”. Foreign exchange intervention picked up in the first three quarters of 2017, in the context of strong capital inflows, with FDI of $34 billion and foreign portfolio flows of $26 billion over the first three quarters of the year.
On what basis is a country named a ‘currency manipulator’?
The three pre-conditions for being named currency manipulator are: a trade surplus of over $20 billion with the US, a current account deficit surplus of 3% of the GDP, and persistent foreign exchange purchases of 2% plus of the GDP over 12 months. All three apply to India. “While there has not been a dramatic increase in trade surplus with the US, the RBI accumulated reserves by absorbing the inflows into domestic capital markets. This caution seems unwarranted considering that India runs a trade deficit overall, based on 36 currency REER (real effective exchange rate), the rupee is still overvalued,” said Abhishek Goenka, CEO, IFA Global.
What about the rupee? Will this report of the US Treasury impact the currency?
The rupee fell 29 paise against the US dollar to close at 65.49 on Monday. However, forex dealers don’t expect a sharp fall as the RBI then props up the rupee by selling dollars. Notwithstanding the pick-up in intervention, the rupee appreciated 6.4% against the dollar over 2017, while the real effective exchange rate also continued its general uptrend from the last few years, appreciating by 3.1%. 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”.
How have India’s foreign exchange reserves moved?
According to latest RBI data, released last Friday, India’s forex reserves rose by $503.6 million to touch a record high of $424.86 billion in the week ended April 6, 2018. Of this, foreign currency reserves were $399.776 billion. Direct intervention has supported a steady increase in foreign exchange reserve levels. 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.
How are analysts viewing this Monitoring List of the US Treasury?
Indranil Sen Gupta of Bank of America Merrill Lynch Global Research says, “We continue to expect the RBI to recoup foreign exchange reserves if it can, despite being put on the US Treasury Report’s currency manipulator watch list. It should continue to pursue an asymmetrical policy of buying forex when the dollar weakens and allowing Rs 65-66 per dollar when it strengthens.” The 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%. “Second, we see RBI forex intervention at $15bn/ 0.6% of the GDP in FY19 — which is well below 2% of the GDP required to be named currency manipulator — with the current account deficit set to rise to 1.9% of the GDP when portfolio inflows are slowing,” Merrill Lynch says.