Most economies, but especially developing ones like India’s are worse off with overvalued (when a rupee buys more dollars than underlying economic factors dictate) exchange rates than undervalued ones.
Overvalued exchange rates are more distorting; they make domestic business less competitive abroad and at home; the first because exports are dearer and the second because imports become cheaper. But politicians dislike devaluation or depreciation of the currency because the value of currency is associated with national pride.
For economic administrators, therefore, it makes more economic and political sense to be able to maintain an undervalued exchange rate provided they could give politicians something to boast about.
When a central bank buys up dollars to maintain a relatively low value of the domestic currency, it accumulates foreign exchange. High reserves, therefore, become a result of a particular exchange rate policy.
Politicians can be shown the former as a compensation for the latter. Political economics, if not in textbook economics or accounting economics, terms this is a win-win situation.
To understand the rationale behind the second function we look back to Pokhran II. The west led by the US had reacted angrily to India’s second set of nuclear tests. Sanctions were imposed, international financial institutions, which more or less do the west’s bidding, were mightily upset, private international capital had taken the cue from the rich country governments and multilateral donors.
India faced a situation where capital flows could have dried up. Even in the Asian crisis, private international capital fled the so called tiger economies. Again, Argentina was reduced to chaos because of the same reason. In the first example, high reserves gave country policy flexibility, an insurance against powerful global players.
In the second and third examples, high reserves give policy protection, the insurance this time is against private global capital.
The importance of high FOREX reserves come seriously to the fore, if we, remember 1991, the hawking of gold reserves and the IMF loan. Then the public sector manager had to plead for pittance in foreign exchange so that a vital input could be brought abroad. With high reserves we are unquestionably and undisputedly better off.
Given India’s comfortable position in the reserves, the country can now move ahead with more economic reforms. There is now an opportunity for the government to press forward with capital account convertibility.
Again with high forex reserves, India can now adopt a more aggressive foreign trade policy that would incorporate a speedier move towards world tariff rates and to give a boost to Indian export growth by building India’s brand equity in the international markets via such funds as the India Brand Equity Fund. The govt can cut import duties to encourage imports and ease restrictions on Indian companies to invest abroad.
Again, it is not that the RBI has been sitting idle over the bulging reserves. It has for instance, decided to prematurely repay its loans worth $ 2.8 billion from the World Bank and the Asian Development Bank. It is a small step but in the right direction. The Government decided to use a part of forex reserves for infrastructure financing through special purpose vehicle.