The rupee-dollar exchange rate is currently hugging Rs 84. From Rs 69.4 to $1 on March 31, 2019, it has depreciated by about 20 per cent. Foreign exchange reserves (FX reserves) have risen from $411.9 billion on March 31, 2019, to $684 billion at the end of August 2024, increasing by about 66 per cent.
India’s dollar GDP, on the other hand, could rise by only about 32 per cent during this period (from $2.7 trillion in 2018-2019 to $3.57 trillion in 2023-2024).
Rising FX reserves usually witness strengthening local currency exchange rates. Why then has the rupee been depreciating? Is depressed dollar GDP growth a consequence of the Reserve Bank of India (RBI)’s policy of building large FX reserves?
Growing FX reserves
India’s FX reserves rose from $303.7 billion in March 2014 to $411.9 billion in March 2019 during Modi 1.0 — growing by about 36 per cent, at about 6.3 per cent per annum.
The pace of growth increased significantly in Modi 2.0 with annual growth rising to 9.4 per cent as reserves climbed to $645.6 billion, with gold reserves rising from $23.4 billion in 2019 to $52.2 billion in 2024.
In the last five months, FX reserves have risen by an additional $39 billion standing at $684 billion in August 2024. FX reserves accumulate only if the RBI buys them from the market. Rising reserves have, therefore, been the RBI’s deliberate policy choice.
Exchange rate depreciated
The RBI valued $303.7 billion of FX reserves in March 2014 at Rs 18.3 trillion, at an exchange rate of Rs 60.2 to $1.
The exchange rate depreciated to Rs 69.3 to $1 in March 2019 (reserves $411.9 billion; Rs 28.6 trillion) at an annual rate of 2.8 per cent during Modi 1.0. With an effective exchange rate of Rs 83.4 to $1 (reserves $645 billion; Rs. 53.8 trillion) in March 2024, the rupee depreciated at a higher annual rate of 3.8 per cent during Modi 2.0.
The RBI’s policy of building FX reserves aggressively (adding $213 billion) during Modi 2.0 contributed immensely to the sharper depreciation in the rupee-dollar exchange rate.
If the RBI had limited the accumulation of FX reserves to the extent it did in Modi 1.0 ($108 billion), the exchange rate would not have depreciated to the extent it depreciated. Smaller additions might have seen negligible depreciation of the rupee-dollar exchange rate.
Consequence of lower dollar GDP growth
India’s GDP growth in dollars is the play of two factors — nominal GDP growth and depreciation of the rupee vis-à-vis the dollar.
India’s nominal GDP grew at 11 per cent in Modi 1.0 (from Rs 112.34 trillion in 2013-2014 to Rs 189 trillion in 2018-2019), which translated to 8.2 per cent in dollar terms (11 per cent (nominal growth) - 2.8 per cent (exchange rate) depreciation). India’s nominal GDP growth of 9.3 per cent in Modi 2.0 (to Rs 295.36 trillion in 2023-2024) translates to 5.5 per cent in dollar terms (9.3 per cent (nominal growth) - 3.8 per cent (exchange rate) depreciation).
A good part (~40 per cent) of the reduction in dollar GDP growth of 2.7 per cent (difference of 8.2 per cent-5.5 per cent) in Modi’s second term is accounted for by higher rupee depreciation of 1 per cent (difference of 3.8 per cent and 2.8 per cent).
If the RBI had not aggressively bought FX reserves and the exchange rate would not have depreciated at a higher rate, India’s dollar GDP growth would have been much higher. If the rupee depreciated by 1.1 per cent, the dollar GDP growth in Modi 2.0 would have equalled the dollar growth of 8.2 per cent of Modi 1.0.
As it was the RBI’s deliberate decision to build higher foreign exchange reserves, the consequential low dollar GDP growth has to be largely attributed to RBI’s policy choice.
$5 trillion GDP drifts further away
The IMF pegged India’s dollar GDP at $2.70 trillion for 2018-2019 and at $3.57 trillion for 2023-2024 recoding GDP growth of 5.7 per cent per annum in the five years of Modi 2.0. At a lower depreciation of 1.2 per cent per annum in the second term, India’s dollar GDP would have grown to $4 trillion in 2023-2024 (a full 0.43 trillion higher).
The government’s fixed dollar goal is a $5 trillion GDP for 2024-2025. The lower growth consequent to high FX reserves accumulation and higher rupee depreciation, slowed India’s progress towards this goal.
The $5 trillion goal has drifted further away partly thanks to the RBI’s policy of accumulating record-breaking FX reserves.
Why did RBI sacrifice GDP growth for higher reserves?
It costs India to hold foreign exchange reserves. The higher cost of reserves can be justified only as an insurance cost against foreign exchange manipulation by outsiders. With flexible exchange rates, India does not need humungous reserves of $684 billion. The more appropriate level is about $250-300 billion.
Why did the RBI keep building FX reserves at the cost of sacrificing GDP growth? There are two probable reasons.
First, RBI Governor Shaktikanta Das wants to leave a legacy of India building the highest level of FX reserves during his tenure. Second, compulsions of the Bimal Jalan committee recommendations force the RBI to keep the rupee value of FX reserves high, which is possible only when the foreign exchange rate keeps depreciating.
India needs to choose carefully — higher dollar GDP or higher foreign exchange reserves (and artificially high exchange rates).
Subhash Chandra Garg is former Finance & Economic Affairs Secretary, and author of ‘The Ten Trillion Dream’ and ‘We Also Make Policy’.
(Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH).