Let’s say an exporter has received payments for its exported product in dollars. The exporter will go to his local bank and exchange those dollars for rupees. The local bank will go to the RBI (which is India’s Central Bank) and exchange those dollars for rupees.
The Central Bank will print an equivalent amount of rupees and give it to the Bank and keep the incoming dollars with it. These dollars will form part of what we call ‘Foreign Exchange Reserves’ of the RBI.
Similarly when an importer needs dollars to pay for its imports. It will go to its local bank and buy dollars. The bank in turn will buy dollars from the RBI. RBI will dip into its foreign exchange reserves to give those dollars.
Foreign Exchange Reserves are the assets held on reserve by the Central Bank in foreign currencies. Foreign Exchange reserves are important as it enables a Central Bank to provide foreign currency to pay for external payment obligations of the country.
During the 1991 Economic Crisis, India had foreign exchange reserves which could barely finance three weeks of imports. India had to mortgage the country’s gold in order to avoid default on payments.
Foreign exchange reserves are generally held in Gold, Dollars, Euro, Yen and other reserve currencies. Reserve currencies are the currencies which are usually held by Central Banks Reserve currencies are the ones which are widely accepted and trusted internationally. Therefore, they are from stable and large economies. Dollar is the premier reserve currency in the world.
How is the exchange rate decided?
Usually it is decided by demand and supply of the currencies involved. Let’s say a country ‘X ’is exporting a lot of goods and services than it imports, the buyers of these goods and services will have to buy more of Country X’s currency thereby increasing its value and vice versa.
But in some cases Central Banks decide to ‘peg’ or ‘set’ an fixed exchange rate for their currency. The rate is still decided by demand and supply but by stating its objective, the Central Bank attempts to buy and sell to maintain the demand and supply in such a way that the exchange rate is around or exactly what it intends it to be.
For eg: if the currency X is appreciating (Demand for Currency X is more), the Central Bank will start buying more dollars and sell more of X’s currency (by printing more of it) and vice versa.
RBI follows a soft peg. It’s stated goal is that it doesn’t target a specific exchange rate but intervenes in the market to curb any excess volatility in the foreign exchange rate.
Some East Asian countries want to keep their exchange rate low so as to keep their exports cheaper such as China. A cheaper domestic currency results in exports being priced cheaper. It encourages exports and creates more jobs.
Then one may ask then why wouldn’t every Central Bank also do so.
In Economics, there are no free lunches. In the next write-up we will look at the trade-offs of pegging one’s currency.
Until then, keep reading, keep learning…
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