As India has gained prominence in the global economy, its central bank, the Reserve Bank of India, has wisely increased the level of foreign exchange holdings.
These reserves are necessary to maintain payments for imports should there be a global economic financial crisis or a sudden devaluation of the currency.
We think that what is happening in India is a harbinger for other economies that maintain explicit or implicit pegs to the U.S. dollar. The coming year will most likely be a tumultuous one in the global economy, characterized by a rising dollar and a changing global trade landscape.
India has gotten ahead of this issue. As its imports have grown at an average rate of 4.4% per year, the Reserve Bank of India has increased its foreign exchange holdings at a 7.6% yearly rate.
Today, the Reserve Bank of India’s FX reserves are sufficient to cover the cost of imports for nearly 10 months, which is around the level it held before the pandemic. During the pandemic in 2020, as imports dropped, its coverage spiked to 16 months.
Pegging a currency to the dollar has its advantages, but it also leaves a country vulnerable to speculative attacks that can disrupt an economy if it has not built up an adequate capital buffer.
China, for example, had to put forward $1 trillion to defend its currency peg to the dollar in 2015.
The takeaway
The decision by the Reserve Bank of India to accept a lower valuation of the rupee and effectively end the peg to the dollar makes sense as the rupee comes under continued pressure.
Not only has there been a slowdown in demand for Indian goods, but the flow of global capital into the United States is also accelerating and foreign direct investment into India is slowing. On top of all this, changing policies in the United States are likely to spur a stronger dollar.
Read RSM’s global economic outlook for 2025 in the latest issue of The Real Economy.
