Topic: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.
Q5. Discuss the role of foreign-exchange reserves in protecting an economy against external shocks. Analyse their limitations during periods of sustained currency pressure. Suggest ways to enhance external-sector resilience. (15 M)
Difficulty Level: Medium
Reference: TH
Why the question
Recent volatility in the rupee and debates on RBI intervention have brought renewed attention to the role of foreign-exchange reserves as a safeguard against external-sector shocks and currency instability.
Key Demand of the question
The question requires discussing how foreign-exchange reserves protect an economy from external disturbances, analysing the limitations of relying on reserves during prolonged currency pressure, and suggesting measures to strengthen overall external-sector resilience.
Structure of the Answer:
Introduction
Briefly define foreign-exchange reserves and highlight their significance as a buffer against balance-of-payments stress, exchange-rate volatility and external financial shocks.
Body
- Role in protecting against external shocks: Contribution towards exchange-rate stability, import security, investor confidence, debt-servicing capacity and management of capital-flow volatility.
- Limitations during sustained currency pressure: Constraints arising from reserve depletion, structural economic weaknesses, opportunity costs, speculative pressures and valuation risks.
- Enhancing external-sector resilience: Measures relating to export competitiveness, import diversification, stable capital inflows, rupee internationalisation and sound macroeconomic fundamentals.
Conclusion
Conclude by emphasising that while reserves provide an important shield against external shocks, durable resilience depends on strong economic fundamentals and a diversified external sector.
