Students preparing through UPSC online coaching and IAS coaching in Hyderabad should understand that the Indian government is taking measures such as cutting withholding tax on government bonds to attract foreign inflows and reduce stress on the rupee.
Forex Reserves
• Forex reserves are the stock of foreign currencies and assets held by the Reserve Bank of India.
• They act as a buffer to protect the economy against external shocks like capital flight, currency depreciation, or global crises.
Forms in Which Forex Reserves Are Preserved
• Foreign Currency Assets (FCA): Held in major currencies like US Dollar, Euro, Pound, and Yen. Largest component of India’s forex reserves.
• Gold Reserves: RBI holds physical gold as part of reserves. Provides stability and acts as a hedge against currency volatility.
• Special Drawing Rights (SDRs): International reserve asset created by the International Monetary Fund. Can be exchanged for freely usable currencies.
INDIA’S FOREX RESERVES COMPOSITION (MAY 2026):
- Foreign Currency Assets – Largest share (~79%), held in USD, Euro, Pound, Yen.
- Gold Reserves – About 17%, acts as a hedge against currency volatility.
- Special Drawing Rights (SDRs) – Around 3%, IMF‑created reserve assets.
Reserve Position in IMF – Less than 1%, India’s contribution that can be drawn in emergencies.
Present Rupee Scenario
• India’s external sector is under stress due to geopolitical tensions, rising crude oil prices, weakening rupee, and foreign capital outflows.
• Declining forex reserves: Nearly $38 billion depletion in two months (2026).
• Persistent FPI outflows: $22.5 billion withdrawn in 2026 so far.
• Rupee depreciation: Fell 11% in one year, touching ₹95.96 per USD (May 2026).
• High crude oil prices: West Asia conflict escalates import bill.
• Global interest rates: US yields remain elevated, reducing emerging market attractiveness.
• Objective: Conserve reserves, stabilise rupee, and attract foreign capital.
Cutting Withholding Tax
• Definition: Tax deducted at source on interest earned by foreign investors in Indian government bonds.
• Current rate: 20% (among highest globally). Earlier concessional 5% till 2023.
• Global comparison: China (10%), Vietnam (5%), Malaysia (exempt).
• Complexities in India: DTAA (Double Taxation Avoidance Agreement) reduces burden for some investors. Non-residents face higher rates without tax residency certificate.
• Objective: Improve post-tax returns, attract FPIs, strengthen rupee, and ease forex pressure.
Forex Conservation Measures
• Gold import duty hike: Raised to curb non-essential imports and reduce the Current Account Deficit (CAD).
• Austerity appeal by PM: Citizens urged to limit gold purchases, foreign travel, and fuel consumption to conserve forex.
• Fuel price adjustments: Suppressed prices strain fiscal credibility; controlled hikes inevitable to maintain macroeconomic discipline.
RBI’s Intervention Strategy
• Massive forex sales:
• $213 bn (2022–23)
• $399 bn (2024–25 record)
• $166 bn (2025–26 till March)
• This leads to selling dollars and increasing rupees in the economy.
• Forward position: Net short $104 bn (Feb 2026), reflecting aggressive intervention.
• Objective: Prevent disorderly depreciation and maintain investor confidence in the rupee.
Positive Developments
• 2013 Taper Tantrum lesson: FCNR(B) swap window raised $26 bn in 3 months; current policymakers reject similar schemes due to risks.
• FDI inflows rising: $6.27 bn in 2025–26 vs $959 mn in 2024–25.
• February 2026 saw $4.6 bn inflows, highest in four years.
• Implication: Despite volatility, long-term investor confidence in India’s growth story remains intact.
DOUBLE TAXATION AVOIDANCE AGREEMENT.
- When a foreign investor earns income in India (like interest, dividends, royalties), they may be taxed both in India and their home country.
- DTAA ensures that such income is taxed only once either in India or in the investor’s home country, or taxed at a reduced rate.
- This makes cross‑border investment more attractive and reduces tax burden.
Key Features
- Reduced tax rates: For example, withholding tax on interest may drop from 20% to 10% or even 5% under DTAA.
- Tax credit mechanism: Investors can claim credit in their home country for taxes paid in India.
- Scope: Covers income types like dividends, interest, royalties, capital gains, and fees for technical services.
Residency certificate requirement: Investors must provide a Tax Residency Certificate (TRC) from their home country to avail DTAA benefits.
Conclusion
India’s forex dilemma reflects the tension between short-term currency stability and long-term economic growth. While cutting withholding tax may improve foreign investor sentiment and ease pressure on the rupee, durable stability requires stronger exports, controlled imports, stable capital inflows, and prudent macroeconomic management.
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