Ashima Goyal

Defending the rupee

Ashima Goyal | Updated on March 12, 2018

Policy should be attuned to the domestic cycle.

Any exchange rate intervention policy in India should be aimed at managing expectations without hurting domestic growth.

India moved too quickly to a de facto complete floating exchange rate regime, although the Reserve Bank of India committed itself to intervene mainly with a view to prevent excess volatility in the currency markets. Emerging market (EM) economies receive capital flows that respond more to global, and not domestic, conditions.

Besides, the thin markets and volatile risk premiums in these economies aggravate the tendency for exchange rates to overshoot their fundamental values. Therefore, determination of the value of their currencies cannot be left to markets alone. A managed float is a more appropriate approach. Feasible actions include administrative as well as monetary policy measures. The former ranges from various types of signalling and controls to actual intervention, i.e. buying and selling in forex markets.

The latter mainly refers to the classic interest rate defence, as is now being employed by the RBI.

The decision to stop ‘intervention’ was taken in 2007, at a time of strong inflows that made sterilisation (in order to neutralise the impact of flooding the markets with rupees to buy up dollars) difficult and costly. Today, the challenges are the opposite, arising from dollar outflows.

In the post-Lehman era of risk-on risk-off bi-directional capital flows, an entirely hands-off approach is not an adequate response. The 2007 decision had led to a market misperception that the RBI cannot and will not do anything about the rupee’s exchange rate. Keeping that in view, the emphatic actions taken in July represent a valuable signal of the RBI’s ability and willingness to act. But even these actions can be effective only if they are appropriate to the Indian context and goals.

Regulatory discretion in a complex environment can, indeed, lead to regulatory overkill, unless clear principles are enunciated and followed.

Some principles are proposed below.


The repeated scams and financial mishaps of the nineties demonstrated the fragility of a controlled system. Hence, financial reforms directed towards steady market-deepening were undertaken. The global financial crisis, in fact, demonstrated the wisdom of India’s slow and steady approach to market development, and the necessity of prudential regulation to check excessive risk-taking.

Action on the exchange rate front should be consistent with these lessons. In forex markets, portfolio-rebalancing types of transactions between market makers are normally much larger than those based on real exposures. These add value, but also underscore the importance of expectations.

Rather than forbidding these types of speculative forex transactions, it is better to reduce incentives for risk-taking among the players engaging in them.

Internationally, forex markets survived the crisis relatively well, partly because central banks imposed limits on the capital available to traders. They, therefore, bore some liability for losses. EM economies are typically characterised by less information and more uncertainty. So, signalling in their case can be even more effective. If the implicit announced exchange rate is changed from being market-determined to one determined by fundamentals, it leaves open the possibility of action when the market-determined levels deviate significantly from the fundamentals. The RBI’s interventions would, then, convey a stronger signal, even without explicitly committing to any specific target exchange rate.

Publishing different types of research-based estimates of fundamental equilibrium-based exchange rates can also contribute to focusing market expectations. Since the market is much larger, the RBI has to now influence expectations; it cannot act totally against them.


Equity inflows were preferred to debt inflows as part of India’s efforts at gradual reduction of capital account controls.

Any defence of the rupee, too, should be in line with this evolution. Higher domestic growth attracts equity. Trying to attract debt is not useful when global interest rates are expected to rise, and also when debt flows constitute only a small fraction of total foreign investments into India.

Foreign equity investors’ assets lose value when the rupee experiences sharp depreciation. But if an interest rate defence is not effective in attracting debt flows, it isn’t going to help existing equity investors either. Moreover, a fall in growth rates will dissuade new equity inflows as well.

A better way to prevent speculators from shorting the rupee by borrowing in domestic markets is to impose position limits and credit curbs. Credit curbs have, for instance, helped bring down gold imports.

The interest rate tool, on the other hand, should target the domestic cycle, not the exchange rate. Better financial intermediation of savings is important for reducing the current account deficit (CAD).

Stock market volatility had made households averse to equity mutual funds. As the rise in short-term interest rates hits debt funds as well, households’ gold preference will only become even stronger.

Policymakers in the US started taking forward interest rate guidance seriously after the 1994 mayhem in bond markets, which followed a steep rise in policy rates by the Federal Reserve. Perhaps, the RBI should also internalise this lesson.


The principle of light-touch regulation or minimum collateral damage implies intervention should be selective and targeted at specific markets. Continuous information should be collected on one-way positions.

If there is evidence of excessive speculation tightening limits and restricting positions are preferable to a domestic liquidity squeeze. Regulations can also affect foreign investors’ positions in non-deliverable forward exchange markets.

If administrative measures reduce one-way positions, a general liquidity squeeze does not contribute to any additional stability in forex markets, even while affecting other markets.

Capital flows do not always match the net import gap. Therefore, the RBI should be ready to move in, while restocking reserves whenever such inflows exceed net imports even in the short term.

Such smoothening becomes even more necessary if forex markets are frozen. Else, the volatility the RBI aims to reduce can only rise. Even small demand-supply mismatches have a large effect on prices in a thin market.

In the Indian context, flexibility in policy is always important, given multiple shocks and constraints. Policy — and that is the final principle — should ultimately be attuned to the real domestic cycle, with growth-supporting stabilisation.

The stabilisation measures the Fed undertook have helped the US make the best post-crisis recovery. In India’s case, strong action on the supply-side and resolution of structural issues are also essential in stabilising the exchange rate and the CAD.

(The author is Professor of Economics, Indira Gandhi Institute of Development Research, Mumbai.)

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Published on August 12, 2013
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