Ashima Goyal

The case for RBI intervention in today's forex market

ASHIMA GOYAL | Updated on: Dec 26, 2011


No central bank can let its currency be affected by short-term capital volatility.

The rupee's exchange rate is said to be market-determined, with the Reserve Bank of India (RBI) intervening only to prevent excess volatility. But if this is the regime, the situation should be ripe for intervention, because of recent excessive volatility.


Market determination means that the demand and supply of foreign exchange in any period is what determines the exchange rate. This is valuable to the extent that the prices realised by markets are equilibrium exchange rates. Flexible exchange rates prevent large deviations from the equilibrium real rates. A fixed exchange rate, by contrast, amounts to an implicit government warranty that encourages excessive unhedged foreign borrowing, building up to crises.

But a pure float also has problems. It can lead to excessive volatility in thin markets. In the context of fragile global markets, capital inflows could slow down or turn into outflows for reasons unrelated to domestic fundamentals. In the event, large deviations from equilibrium do occur, and can have unfortunate effects in terms of disrupting trade or working against the reduction of inflationary expectations. Depreciation only adds to inflation. A country with a current account deficit (CAD) need not always suffer depreciation of its currency to the extent foreign capital is willing to come in. Forward-looking markets recognise a small CAD to be sustainable for financing more investment and growth that could eventually be a source to generate future surpluses.

But they forget these during global panics. No central bank can let its currency be affected by such short-term capital volatility. They have, therefore, intervened even in advanced markets such as Japan and Switzerland that are supposed to have full floats.

The literature on exchange rates recognises a tendency of markets to deviate from equilibrium, whenever there is ‘learning' and less-than-perfect information. So, the central bank has a more general role in focusing expectations. This it does through communication, whenever it creates news or reduces noise. Both are valuable functions, especially in emerging markets, where news is relatively scarce.

In the past few years, the rupee-dollar exchange rate has tended to follow movements of the euro-dollar rate. That is, the rupee has gained, as the dollar has weakened globally and vice versa. In other words, capital flows were driving the rupee based on global and not on domestic patterns. The value of the rupee may have been determined by the demand and supply of foreign exchange, but the latter was driven by market sentiment and not economic fundamentals. A strong government can influence this sentiment towards local fundamentals.


The microstructure of the foreign exchange market is unlike any other market. It is a bilateral market, where traders do not know aggregate net demand, but infer it from their own order flows. The size of intra-bank transactions is many times the size of export-and-import-related goods market transactions. Banks unwind portfolios, explore the market, and use tiny arbitrage opportunities to make profits. These factors help to maintain robust trade with diverse buy-and-sell side positions. But in such a market, the central bank is a special agent and its buy-or-sell position conveys important information affecting markets.


Therefore, the central bank has many ways by which it can affect the exchange rate — not just through buying and selling foreign exchange, and not just the traditional interest rate channel. The latter anyway is not fully effective, since many types of controls still hinder movement of capital in response to interest rate differentials.

The central bank can choose what sort of signal it wants to send. It can choose to reveal the direction of intervention, but not the quantity or the target. Timing also matters. It can utilise market structure to get the maximum impact with minimal action.

Just a few well-chosen words can move markets. If the markets think that the central bank is credible, they may implement its goals even without the latter actually intervening. In India, the range of capital controls gives further choices. Strategic relaxation is now being used to bring in more inflows.


There is a perception that since Indian reserves just cover our international liabilities, they should not be used to finance a CAD. But it is only rarely that daily inflows will just finance the CAD. Banks and foreign exchange markets perform a buffering role, and the central bank must contribute to that buffer in periods of extended uncertainty. Saving its buffer for the future may turn a small shower into a sustained rainstorm, if a downward spiral sets in.

But markets are fickle and tend to panic easily in emerging markets. So the level of reserves, however large, tends to become a threshold. Any substantial reduction is hence regarded as a sign of weakening. But central banks globally have formed clusters to strengthen themselves against sustained contagion.

Bilateral and multilateral swap lines are available. Contingent capital lines that contain contagion across countries are much less expensive than full-blown or festering crises. Central banks have the ammunition even to give today's large markets confidence.

(The author is Professor of Economics, IGIDR, Mumbai.)

Published on December 07, 2011
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