Role of RBI in Foreign Exchange Markets in India

Post independence, India’s exchange rate was fixed by the RBI against pound sterling, under the fixed or pegged exchange rate mechanism. Subsequently the exchange rate under the fixed exchange rate mechanism was changed to dollars and then to a basket of currencies.

The first step at reforms in exchange rate management was taken in 1993, and then referred to as ‘Liberalized Exchange Rate Management System’ or LERMS. Under this the dollar was used as intervention currency, which implied that primary exchange rate, all official government statistics would be dominated in U.S. dollar in terms of global trends and convenience. Under LERMS there was a ‘dual exchange rate’, one officially decided by the RBI and the other through market forces. All foreign exchange transactions upto 40% was to be at the official rate and the remaining at the market rate.

However, after 1999 the official rate was discontinued and exchange rate became market-determined exchange rate (MDER). Under MDER the forces of demand and supply of dollars in India determine the exchange rate. The demand for dollars is downward sloping (lower demand when more rupees have to be offered and higher demand when lesser rupees have to be offered). Similarly the supply of dollars is upward sloping (less is sold when lesser rupees are offered and more is sold when more rupees are offered). Thus this interaction of demand and supply determines the exchange rate, at which the demand and supply of dollars balance out.

Any surge in the inflow of dollars leads to the rupee gaining value (appreciation). This renders imports cheaper and exports expensive. To prevent impact on exports under MDER, the RBI purchases dollars by creating an artificial demand for the excess dollars in circulation. Any act of purchase of dollars by the RBI impacts liquidity as rupees get released into the system creating inflationary pressures. In such circumstances the RBI simultaneously goes for the reverse repo auction to soak up the excess liquidity created on account of purchase of dollars by the RBI. The reverse repo auction is done under the Market Stabilization Scheme (MSS).

Any act of interference by a Central Bank like the RBI in influencing the exchange rate is called as ‘dirty floats’. But in India it is referred to as ‘managed floats’. In adverse circumstances of demand for dollars going up more than the supply of dollars, it results in rupee losing value (depreciation). Though it can positively impact exports and discourage imports, it is usually seen as an erosion of faith in the home currency and can escalate into a currency crisis.

In such circumstances the government has to sell foreign currency to augment the supply of dollars. However, the experience has been that more the currency is sold, more is the depreciation. Thus RBI instead of targeting any exchange rate, intervenes in the foreign exchange market only to manage the volatility and disruptions to the macro economic situation.