By now we all are aware of the problems posed due to the larger capital inflows into the country. The central bank of India (RBI) is doing its best to balance several of its objectives viz. the impossible trinity: a liberal capital account, independent monetary policy and a managed exchange rate. RBI, depending on the situation, generally focuses on one of the objectives of the impossible trinity. Recently, RBI has been largely laying thrust on financial stability and the exchange rate. The Indian rupee (INR) has appreciated by around 10 % in the year 2007.
RBI has been ?intervening? in the foreign exchange markets viz. buying the US Dollar (USD) in order to stem the rapid INR appreciation. This is mainly done to retain the external competitiveness of the Indian exporters and to dilute the adverse second order effects of the same on the real economy.
A sterilised intervention occurs when RBI sucks out the liquidity (INR) infused due to its USD buying, by using various tools such as cash reserve ratio hike, issue of bonds, LAF operations, etc. Depending on the tools used, the cost of sterilisation is borne by banks, government or RBI
A unsterilised intervention would lead to the liquidity remaining in the banking system leading to a rapid growth in monetary base (M3) thus impacting the interest rates, real economy and ultimately the exchange rates. In an unsterilised intervention (to stem appreciation), the net foreign exchange assets of RBI rise to that extent.
It is often a subject of debate on the extent (more or less) of RBI?s intervention in the foreign exchange markets and its effectiveness in achieving its objective of ?reducing the volatility (read appreciation) of the USD-INR?
Why do central banks intervene in the foreign exchange markets?
As RBI puts it in its Report on Currency & Finance (2006-07), that central banks inter alia intervene in the foreign exchange markets:
? To influence trend movements in the exchange rates because they perceive long-run equilibrium values to be different from actual values.
? To maintain export competitiveness.
? To manage volatility to reduce risks in financial markets.
? To protect the currency from speculative attack and crisis
Further, IMF (1977) states that the primary intervention objective of central banks should be to ?counter disorderly market conditions?.
For the time being RBI?s objective of intervention is to maintain the exports competitiveness of the rupee.
In recent times, intervention has been necessitated by huge capital inflows, especially in emerging markets like India, which exert large influence on the exchange rates, more than the underlying fundamental factors such as economic growth and trade balances.
The short-term effectiveness of the ?intervention? depends of various factors including market positioning, timing of the intervention, size of the intervention vis-?-vis the market turnover, etc.
FII inflows hold a lion?s share in the total capital flows in India. There were some school of thought that RBI has been ?over intervening? and subsequently ?oversterlising? with respect to the ?net? FII inflows, viz. it?s buying more USD than the net FII inflows and then sucking out more INR.
If the objective of RBI is to smoothen the volatility of USD-INR pair when large flows come in, it?s logical to conclude that the intervention would be necessary and most effective (in the short run) when the gross FII inflows (USD) hit the banking system, and not the net ones (purchases less sales). From November 2006 to September 2007, the gross FII purchases have been around 10 times (average) of the net figure. A timing mismatch of the gross inflows and outflows would also push RBI to intervene on ?gross basis?. The herding (bunched up inflows) influences the short-term exchange rate movement in the direction of inflows.
As can be observed from Table I, RBI has intervened even in episodes when the net inflows have been negative. As ex RBI governor Bimal Jalan (2003) puts it, ?Unlike trade flows, capital flows in ?gross? terms, which affect exchange rate, can be several times higher than ?net? flows on any day. Therefore, herding becomes unavoidable.? In the period covered RBI on an average has sterilised around 40% of the gross FII inflows, though the figure on net inflows would be much higher.
Another aspect of effectiveness of the intervention is the ?proportion of RBIs USD buying to the total foreign exchange market turnover?. Though the results are mixed, usually higher the proportion, more effective will the intervention be. As can be observed from Table II, RBI interventions have been in the range of 0% to 2.66%, with a median of 0.41%. In February 2007, the intervention proportion to the total turnover was the highest (2.66%), and the INR appreciation was one of the lowest at 0.25%. On the flip side, INR appreciated as much as 2%, in October 2006, when RBI did not buy any USDs. Nevertheless, the proportion of RBI?s interventions does not seem to be very significant vis-?-vis the market turnover.
As per RBI (Report on Currency & Finance 2006-07) it has been observed that while empirical evidence on the effectiveness of central bank intervention is available in large numbers for some specific developed countries, the evidence on foreign exchange intervention in developing countries, including India, is weak.
There has been some amount of literature suggesting that interventions hardly achieve their objectives in the long run, especially on the exchange rates, though it may influence the exchange rates only in the short run.
To conclude, RBI is likely to continue to intervene (buy USDs) in the foreign exchange markets to smoothen the volatility in the USD-INR pair. The extent and timing of the intervention is likely be a function of evolving situation including INR movements and liquidity in the system. And the better method to analyse the extent and effectiveness of interventions would be to take the gross inflows as the base. In the current situation, intervention can address the problem of INR appreciation for the time being, but doesn?t seem to be a long-term solution to the issue. Ultimately, it is the intrinsic values of the currencies which hold good over the longer term.
The author is CEO & CIO, Quantum Asset Management Company
