Has RBI got its strat­egy on ex­change rates wrong?

The ac­cu­mu­la­tion of forex by RBI in the re­cent past does not ap­pear ex­ces­sive when com­pared with his­tor­i­cal trends


The steady ap­pre­ci­a­tion of the In­dian ru­pee this year has led to fears that In­dian ex­ports have been priced out of global mar­kets. Three of the four mea­sures of the real ef­fec­tive ex­change rate (REER) tracked by the Re­serve Bank of India (RBI) show that the ru­pee is grossly over­val­ued.

Another group of crit­ics makes ex­actly the op­po­site point. The build-up of for­eign ex­change re­serves shows that RBI has been in­ter­ven­ing too heav­ily in the for­eign ex­change mar­ket to keep the ru­pee down, they ar­gue. A cen­tral bank com­mit­ted to an in­fla­tion tar­get should not be so fo­cused on man­ag­ing the ex­change rate.

The In­dian cen­tral bank thus finds it­self trapped in a pin­cer—be­tween those who ac­cuse it of al­low­ing the ru­pee to ap­pre­ci­ate too much, and those who in­sist that it is too fo­cused on keep­ing the ru­pee down.

Has India got its ex­change rate pol­icy all wrong?

A com­par­i­son with what other large emerg­ing mar­ket economies have done over the past year of­fers some im­por­tant clues. The data on per­cent­age changes in REER is taken from the Bank for In­ter­na­tional Set­tle­ments so that com­par­isons across coun­tries are pos­si­ble.

Most peers among the emerg­ing mar­kets have seen their REERS go up over the past year be­cause of the dol­lar slump. India is some­where in the mid­dle of the pack.

REER is the weighted av­er­age of a coun­try’s cur­rency rel­a­tive to an in­dex or bas­ket of other ma­jor cur­ren­cies, ad­justed for the ef­fects of in­fla­tion ( see Chart 1).

The data on the per­cent­age in­crease in for­eign ex­change re­serves tells us some­thing quite dif­fer­ent. India has ac­cu­mu­lated more for­eign ex­change re­serves than most of its peers.

The ques­tion is why it has done so, an is­sue that is taken up later in this ar­ti­cle.

Does the rapid in­crease in re­serves make India a cur­rency ma­nip­u­la­tor?

This is an im­por­tant ques­tion given the strong sig­nals em­a­nat­ing from the Don­ald Trump ad­min­is­tra­tion that the US could get into trade wars with coun­tries that have been ma­nip­u­lat­ing their cur­rency to cap­ture mar­kets. China is the prime tar­get, but all emerg­ing mar­ket coun­tries need to worry.

Chart 2 does not show a strong cor­re­la­tion be­tween re­serves ac­cu­mu­la­tion and cur­rency move­ments.

The case against cur­rency ma­nip­u­la­tion would be stronger if there was a clear neg­a­tive cor­re­la­tion—or if those coun­tries that in­ter­vened most heav­ily in the for­eign ex­change mar­ket by buy­ing dol­lars would also be the ones that saw min­i­mal ex­change rate ap­pre­ci­a­tion, or vice versa.

Re­serve ac­cu­mu­la­tion by RBI has tended to move in tan­dem with net cap­i­tal in­flows into the In­dian economy. Chart 3 shows that the two move in tan­dem—es­pe­cially dur­ing ex­treme quar­ters.

How­ever, the cor­re­la­tion co­ef­fi­cient (a mea­sure of how closely two vari­ables move in tan­dem, tak­ing val­ues be­tween 0 and 1) be­tween the two is 0.45. This roughly sug­gests that move­ments in for­eign port­fo­lio in­vest­ment (FPI) in­flows ac­count for only about half of the in­crease or de­crease in forex re­serves.

The amount of dol­lars RBI buys in any quar­ter also de­pends on other factors such as the quar­terly trade deficit or the do­mes­tic liq­uid­ity sit­u­a­tion or the abil­ity of the cen­tral bank to con­duct open mar­ket op­er­a­tions to ster­il­ize its for­eign ex­change in­ter­ven­tion.

The fi­nal ques­tion: Has RBI got ex­cess for­eign ex­change in its kitty?

Any coun­try needs for­eign ex­change re­serves as in­surance against un­ex­pected global shocks.

But there are also fis­cal costs in­volved since ster­il­ized in­ter­ven­tion in the for­eign ex­change mar­ket in ef­fect means swap­ping high-yield­ing do­mes­tic se­cu­ri­ties for low-yield­ing for­eign se­cu­ri­ties.

There are three com­mon ways to as­sess the ad­e­quacy of re­serves—in terms of how many months of im­ports they cover, their size with re­spect to short-term for­eign debt that needs to be re­deemed within a year, and as a pro­por­tion of the stock of broad money in the economy.

The third mea­sure has not been con­sid­ered here since money sup­ply plum­meted in fis­cal year 2017 be­cause of de­mon­e­ti­za­tion.

The other two mea­sures—im­port cover and short-term debt cover—do not sug­gest that the size of the re­serves at this point of time is out of sync with what India has had over the past decade.

How­ever, the for­ward con­tracts that RBI has been en­ter­ing into to buy dol­lars in the fu­ture have not been taken into ac­count ( see Charts 4A and 4B).

India has seen rapid re­serves ac­cu­mu­la­tion pre­vi­ously as well—at the turn of the cen­tury when Bi­mal Jalan was RBI gov­er­nor, in the quar­ters pre­ced­ing the fi­nan­cial cri­sis when Y.V. Reddy had to en­sure that cap­i­tal in­flows did not over­whelm do­mes­tic mon­e­tary pol­icy, and now over the past three years when Raghu­ram Ra­jan fol­lowed by Ur­jit Pa­tel have been in charge.

Such episodes gen­er­ate the same dilem­mas. Should the cur­rency be al­lowed to ap­pre­ci­ate? Should the cen­tral bank step in to pre­vent ex­ports be­com­ing un­com­pet­i­tive? To what ex­tent should it worry about for­eign ex­change in­ter­ven­tion cre­at­ing do­mes­tic ex­cess liq­uid­ity prob­lems? Should it put up tem­po­rary cap­i­tal con­trols?

The an­swers are never easy.

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