RBI Intervention

In the wake of the rupees slide, there has been much talk about the RBIs intervention in the currency markets to support the Indian currency, including a massive selloff of dollars. But what exactly is RBI intervention, how does it work and what impact can it have? Heres a quick guide to understanding what tools the RBI has at its disposal and what it can do.

Fall of the rupee: The rupee on Wednesday closed at an all-time low of 54.49 to the dollar. It has recovered on Thursday but was still at 54.23 against the dollar. The local currency first slumped to an all-time low of 54.46 against the dollar in afternoon trade even as the Reserve Bank of India broke its silence over the falling rupee, saying it would do its "best possible to curb volatility".

Direct Intervention: In case of any currency movement, a countrys central bank can directly intervene to either push the currency up, as India has been doing, or to keep it artificially low, as the Chinese central bank does. To push up a currency, a central bank can sell dollars, which is the global reserve currency, or the currency against which all others are measured. When it needs to keep its currency lower, it can buy dollars, as the Chinese do, to the point where they are the largest holders of dollar-backed US Treasury paper.

Indirect Intervention: A central bank can also intervene indirectly by regulatory action, as the RBI has done in the past few weeks. The banking regulator has relaxed caps on the interest rates for foreign currency non-resident deposits (FCNR) in the hope that this will attract depositors to put more dollars into such accounts. It has also allowed banks to self-regulate export credit limits. On May 10, it asked exporters to cut by half their dollar holdings in exchange earners foreign currency (EEFC) accounts in an attempt to release more dollars into the system.

 Why Intervene: The RBI has been intervening in the currency markets because a weaker currency pushes up the countrys import bill you pay more rupees for the same amount of dollars and contributes to the current account deficit. It is also indicative of a countrys economic health and a weaker currency is a signal to investors that the economy is not being well-managed. India has a huge import bill largely because it buys almost 80 per cent of its oil from abroad, and a weak rupee can wreak havoc with the governments finances. On Wednesday, RBI deputy governor KC Chakrabarty said that the market would decide the value of the rupee and that the central bank would only intervene to halt volatile currency movements caused by speculative trades.

Dollar sales: The Reserve Bank of India has been intervening in the forex market since December 2011, when the rupee hit a record low, to stabilize the currency. Over the past couple of weeks, it has stepped up its dollar sales to stem the rupees slide. On Monday, the RBI injected $500 million into the currency markets, but that has been offset by high, bunched-up import demand.

Intervention Impact: The reason that the rupee has continued to fall is because the RBI is caught in a cycle where it has to battle inflation, liquidity crunch and a falling rupee at the same time. Unfortunately, any action it takes to tackle one could be negated by the others. Inflation is already at a high level of 7.23 per cent, higher than expected. To tackle inflation, the RBI must keep rates high and liquidity tight, but that can stifle economic growth and push the currency down. If it sells dollars to support the currency, that too sucks liquidity out, choking growth. Slower growth makes India an unattractive destination for foreign investors, which in turn leads to drying up of dollar flow. But if it releases too much liquidity into the system, inflation could go into double digits and push the value of the rupee down, completing the vicious cycle. Clearly, the RBI at this time has very limited options.

 Fiscal Deficit: This is the 800-pound financial gorilla in the room. Indias fiscal deficit for 2012-13 is projected at 5.1 per cent of GDP. A large part of this is driven by Indias trade deficit, or when imports are higher than exports. A high trade deficit contributes to the fiscal deficit, which the government needs to cover. A weak currency will only drive the import bill higher, expanding the fiscal deficit. In such a case, the government will need to borrow more from the RBI, leaving less money for growth.

RBI's Intervention in Foreign Exchange Market

In the aftermath of the currency crises around the world, the role of the central banks' interventions in the foreign exchange market has gained in importance. It is obvious that such intervention affects the exchange rate in two ways, first, by affecting the extent of excess demand in the foreign exchange market, and thereafter through a complex interplay of the macroeconomic variables. The stylized literature has addressed this issue by estimating the so-called offset coefficients, a method that is ad hoc and that is marked by the conspicuous absence of an underlying macro-model. In this paper, we build on the stylized Mundell-Fleming model, and derive an estimable reduced form expression that allows us to link exchange rate movements with the RBI's interventions. The model itself and the subsequent empirical result indicate that the effect of RBI's intervention in the foreign exchange market is at best unclear. Specifically, given the time span of the data, the RBI's interventions in the market seem to have been ineffective.