RBI’S ROLE IN FX MARKETS

MARKET STABILISATION SCHEME

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RBI’S ROLE AS MANAGER OF FOREIGN EXCHANGE

The Indian economy saw a surge in capital inflows in 2020, despite the Covid-19 pandemic, through
foreign direct investment/FDI (for example, in Jio Telecom) and foreign portfolio investment/FPI (in
the secondary markets).

• FDI, and FPI, among others, constitute the capital account.

With commodity prices crashing in 2020, including the price of crude oil, of which India imports
about USD 100 billion a year, India saw a rare surplus on the current account.

The strong surplus on both the current account and capital account should have led to appreciation
of the exchange rate of the Rupee against the US Dollar.

Despite this, the Rupee was reportedly the worst-performing Asian currency in 2020.

Why?

• Blame it on the RBI!

Why would the Reserve Bank of India keep the exchange rate low, risking the United States' wrath by
potentially being labeled a currency manipulator?

A Dollar deluge puts upward pressure on the exchange rate of the Rupee i.e., the Rupee would
appreciate against the US Dollar. Imports become cheaper while exports can become uncompetitive.
India, with the rare exception of the financial year 2020-21, has been running a perennial current
account deficit; in other words, our exports of goods and services and NRI remittances are not
sufficient to meet our import bill. Exports are critical for managing the current account. RBI,
therefore, may step in to curb excessive Rupee appreciation (which can make exports uncompetitive)
in the face of capital inflows.

RBI’s intervention in the FX markets

RBI’s exchange rate policy is termed managed float. Unlike the developed market currencies (the US
Dollar, Euro, Pound Sterling, Swiss Franc, etc.), which float freely with market conditions, RBI
intervenes in the Foreign Exchange (FX) markets to curb volatility and speculative activity. In the
scenario of excessive capital inflows, RBI purchases Dollars and sells Rupees.

Unintended Consequences on Domestic Liquidity

RBI’s intervention in the FX markets leads to unintended consequences. In buying foreign currency
assets (US Dollars), RBI unleashes an equivalent amount of Rupee liquidity into the system; when
purchasing Dollars, RBI credits banks with Rupees, increasing the money supply. Where does RBI get
the Rupees? It’s from thin air! Central banks not only print fiat currency, but they also create
electronic currency when paying for the purchase of foreign currency assets and domestic assets
(e.g., open market purchase operations of government securities). The former Chairman of the US
Federal Reserve Ben Bernanke acquired the nickname of “Helicopter Ben” for his allusion to the
central bank dropping money from a Helicopter!

Sterilization Operations

The Rupees infused into the system through RBI’s FX market intervention can be potentially
inflationary and cause short-term rates to fall below the policy repo rate. RBI has monetary policy
tools for neutralizing or “sterilizing” the excess domestic liquidity. It can conduct open market sale
operations of government securities. Such securities are purchased by banks and paid out of their
“excess reserves” i.e., balances maintained by banks with RBI, in excess of the reserve
requirement(CRR). Here the purchase consideration is debited to the banks’ current account
maintained with RBI, and the Rupees in the accounts of banks vanish into thin air. It moves out of the
system, thereby negating the rupee liquidity injected through RBI’s intervention in the FX market.

Table 1 below depicts the effect of RBI’s FX market intervention, both for purchase and sale of FX.
The first two rows are relevant for the scenario of FX purchase discussed in the above paragraphs.

Nature of Intervention Effect on Foreign Effect on Domestic Effect on Liquidity in

Currency Assets Assets (Government the Banking
(FX Reserves) Securities) System/Money Supply

Non-Sterilized FX Increases No Impact Increases

Intervention (Purchase)

Sterilized FX Increases Decreases No Impact

Intervention (Purchase)

Non-Sterilized FX Decreases No Impact Decreases

Intervention (Sale)

Sterilized FX Decreases Increases No Impact

Intervention (Sale)

(*Adapted from RBI's "Report on Currency and Finance")

MSS SCHEME

RBI has built up a war chest of about USD 600 billion of foreign currency assets through such
interventions in the FX market. Continuous open market sale operations of domestic government
securities to sterilize the consequent impact on Rupee liquidity can deplete RBI’s stock of such
securities. Therefore, the Market Stabilisation Scheme (MSS) was envisaged by which the Central
Government would provide RBI with adequate stock of government securities to undertake
sterilization activity. In paying for its investment in the securities, RBI credits a separate cash account
of the Government held with RBI.

RBI can use the securities under MSS (on its balance sheet) to mop up the excessive domestic
liquidity (arising from its FX market intervention) from banks. It is noteworthy that RBI does not
appear to have conducted sterilization operations in the Covid-19 era, perhaps to keep domestic
liquidity in surplus and mitigate the pandemic's impact on the economy.

• The XL sheet “FX market intervention” explains RBI’s intervention with the example of RBI’s
balance sheet.
RUPEE IN 2022

The discussion so far has centered around the scenario of RBI’s intervention in the FX market to curb
Rupee appreciation. In 2022, RBI faced a diametrically opposite scenario. Rupee depreciated sharply.

• The Indian Rupee (INR) came under pressure as crude oil prices surged and equities
witnessed record FPI outflows.

While this may be good news for exporters, Rupee depreciation increases the cost of imports and is
inflationary.

Therefore, RBI sold a significant amount of US Dollars from its FX reserves in 2022, buying Rupees in
the process, in order to defend the Rupee against depreciation ( in a FX transaction, when one
currency is sold, another currency is bought-FX trading happens in pairs ).

The last two rows in Table 1 above, are relevant for the scenario of FX sale, to defend the Rupee.

Summary of RBI’S ROLE AS MANAGER OF FOREIGN EXCHANGE

• Regulating transactions related to the external sector and facilitating the development of the
foreign exchange market

• Ensuring smooth conduct and orderly conditions in the domestic foreign exchange market

• Investing the country’s foreign exchange reserves built up by purchase of foreign currency from
the market, with the overarching objective of safety, liquidity and return in that order.

(This document has been adapted from Balachandran R’s article published in Artha, the e magazine of IIM Calcutta).

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