What is Exchange Rate Management and Currency Intervention?
Historical Background
Key Points
9 points- 1.
The Reserve Bank of India (RBI) is the primary authority for exchange rate management in India.
- 2.
India follows a managed float exchange rate system, where the market largely determines the exchange rate, but the RBI intervenes to smooth out excessive fluctuations.
- 3.
Intervention involves selling foreign currency (e.g., US dollars) to prevent rupee depreciation by increasing dollar supply or buying foreign currency to prevent rupee appreciation by absorbing dollar supply.
- 4.
The primary objectives are to maintain exchange rate stability, curb imported inflation, maintain investor confidence, and ensure orderly conditions in the foreign exchange market.
- 5.
Currency intervention can impact domestic money supply and liquidity; the RBI often uses sterilization operations buying or selling government bonds to neutralize this impact.
- 6.
Factors influencing intervention decisions include the balance of payments position, inflation outlook, global economic conditions, and the level of foreign exchange reserves.
- 7.
Excessive or sustained intervention can lead to a significant depletion of foreign exchange reserves.
- 8.
The RBI's stated policy is to intervene only to address excessive volatility and not to target a specific exchange rate level.
- 9.
A stable exchange rate is crucial for India's import-dependent economy and for attracting Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
Visual Insights
RBI's Currency Intervention Mechanism to Counter Rupee Depreciation
This flowchart illustrates the step-by-step process of how the Reserve Bank of India intervenes in the foreign exchange market to manage rupee depreciation and maintain stability.
- 1.Global/Domestic Factors Cause Rupee Depreciation (e.g., Capital Outflows, Strong USD)
- 2.RBI Observes Excessive Volatility/Depreciation
- 3.RBI Decides to Intervene
- 4.RBI Sells US Dollars (from its Forex Reserves) in the Open Market
- 5.Increased Dollar Supply in Market
- 6.Rupee Value Stabilizes / Depreciation Slows Down
- 7.Impact on Domestic Liquidity (Dollar sale absorbs Rupee liquidity)
- 8.RBI Conducts Sterilization Operations (e.g., OMOs to manage liquidity)
- 9.Orderly Foreign Exchange Market Maintained
Exchange Rate Management: Objectives & Tools
This mind map provides a comprehensive overview of the objectives behind exchange rate management and the various tools employed by the RBI, including currency intervention, to achieve these goals.
Exchange Rate Management (RBI)
- ●Objectives
- ●Tools & Strategies
- ●Exchange Rate Regime
- ●Influencing Factors
Recent Developments
4 developmentsSignificant RBI intervention in 2022-23 to counter rupee depreciation against a strong US dollar, driven by aggressive US Fed rate hikes and capital outflows.
Global geopolitical events, commodity price volatility, and global interest rate differentials continue to necessitate active exchange rate management.
Debate on the effectiveness and cost of intervention, particularly concerning the impact on foreign exchange reserves.
RBI aims to build a strong buffer of reserves to withstand future external shocks.