RBI Report on Foreign Exchange Interventions

Foreign exchange intervention is a monetary policy tool that involves a central bank buying or selling foreign currency to influence the exchange rate of its own currency. It’s also known as currency intervention or currency manipulation. 

• How it works
  • The central bank uses its own reserves or authority to generate currency 
  • The central bank buys or sells foreign currency in the foreign exchange market 
  • The goal is to influence the exchange rate and trade policy 

• Why it’s done
  • To stabilize the exchange rate when the domestic currency appreciates or depreciates 
  • To influence the monetary funds transfer rate of the national currency 

• Other foreign exchange controls 
  • Restricting the amount of currency that can be imported or exported
  • Banning the use of foreign currency within the country
  • Banning locals from possessing foreign currency
  • Restricting currency exchange to government-approved exchangers
  • Setting fixed exchange rates

Key Findings of the Report

• Forex Interventions
  • Spot and forward interventions effectively reduce capital flow volatility.
• Threshold Effects
  • Moderate-scale interventions are more effective in reducing the volatility of exchange rates than large-scale interventions.
• Global Spillovers
  • The main driver of exchange rate volatility in India is portfolio flows triggered by global risk sentiment.

Implications for Exchange Rate Policy

• Foreign exchange interventions are an important tool to counterbalance volatility from international capital flows.
• Exchange rate policy should concentrate on smoothing volatility rather than regulating the level of exchange rates by means of large-scale interventions.

Effect on Indian Economy

• Historical evidence shows that exchange rate volatility has destabilized real economic activity in India.
• Gradual liberalization of India’s current and capital transactions has led to more exchange rate fluctuations.

Macroeconomic Policy Framework

• Inflation targeting strengthened India’s macroeconomic policy framework, where foreign exchange interventions were merged together to result in more stability for emerging market economies.