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What’s lost, what’s gained as RBI defends rupee

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As the US Federal Reserve fights decades-high inflation with higher interest rates, the rupee is depreciating against the dollar, prompting the Indian central bank to intervene in the forex markets to reduce volatility. Mint explains how RBI intervention works.

How does RBI intervene in markets?

With the country following a market-determined exchange rate system, the rupee’s exchange rate against other currencies is largely determined by market demand and supply. In order to maintain orderly conditions and curb excessive volatility of the exchange rate, the RBI intervenes in the foreign exchange market by buying or selling foreign currencies. The intervention could result in depletion of forex reserves and a fall in the import cover. With the RBI leaning towards taming of rupee depreciation, the country’s forex reserves have dropped to $545.65 billion as of 16 September 2022 as against $639.64 billion a year back.

What was the need for the intervention?

The US Federal Reserve has been raising interest rates to bring down inflation. Data for May, June and July 2022, show US inflation at 8.6%, 9.1% and 8.5% respectively. The US central bank has increased benchmark overnight interest rates to 3.00-3.25% to bring down inflation, with the latest increase of 75 basis points coming last week. This has resulted in foreign portfolio investment (FPI) outflows from India, weakening the rupee. Also, the Russia-Ukraine conflict has boosted crude oil prices and weakened the rupee. The RBI has been intervening in the market to counter rupee depreciation.

Taming volatility

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Taming volatility

What has been  the nature of RBI’s intervention in 2022?

The rupee has depreciated from 73.821 a year ago to 81.62 as of 22 September 2022. In the wake of the Russia-Ukraine war, the RBI in March 2022, sold foreign currency worth $20.1 billion. Expectations of the US Fed raising benchmark overnight interest rates, and the actual event, resulted in sale of foreign currency by the RBI in July 2022 of $19.05 billion.

What is the impact on the economy?

A weaker rupee increases costs of imports, leading to imported inflation or cost push inflation. RBI says a 5% depreciation could lead to inflation increasing by approximately 20 basis points. But for RBI’s intervention, the common man would have been paying more for cooking gas and petrol. Also, with major countries fearing recession, demand for Indian exports might be affected, and result in India’s current account deficit increasing to 3% of GDP in 2022 from 1.25% in the previous fiscal year.

What is the way out in the current scenario?

There is limited scope in avoiding the global consequences. Yet, FPI withdrawals can be minimized through reforms such as the bankruptcy regime in 2016. This would increase confidence among foreign investors in India’s economic fundamentals. Citizens can also play their part, reducing the demand for foreign exchange during periods of crisis, especially the demand for gold which constitutes the second largest commodity imported by India.

Jagadish Shettigar and Pooja Misra are faculty members at BIMTECH

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2022-09-25 18:26:18

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