Overview
According to a Reserve Bank of India (RBI) assessment, foreign exchange interventions, such as spot and forward trades, are successful in reducing capital flow volatility, with symmetric effects from purchases and sales. Michael Debabrata Patra, Sunil Kumar, Joice John, and Amarendra Acharya are the authors of the report “Foreign Exchange Intervention: Efficacy and Trade-offs in the Indian Experience.” Patra served as the RBI’s deputy governor till January 14. The article’s authors’ opinions are their own and do not necessarily reflect those of the RBI. The identification of threshold effects in forex interventions was also mentioned in the paper.

Sand in the Wheels tactics to reduce exchange rate volatility
The report made it clear that attempts to “throw sand in the wheels” in order to lessen exchange rate volatility are more successful than extensive interventions meant to affect the level of the exchange rate. According to the paper, both spot and forward foreign exchange interventions successfully reduce the volatility of capital flows, with symmetric effects of purchases and sales. It is also found that forex interventions have threshold effects. It is more efficient to throw sand in the wheels to reduce exchange rate volatility than to use significant interventions to affect the level of exchange. It went on to say that this conclusion has significant ramifications for how exchange rate policy is implemented in nations like India.

Effects of Capital Flows and Forex Interventions
The study, which examined how well the RBI has intervened in the foreign exchange market, concluded that changes in portfolio flows brought on by global spillovers were the main cause of exchange rate volatility in India. Purchases and sells had symmetric impacts, and it was discovered that both spot and forward forex interventions successfully reduced capital flow volatility. Furthermore, threshold effects are suggested by the effect of gross spot interventions on exchange rate volatility, which is consistent with the “leaning against the wind” theory. The report’s empirical research shows that the Indian economy has gone through times of exchange rate volatility due to the growing liberalization of capital and current transactions. Real economic activity was destabilized as a result.

According to the analysis, swings in portfolio flows caused by risk-on-risk-off sentiments are the main cause of this volatility. Global spillovers have a greater impact than variations in inflation or interest rates. This conclusion has important ramifications for how exchange rate policies are developed and implemented in nations like India. The paper emphasized how the macroeconomic policy framework of emerging market economies (EMEs) has been considerably reinforced by combining inflation targeting with foreign exchange interventions. As a result, these interventions are now acknowledged as valid tools in the macroeconomic toolbox of EMEs.

RBI’s continuous interventions are at what cost?
Nonetheless, it is important to note that the nation’s foreign exchange reserves have suffered as a result of aggressive forex interventions. When the value of the rupee declines, the RBI sells dollars to support the rupee, which depletes the forex fund. As expected, figures released by the RBI on Friday indicated that India’s foreign exchange reserves had fallen for a sixth consecutive week and were at a 10-month low of $625.87 billion as of January 10. The reported week saw the largest drop in reserves in two months, down $8.72 billion. The reserves have decreased by $79 billion from their peak of $704.89 billion in late September and have dropped by a total of $23.5 billion during the last five weeks.

Both the appreciation or depreciation of foreign assets held in the reserves and the central bank’s activity in the forex market result in changes in foreign currency assets. The RBI steps in on both sides of the foreign exchange market to stop excessive rupee volatility. Weak capital flows and a rising U.S. dollar have been ongoing challenges for the euro in recent weeks. However, the rupee’s losses have been kept to a minimum by the central bank’s regular interventions through state-run banks.

According to a Reuters story this week, the RBI would use its foreign exchange reserves more sparingly in the future to reduce volatility in the domestic currency market in the face of significant global headwinds. The rupee experienced its eleventh straight weekly decline in the week of January 10, when it fell to its then-record low of 85.97. The currency experienced its biggest weekly decrease in 18 months last week, dropping 0.6% to close at 86.61 to the dollar on Friday. India’s reserve tranche stake in the International Monetary Fund is also included in the foreign exchange reserves.

Future of the Rupee
According to Madan Sabnavis, Chief Economist at Bank of Baroda, we may have recovered from a large portion of the Rupee’s depreciation versus the US currency. Sabnavis contends that a stronger dollar is mostly to blame for the pressure on the Rupee to depreciate.

However, Sabvanis contends that India’s solid fundamentals have restrained the rupee’s decline, with the domestic currency’s depreciation being less than that of other world currencies on both a spot rate and inflation-adjusted basis.