Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 External Sector Openness And Conduct Of Monetary Policy : The Indian Experience

Exchange Rate Management

As noted earlier, the day-to-day movements in exchange rates have been largely market-determined. The objective of exchange rate management has been to ensure that the external value of the rupee is realistic and credible as evidenced by a sustainable current account deficit and manageable foreign exchange situation. Subject to this predominant objective, the exchange rate policy is guided by the need to reduce excess volatility, prevent the emergence of destabilising speculative activities, help maintain adequate level of reserves, and develop an orderly foreign exchange market. However, the foreign exchange market in India, like other developing countries, is not yet very deep and broad and is characterised by uneven flow of demand and supply over different periods. The market is also characterised by a few major players and lumpy public sector demands particularly on account of payments of oil imports and servicing of public debt. This can lead to adverse expectations, which tend to be self-fulfilling in nature, given their effect on ''leads and lags'' in payments and receipts. Often, a self-sustaining triangle can develop comprising the supply-demand mismatch, increased inter-bank activity to take advantage, and accentuated volatility triggered by negative sentiments. In thin and underdeveloped markets dominated by a few leading operators, there is a natural tendency to do what everyone else is doing.

Given the large volume of capital flows and their sterilisation by the Reserve Bank, it would also be interesting to know the dynamics of the adjustment process through which shocks to exchange rate, net foreign assets and net domestic assets impinge upon each other. Following Moreno (1996), these dynamics can be examined in a vector autoregression (VAR) framework. Moreno (op cit.) undertook his analysis for Korea and Taiwan and found that sterilisation is an important element of the response to shocks to foreign assets, i.e., monetary authorities try to neutralise the effect of net foreign assets on base money. On the other hand, monetary authorities are ready to accept fluctuations in exchange rate and domestic money supply from changes in their domestic assets. This Box follows a similar methodology to examine the dynamics in the Indian context. A four-variable VAR is estimated over the period April 1994 to March 2004 using monthly data. The variables included were (in the following order):

1. exchange rate of the Indian rupee vis-à-vis the US dollar,

2. wholesale prices,

3. net foreign assets (NFA) of the Reserve Bank and

4. net domestic assets (NDA) of the Reserve Bank. As noted in Box IV.6 causality runs from NFA to NDA.

Accordingly, the ordering of NFA before NDA in the VAR can be considered appropriate. All the variables are in logarithmic form ⁶ and the VAR was estimated with a trend term. Monthly dummies were included as exogenous variables to account for seasonality.

Analysis of impulse responses is undertaken to study the dynamics. A positive shock to (i.e., an increase in) net foreign assets leads to an immediate policy response that tends to sterilise these capital flows. This is reflected in a decline in net domestic assets of the Reserve Bank. The OMO sales are able to almost fully offset the increase in net foreign assets. In contrast to a large increase in NFA, reserve money movements are fairly muted⁷. Reserve money shows a marginal increasing trend for the first six months after the shock and gradually returns to its baseline. As regards exchange rate, a shock to NFA has the expected effect. Exchange rate appreciates immediately after the shock and the peak appreciation occurs nearly a year after the initial shock. A positive shock to net domestic assets leads to a commensurate increase in reserve money. In subsequent months, net foreign assets decline and offset the increase in NDA. As a result, reserve money remains above the baseline for almost one year. Reflecting the expansionary effect of the base money, exchange rate depreciates with a lag of about six months. Depreciation reaches its peak around two years after the shock and the exchange rate stabilises at its new level. Finally, a positive shock to the exchange rate (i.e., a depreciation of the rupee) leads to a fall in net foreign assets of the Reserve Bank. The decline in NFA reflects market sales of foreign currency by the Reserve Bank consistent with its stated policy objective of meeting temporary demand-supply gaps in order to ensure orderly conditions in the foreign exchange market. In the process, the Reserve Bank acquires domestic securities against sales of foreign currency and this leads to an increase in net domestic assets. The impulse responses indicate that the increase in NDA more or less offsets the decline in NFA. As a result of almost complete sterilisation, the reserve money is broadly unchanged. Thus, in response to volatility in foreign exchange market, the Reserve Bank makes sales of foreign currency to ensure orderly correction while trying to insulate domestic monetary conditions.

Taken together, the empirical evidence suggests that the Reserve Bank was able to offset the expansionary effect of foreign capital flows on domestic money supply, consistent with its macroeconomic objectives. by a few major players and lumpy public sector demands particularly on account of payments of oil imports and servicing of public debt. This can lead to adverse expectations, which tend to be self-fulfilling in nature, given their effect on 'leads and lags' in payments and receipts. Often, a self-sustaining triangle can develop comprising the supply-demand mismatch, increased inter-bank activity to take advantage, and accentuated volatility triggered by negative sentiments. In thin and underdeveloped markets dominated by a few leading operators, there is a natural tendency to do what everyone else is doing in the event of any adverse development rather than taking a contra position (RBI, 2001). The consequent volatility that sets in may not be in tune with the fundamentals.

It is essential to recognise that the capacity of economic agents in developing economies, particularly poorer segments, to manage volatility in all prices, goods or foreign exchange is highly constrained and there is a legitimate role for non-volatility as a public good. After the liberalisation of the exchange rate regime in the mid-1990s, the Reserve Bank had, therefore, to chart its own course of exchange rate management, learning from the contemporary experiences. There is now a well-laid out policy response to sudden changes in capital flows so as to stabilise markets: on demand-side, including monetary tightening and changes in the cost of import finance as well as on supply-side, including the Reserve Bank's operations in the foreign exchange market and changes in the cost of delaying export proceeds. The Reserve Bank has been prepared to make sales and purchases of foreign currency in order to even out lumpy demand and supply in the relatively thin forex market and to smoothen jerky movements. However, such intervention is not governed by a predetermined target or band around the exchange rate.

The broad principles that have guided India after the Asian crisis of 1997 are:

1. careful monitoring and management of the exchange rate without a fixed or pre-announced target or a band;

2. flexibility in the exchange rate together with ability to intervene, if and when necessary;

3. a policy to build a higher level of foreign exchange reserves which takes into account not only anticipated current account deficits but also 'liquidity at risk' arising from unanticipated capital movements; and

4. a judicious management of the capital account.

India's exchange rate policy of focusing on managing volatility with no fixed rate target while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way has stood the test of time. As a result of these timely and coordinated measures, India was successful in containing the contagion effect of the Asian crisis. In addition, safeguards developed over a period of time also helped in limiting the contagion; these included: low current account deficit; comfortable foreign exchange reserves; low level of short-term debt; and absence of asset price inflation or credit boom. These positive features were the result of prudent policies pursued over the years notably, cap on external commercial borrowings with restrictions on end-use, low exposure of banks to real estate and stock market, insulation from large intermediation of overseas capital by the banking sector, close monitoring of off-balance sheet items and tight legislative, regulatory and prudential control over non-bank entities (RBI, 2004a). The Indian approach to exchange rate management has been described as ideal for Asia. The Indian experience highlights the need for emerging market economies to allow greater flexibility in exchange rates but the authorities should also have the capacity to intervene in foreign exchange markets in view of herding behaviour. A key lesson is that flexibility and pragmatism are required in the management of exchange rate in developing countries, rather than adherence to strict theoretical rules (RBI, 2004a).

A key part of the policy package, as noted earlier, is the use of monetary measures to ensure orderly conditions in the foreign exchange market. This Section briefly addresses the efficacy of such measures in influencing the exchange rate. According to the uncovered interest parity (UIP) condition, an increase in the domestic interest rate should be associated with a depreciation of the domestic currency to equalise returns on domestic and foreign assets. However, cross-country empirical evidence strongly rejects UIP. The failure of UIP provides a rationale for monetary measures to influence exchange rates in the short-run. Econometric evidence suggests that positive monetary policy shocks, inter alia, induce an appreciation of the domestic currency. In the Indian context, existing studies also indicate that monetary policy tightening measures have been successful in restoring orderly conditions in the foreign exchange market. Both these studies find that increase in interest rates has the expected effect of strengthening the exchange rate in the short-run; over time, however, the effect peters out, consistent with the theory.

These results are re-confirmed by analysis presented in Module 6. Impulse responses based on a 5-variable VAR - industrial production, wholesale price index, Bank Rate, broad money and exchange rate - show that interest rate increases temporarily in response to an exogenous positive exchange rate shock. Similarly, impulse responses indicate that exchange rate appreciates in response to a positive interest rate shock. The results, thus, suggest that monetary policy measures taken to ensure orderly conditions in the foreign exchange market have the desired impact.

In brief, in the face of sustained capital flows and, in the recent years, surpluses on the current account, the foreign exchange market has been characterised by excess supply conditions. Authorities in India have responded to these excess supplies through a multi-pronged approach. In the context of large forex inflows, an ongoing view is taken for operational purposes on:

1. the extent of forex market intervention and consequent build-up of reserves; and

2. whether to sterilise or not and if so, to what extent.

Operations involving sterilisation are undertaken in the context of a policy response which has to be viewed as a package encompassing exchange rate policy, level of reserves, interest rate policy along with considerations related to domestic liquidity, financial market conditions as a whole, and degree of openness of the economy. The policy response depends on several considerations involving trade-offs between the short term and the long term; judgement on whether capital flows are temporary or enduring; as well as on the operation of self-correcting mechanisms in the market and market responses in terms of sentiments. Whereas the distinction between short term and long term flows is conceptually clear, in practice, it is not always easy to distinguish between the two for operational purposes. Moreover, at any given time, some flows could be of an enduring nature whereas others could be short term and, hence, reversible. More important, what appears to be short-term, could tend to last longer and vice versa, imparting a dynamic dimension to judgment about their relative composition (RBI, 2003d). In a scenario of uncertainty facing the authorities in determining temporary or permanent nature of inflows, it is prudent to presume that such flows are temporary till such time that they are firmly established to be of a permanent nature (RBI, 2004c).

Notwithstanding the large scale capital inflows, sterilisation operations coupled with other measures to manage the capital account have been largely able to keep money supply in line with desired trajectory. Furthermore, in contrast to experiences and fears often expressed with sterilisation, interest rates in India softened over the period across the spectrum. Illustratively, the Bank Rate has halved from 12 per cent to six per cent between March 1997 and March 2004. The yields on Government of India securities (10-year paper) fell from 13.4 per cent to 5.2 per cent over the same period although these have increased somewhat in the subsequent months.

⁶As net domestic assets (NDA) have turned negative over the latter part of the sample, following Moreno (1996), these have been proxied by the difference between log of reserve money and log of net foreign assets.

⁷Although reserve money is not a part of the VAR, the response of reserve money to various shocks is computed as the sum of the responses of NDA and NFA to various shocks.