For over two months now, India’s central bank has neither bought nor sold dollars from the currency markets. Instead it has let the dollar find its own level or value solely through the play of market forces.
The Reserve Bank of India intervenes in the foreign exchange market, depending on the level of the currency it is comfortable with. It sells dollars to prevent the rupee from weakening when demand exceeds supply and buys dollars whenever inflows are high.
Sometimes, to lessen the impact of such flows on domestic liquidity, the Reserve Bank also intervenes in the forward market, wherein there is no actual flow of currency because of the transaction. But in January, for which the data was released by the central bank last week, the RBI has not intervened even in the forward market.
The current stance of the central bank is intriguing mainly because the central bank is not buying dollars even though there have been inflows. One of the major source of dollar inflows is through the foreign portfolio investment route. Between December and now over $3 billion has been invested in the equities market. The central bank has not absorbed a single dollar and during this period, the rupee rose about 2 to 3%.
Economists covering other Asia Pacific emerging economies say that many central banks in Asia are not mopping up dollar inflows and letting their currencies appreciate.
A prime concern for the central bank these days is tackling high inflation. Though much of the inflation these days is on account of supply side factors, the central bank has a role in managing inflation expectations through its actions. By not intervening in the currency markets, the central bank to an extent helps containing inflation. For one, a strong domestic currency translates into cheaper imports, which in turn helps contain imported inflation (arising out of high prices of importables).
Also by not buying dollars, the central bank also tends to contain the growth in domestic liquidity. Whenever it buys dollars, it releases local currencies into the market. If these funds are in excess of what the system can absorb, then the central sells government bonds and mops up rupees- a process which is called sterilisation.
There are fiscal costs involved in such transactions because the government has to service the bonds and the interest pay-out ends up being higher than the return on the dollar investments which are made out of the forex reserves. The RBI may thus be achieving multiple policy objectives by simply not intervening in the currency markets.
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