Study of monetary policy vis-a-vis exchange rates related impact on exchange rate risks and forex markets

Abstract

“Monetary policy making has become a delicate balancing act between the imperatives of domestic economic, financial and monetary concerns and the evolving international situation that we have to observe closely on a real time basis and to take it as a given” –Rakesh Mohan, Deputy Governor, RBI Monetary Policy of an economy is the policy statement through which the Central bank of an economy seeks to ensure price stability amidst factors like money supply, interest rates, and inflation. In the Indian context, the post-liberalization era of 1991 onwards has seen a paradigm shift the operations of Reserve Bank of India (RBI)1 in the face of surges in capital flows, integration of India with world trade and finance, and hence the external sector of India. The aim of our study was: 1) To analyze the policy targets of RBI amidst the conflicting goals of price, interest rates, and exchange rates stabilization 2) To analyze the nature and efficacy of RBI’s intervention in the Forex markets and hence the movement of exchange rates 3) To perform a cost-benefit analysis of optimality of India’s burgeoning Forex reserves. In order to meet the challenges thrown by financial liberalization and the growing complexities of monetary management, the Reserve Bank switched from a monetary targeting framework to a multiple indicator approach from 1998-992. Short-term interest rates have emerged as the key indicators of the monetary policy stance. India’s current exchange rate policy has been focused on managing volatility without a fixed rate target. We feel that RBI is targeting a stable real effective exchange rate (REER), and is using interest rates as a policy tool to adjust these forces in the economy. The Balance of Payment analysis showed that there is also an increasing influence of capital flows in determining exchange rate movements as against trade deficits and economic growth in the earlier years. While this positively reflects the integration of India with global markets, the quality of the capital flows can be questioned considering the volatile Portfolio investments. RBI intervenes in the Forex markets through direct purchase/sale of dollars through sterilized intervention in its aim of avoiding volatility in rupee movements in either direction. Our study showed the pros/cons of this strategy and over the last 3-4 years, RBI hasn’t even gone for a complete sterilization. Moreover, the intervention of RBI in the Forex markets can be questioned as a circular effect which has not stabilized and it had to continuously intervene in the Forex markets. This poses questions on the stability of the underlying economy and its transmission mechanisms vis-à-vis increased capital flows. One of the direct effects of the exchange rate management has been the build up of India’s foreign exchange reserves which is now the sixth largest in the world. While there is no doubt about the economic importance of Forex reserves, especially for a developing economy like India, we have analyzed the optimality of India’s foreign exchange reserves. Our Analysis shows RBI is maintaining excess forex reserves irrespective of method taken for calculating optimal forex reserves level. There is a trade off in maintaining huge reserves. On the flip side there is maintenance cost incurred by RBI which is due to interest rate differentials between US and IND. But maintaining reserves help it in insulating external sector and Indian export competitiveness by intervening in forex markets as and when required. Also since most of the reserves are of portfolio nature, which are volatile therefore it also justifies current level of reserves. We also looked into alternate possibilities of utilizing India’s foreign reserves in infrastructure financing and domestic growth. The ultimate success of monetary policy could be judged in terms of inflation conditions and RBI’s ability to maintain stable conditions in the financial markets. The inflation record over the past five years is satisfactory as compared to other developing economies. The Reserve Bank has so far been able to balance its objectives of exchange rate and monetary policy objectives by choosing an intermediate exchange rate regime coupled with partial sterilized intervention.