RBI Intervention in Foreign Exchange Market Submitted By: Avinash N Anuj Goyal Mr

Siddharth Sham Chandak Rajavageeshwaran

IntroductionThe Reserve Bank of India (RBI) is the nations central bank. Since 1935,
when it began itsoperations, it has stood at the centre of Indias financial system, with a
fundamental commitmentto maintaining the nations monetary and financial
stability.Main FunctionsMonetary Authority: Formulates, implements and monitors the
monetary policy. Objective: maintaining price stability and ensuring adequate flow of
credit to productive sectors.Regulator and supervisor of the financial system:
Prescribes broad parameters of banking operations within which the countrys banking
and financial system functions. Objective: maintain public confidence in the system,
protect depositors interest and provide cost-effective banking services to the
public.Manager of Foreign Exchange Manages the Foreign Exchange Management
Act, 1999. Objective: to facilitate external trade and payment and promote orderly
development and maintenance of foreign exchange market in India.Issuer of currency:
Issues and exchanges or destroys currency and coins not fit for circulation. Objective:
to give the public adequate quantity of supplies of currency notes and coins and in good
quality.Developmental role Performs a wide range of promotional functions to support
national objectives.Related Functions Banker to the Government: performs merchant
banking function for the central and the state governments; also acts as their banker.
Banker to banks: maintains banking accounts of all scheduled banks.

RBI as Manager of Foreign ExchangeWith the transition to a market-based system for

determining the external value of the Indianrupee, the foreign exchange market in India
gained importance in the early reform period. Inrecent years, with increasing integration
of the Indian economy with the global economy arisingfrom greater trade and capital
flows, the foreign exchange market has evolved as a key segmentof the Indian financial
market.ApproachThe Reserve Bank plays a key role in the regulation and development of
the foreign exchangemarket and assumes three broad roles relating to foreign exchange: v
regulating transactions related to the external sector and facilitating the development of
the foreign exchange market v Ensuring smooth conduct and orderly conditions in the
domestic foreign exchange market v Managing the foreign currency assets and gold
reserves of the countryToolsThe Reserve Bank is responsible for administration of the
Foreign Exchange ManagementAct,1999 and regulates the market by issuing licences to
banks and other select institutions to actas Authorised Dealers in foreign exchange. The
Foreign Exchange Department (FED) isresponsible for the regulation and development of
the market.On a given day, the foreign exchange rate reflects the demand for and supply
of foreignexchange arising from trade and capital transactions. The RBIs Financial
Markets Department(FMD) participates in the foreign exchange market by undertaking
sales / purchases of foreigncurrency to ease volatility in periods of excess demand
for/supply of foreign currency.The Department of External Investments and Operations
(DEIO) invests the countrys foreignexchange reserves built up by purchase of foreign
currency from the market. In investing itsforeign assets, the Reserve Bank is guided by
three principles: Safety, Liquidity and Return.

**** (The details of exactly how the intervention is carried out are not publicinformation.
However, the broad outlines are easy to discern by reading publicly-available
documents.)Evolution of Indian Foreign Exchange MarketThe evolution of Indias
foreign exchange market may be viewed in line with the shifts in Indiasexchange rate
policies over the last few decades. With the breakdown of the Bretton WoodsSystem in
1971 and the floatation of major currencies, the conduct of exchange rate policy poseda
serious challenge to all central banks world wide as currency fluctuations opened
uptremendous opportunities for market players to trade in currencies in a borderless
market. Inorder to overcome the weaknesses associated with a single currency peg and to
ensure stabilityof the exchange rate, the rupee, with effect from September 1975, was
pegged to a basket ofcurrencies. The impetus to trading in the foreign exchange market in
India since 1978 whenbanks in India were allowed to undertake intra-day trading in
foreign exchange. The exchangerate of the rupee was officially determined by the
Reserve Bank in terms of a weighted basket ofcurrencies of Indias major trading partners
and the exchange rate regime was characterised bydaily announcement by the Reserve
Bank of its buying and selling rates to the AuthorisedDealers (ADs) for undertaking
merchant transactions. The spread between the buying and theselling rates was 0.5
percent and the market began to trade actively within this range and theforeign exchange
market in India till the early 1990s,remained highly regulated with restrictionson external
transactions, barriers to entry, low liquidity and high transaction costs. The exchangerate
during this period was managed mainly for facilitating Indias imports and the strict
controlon foreign exchange transactions through the Foreign Exchange Regulations Act
(FERA) hadresulted in one of the largest and most efficient parallel markets for foreign
exchange in theworldAs a stabilisation measure, a two step downward exchange rate
adjustment in July 1991effectively brought to close the regime of a pegged exchange rate.
Following therecommendations of Rangarajans High Level Committee on Balance of
Payments, to movetowards the market-determined exchange rate, the Liberalised
Exchange Rate ManagementSystem (LERMS) was introduced in March 1992, was
essentially a transitional mechanism and adownward adjustment in the official exchange
rate and ultimate convergence of the dual rates

was made effective and a market-determined exchange rate regime was replaced by a
unifiedexchange rate system in March 1993, whereby all foreign exchange receipts could
be convertedat market determined exchange rates. On unification of the exchange rates,
the nominal exchangerate of the rupee against both the US dollar as also against a basket
of currencies got adjustedlower. Thus, the unification of the exchange rate of the Indian
rupee was an important steptowards current account convertibility, which was finally
achieved in August 1994, when Indiaaccepted obligations under Article VIII of the
Articles of Agreement of the IMF.With the rupee becoming fully convertible on all
current account transactions, the risk bearingcapacity of banks increased and foreign
exchange trading volumes started rising. This wassupplemented by wide-ranging reforms
undertaken by the Reserve Bank in conjunction with theGovernment to remove market
distortions and deepen the foreign exchange market. Severalinitiatives aimed at
dismantling controls and providing an enabling environment to all entitiesengaged in
foreign exchange transactions have been undertaken since the mid-1990s.The focushas
been on developing the institutional framework and increasing the instruments for

effectivefunctioning, enhancing transparency and liberalising the conduct of foreign

exchange business soas to move away from micro management of foreign exchange
transactions to macromanagement of foreign exchange flows. Along with these specific
measures aimed at developingthe foreign exchange market, measures towards liberalising
the capital account were alsoimplemented during the last decade. Thus, various reform
measures since the early1990s havehad a profound effect on the market structure, depth,
liquidity and efficiency of the Indianforeign exchange market.Sources of Supply and
DemandThe major sources of supply of foreign exchange in the Indian foreign exchange
market arereceipts on account of exports and invisibles in the current account and inflows
in the capitalaccount such as foreign direct investment (FDI), portfolio investment,
external commercialborrowings (ECB) and non-resident deposits. On the other hand, the
demand for foreignexchange emanates from imports and invisible payments in the
current account, amortisation of ECB(including short-term trade credits) and external aid,
redemption of NRI deposits and out flows onaccount of direct and portfolio investment.
In India, the Government has no foreign currency

account, and thus the external aid received by the Government comes directly to the
reserves and theReserve Bank releases the required rupee funds. Hence, this particular
source of supply of foreignexchange is not routed through the market and as such does
not impact the exchange rate. During lastfive years, sources of supply and demand have
changed significantly, with large transactionsemanating from the capital account, unlike
in the 1980s and the 1990s when current accounttransactions dominated the foreign
exchange market. The behaviour as well as the incentive structureof the participants who
use the market for current account transactions differs significantly fromthose who use
the foreign exchange market for capital account transactions. Besides, the change inthese
traditional determinants has also reflected itself in enhanced volatility in currency
markets. Itnow appears that expectations and even momentary reactions to the news are
often more important indetermining fluctuations in capital flows and hence it serves to
amplify exchange rate volatility(Mohan, 2006a). On many occasions, the pressure on
exchange rate through increase in demandemanates from expectations based on certain
news. Sometimes, such expectations are destabilisingand often give rise to self-fulfilling
speculative activities. The role of the Reserve Bank comes intofocus when it has to
prevent the emergence of destabilising expectations and recourse is undertakenin such
ocassions to direct purchase and sale of foreign currencies, sterilisation through open
marketoperations, management of liquidity under liquidity adjustment facility (LAF),
changes in reserverequirements and signaling through interest rate changes. In the last
few years the demand/supplysituation is affected by hedging activities through various
instruments that have been made availableto market participants to hedge their risks

Indias Foreign Exchange Reserves INDIAS FOREIGN EXCHANGE RESERVES End

Foreign Exchange Reserves (` billion) Foreign Exchange Reserves (US $ million) Total
Movement of SDRs Gold Foreign Reserve Total SDRs Gold Foreign Reserve Total
Foreign in ForeignMonth # Currency Tranche (2+3+ # Currency Tranche (7+8+
Exchange Exchange Assets Position 4+5) Assets Position 9+10) Reserves Reserves in
IMF in IMF (in SDR (in SDR million) million)* 1 2 3 4 5 6 7 8 9 10 11 12 13Mar-01
0.11 127 1845 29 2001 2 2,725 39,554 616 42,897 34,034 5,306Mar-02 0.50 149 2491 30

2670 10 3,047 51,049 610 54,716 43,876 9,842Mar-03 0.19 168 3415 32 3615 4 3,534
71,890 672 76,100 55,394 11,518Mar-04 0.10 182 4662 57 4901 2 4,198 1,07,448 1,311
1,12,959 76,298 20,904Mar-05 0.20 197 5931 63 6191 5 4,500 1,35,571 1,438 1,41,514
93,666 17,368Mar-06 0.12 257 6473 34 6764 3 5,755 1,45,108 756 1,51,622 1,05,231
11,565Mar-07 0.08 296 8366 20 8682 2 6,784 1,91,924 469 1,99,179 1,31,890
26,659Mar-08 0.74 401 11960 17 12380 18 10,039 2,99,230 436 3,09,723 1,88,339
56,449Mar-09 0.06 488 12301 50 12839 1 9,577 2,41,426 981 2,51,985 1,68,544
-19,795Mar-10 226 812 11497 62 12597 5,006 17,986 2,54,685 1,380 2,79,057 1,83,803
15,259Mar-11 204 1026 12249 132 13610 4,569 22,972 2,74,330 2,947 3,04,818
1,92,254 8,451Mar-12 229 1383 13305 145 15061 4,469 27,023 2,60,069 2,836 2,94,397
1,90,045 -2,209 : Negligible.# : Gold has been valued close to international market
price.* : Variations over the previous March.Note : 1. Gold holdings include acquisition
of gold worth US$ 191 million from the Government during 1991-92, US$ 29.4 million
during1992-93, US$ 139.3 million during 1993-94, US$ 315.0 million during 1994-95
and US$ 17.9 million during 1995-96. On the otherhand, 1.27 tonnes of gold amounting
to `435.5 million (US$11.97 million), 38.9 tonnes of gold amounting to `14.85 billion
(US$ 376.0million) and 0.06 tonnes of gold amounting to `21.3 million (US$ 0.5 million)
were repurchased by the Central Government onNovember 13, 1997, April 1, 1998 and
October 5, 1998 respectively for meeting its redemption obligation under the Gold
BondScheme.2. Conversion of foreign currency assets into US dollar was done at
exchange rates supplied by the IMF up to March 1999. EffectiveApril 1, 1999, the
conversion is at New York closing exchange rate.3. Foreign currency assets excludes US$
250.00 million (as also its equivalent in Indian Rupee) invested in foreign
currencydenominated bonds issued by IIFC (UK) since March 20, 2009, excludes US$
380.00 million since September 16, 2011, US$ 550.00million since February 27, 2012
and US$ 673.00 million since 30th March 2012.

A Sketch of the ProblemLet me begin by outlining, in purely intuitive terms, what the
problem is. Suppose there are twocurrencies, the domestic one, henceforth, rupees, and
the foreign one, dollars. Let the demandcurve for dollars be described by the line AB in
Figure 1 and the supply curve by the upwardsloping line. If this were a competitive
market the equilibrium exchange rate or, equivalently, theprice of dollars would be p*, as
shown.Now suppose, for whatever reason, the central bank wants to devalue the currency
to theexchange rate p**. 6 If this is to be done not by law or diktat but by market
intervention, anatural way to achieve this is for the central bank to demand CD dollars.
This quantityintervention would push the demand curve out to AB and raise the price
of dollars to p**.

This, in a nutshell, is what Indias RBI and legions of central banks in developing
countries do.Note that in the process the central bank would end up acquiring CD dollars
and releasing CDmultiplied by p** rupees onto the market, thereby raising tricky
questions of inflationarypressures and the need to sterilize. That this is a natural way of
thinking about how to influenceexchange rates is clear from textbook descriptions of
what central banks do under managed ordirty float. [The method whereby] the central
banks step in and buy and sell currencies toprevent them from falling or rising in value
beyond predetermined limits have also been used.In a competitive market of this kind,

there is no advantage to an intervention where the extent ofdemand for dollars is made
contingent on the price. As long as the new demand curve goesthrough point D the net
effect is the same. If, for instance, the central bank decides to buy lessdollars if the price
is low so that the new aggregate demand curve is given by the broken line inFigure 1,
which goes through D, the final equilibrium is still at price p** and the amount ofdollars
acquired by the central bank is still CD.At first sight this seems natural enough. If the
demand for dollars is the same at the equilibriumprice, in this case p**, then the fact that
demand would be different at out-of-equilibrium pricescan surely not influence the
equilibrium price. This logic, however, is true only for purelycompetitive markets.

Foreign Exchange InterventionIn the post-Asian crisis period, particularly after 2002-03,
capital flows into India surged creatingspace for speculation on Indian rupee. The
Reserve Bank intervened actively in the forex marketto reduce the volatility in the
market. During this period, the Reserve Bank made directinterventions in the market
through purchases and sales of the US Dollars in the forex marketand sterilised its impact
on monetary base. The Reserve Bank has been intervening to curbvolatility arising due to
demand-supply mismatch in the domestic foreign exchange marketSales in the foreign
exchange market are generally guided by excess demand conditions that mayarise due to
several factors. Similarly, the Reserve Bank purchases dollars from the market whenthere
is an excess supply pressure in market due to capital inflows. Demand-supply
mismatchproxied by the difference between the purchase and sale transactions in the
merchant segment ofthe spot market reveals a strong co-movement between demandsupply gap and intervention bythe Reserve Bank . Thus, the Reserve Bank has been
prepared to make sales and purchases offoreign currency in order to even out lumpy
demand and supply in the relatively thin foreignexchange market

and to smoothen jerky movements. However, such intervention is generally not governed
by anypredetermined target or band around the exchange rate (Jalan, 1999).The volatility
of Indian rupee remained low against the US dollarthan against other majorcurrencies as
the Reserve Bank intervened mostly through purchases/sales of the US dollar.Empirical
evidence in the Indian case has generally suggested that in the present day managedfloat
regime of India, intervention has served as a potent instrument in containing the
magnitudeof exchange rate volatility of the rupee and the intervention operations do not
influence as muchthe level of rupeeThe intervention of the Reserve Bank in order to
neutralise the impact of excess foreignexchange inflows enhanced the RBIs Foreign
Currency Assets (FCA) continuously. In order tooffset the effect of increase in FCA on
monetary base, the Reserve Bank had mopped up theexcess liquidity from the system
through open market operation (Chart 2.3). It is, however,pertinent to note that Reserve
Banks intervention in the foreign exchange market has beenrelatively small in terms of
volume (less than 1 per cent during last few years), except during2008-09. The Reserve
Banks gross market intervention as a per cent of turnover in the foreignexchange market
was the highest in 2003-04 though in absolute terms the highest interventionwas US$ 84
billion in 2008-09 (Table 2.3). During October 2008 alone, when the contagion ofthe
global financial crisis started affecting India, the RBI sold US$ 20.6 billion in the
foreignexchange market. This was the highest intervention till date during any particular
month.

Trends in Exchange RateA look at the entire period since 1993 when we moved towards
market determined exchangerates reveals that the Indian Rupee has generally depreciated
against the dollar during the last 15years except during the period 2003 to 2005 and
during 2007-08 when the rupee had appreciatedon account of dollars global weakness
and large capital inflows . For the period as a whole,1993-94 to 2007-08, the Indian
Rupee

has depreciated against the dollar. The rupee has also depreciated against other
majorinternational currencies. Another important feature has been the reduction in the
volatility of theIndian exchange rate during last few years. Among all currencies
worldwide, which are not on anominal peg, and certainly among all emerging market
economies, the volatility of the rupee-dollar rate has remained low. Moreover, the rupee
in real terms generally witnessed stability overthe years despite volatility in capital flows
and trade flows

The various episodes of volatility of exchange rate of the rupee have been managed in a
flexibleand pragmatic manner. In line with the exchange rate policy, it has also been
observed that theIndian rupee is moving along with the economic fundamentals in the
post-reform period.Thus, ascan be observed maintaining orderly market conditions have
been the central theme of RBIsexchange rate policy. Despite several unexpected external
and domestic developments, Indiasexchange rate performance is considered to be
satisfactory. The Reserve Bank has generallyreacted promptly and swiftly to exchange
market pressuresthrough a combination of monetary, regulatory measures along with
direct and indirectinterventions and has preferred to withdraw from the market as soon as
orderly conditions arerestored.Moving forward, as India progresses towards full capital
account convertibility and gets moreand more integrated with the rest of the world,
managing periods of volatility is bound to posegreater challenges in view of the
impossible trinity of independent monetary policy, open capitalaccount and exchange rate
management. Preserving stability in the market would require more

flexibility, adaptability and innovations with regard to the strategy for liquidity
management aswell as exchange rate management. Also, with the likely turnover in the
foreign exchange marketrising in future, further development of the foreign exchange
market will be crucial to managethe associated risks.Current Rupee Market
StructureWhile analysing the exchange rate behaviour, it is also important to have a look
at the marketmicro structure where the Indian rupee is traded. As in case of any other
market, trading inIndian foreign exchange market involves some participants, a trading
platform and a range ofinstruments for trading. Against this backdrop, the current market
set up is given below.Market Segments and PlayersThe Indian foreign exchange market
is a decentralised multiple dealership market comprisingtwo segments the spot and the
derivatives market. In a spot transaction, currencies are traded atthe prevailing rates and
the settlement or value date is two business days ahead. The two-dayperiod gives
adequate time for the parties to send instructions to debit and credit the appropriatebank
accounts at home and abroad. The derivatives market encompasses forwards, swaps,
andoptions. As in case of other Emerging Market Economies (EMEs), the spot market
remains animportant segment of the Indian foreign exchange market.With the Indian

economy gettingexposed to risks arising out of changes in exchange rates, the derivative
segment of the foreignexchange market has also strengthened and the activity in this
segment is gradually rising.Players in the Indian market include (a) Authorised Dealers
(ADs),mostly banks who areauthorised to deal in foreign exchange , (b) foreign exchange
brokers who act as intermediariesbetween counterparties, matching buying and selling
orders and (c) customers individuals,corporate, who need foreign exchange for trade
and investment purposes. Though customers area major player in the foreign exchange
market, for all practical purposes they depend upon ADsand brokers. In the spot foreign
exchange market, foreign exchange transactions were earlierdominated by brokers, but
the situation has changed with evolving market conditions as now thetransactions are
dominated by ADs. The brokers continue to dominate the derivatives market.

The Reserve Bank like other central banks is a market participant who uses foreign
exchange tomanage reserves and intervenes to ensure orderly market conditions.The
customer segment of the spot market in India essentially reflects the transactions reported
inthe balance of payments both current and capital account. During the decade of the
1980s and1990s, current account transactions such as exports, imports, invisible receipts
and paymentswere the major sources of supply and demand in the foreign exchange
market.Over the last fiveyears, however, the daily supply and demand in the foreign
exchange market is beingincreasingly determined by transactions in the capital account
such as foreign direct investment(FDI) to India and by India, inflows and outflows of
portfolio investment, external commercialborrowings (ECB) and its amortisations, nonresident deposit inflows and redemptions.It needs to be observed that in India, with the
government having no foreign currency account,the external aid received by the
Government comes directly to the reserves and the RBI releasesthe required rupee funds.
Hence, this particular source of supply of foreign exchange e.g.external aid does not go
into the market and to that extent does not reflect itself in the truedetermination of the
value of the rupee.The foreign exchange market in India today is equipped with several
derivative instruments.Various informal forms of derivatives contracts have existed since
time immemorial though theformal introduction of a variety of instruments in the foreign
exchange derivatives market startedonly in the post reform period, especially since the
mid-1990s. These derivative instruments havebeen cautiously introduced as part of the
reforms in a phased manner, both for product diversityand more importantly as a risk
management tool. Recognising the relatively nascent stage of theforeign exchange market
then with the lack of capabilities tohandle massive speculation, the underlying exposure
criteria had been imposed as aprerequisite.

Foreign Exchange Market TurnoverThe depth and size of foreign exchange market is
gauged generally through the turnover in themarket. Foreign exchange turnover considers
all the transactions related to foreign currency, i.e.purchases, sales, booking and
cancelation of foreign currency or related products. Forex turnoveror trading volume,
which is also an indicator of liquidity in the market, helps in price discovery.In the
literature, it is held that the foreign exchange market turnover may convey
importantprivate information about market clearing prices, thus, it could act as a key
variable whilemaking informed judgment about the future exchange rates.Trading
volumes in the Indianforeign exchange market has grown significantly over the last few

years. The daily averageturnover has seen almost a ten-fold rise during the 10 year period
from 1997-98 to 2007- 08from US $ 5 billion to US $ 48 billion (Table 3.1). The pickup
has been particularly sharp from2003-04 onwards since when there was a massive surge
in capital inflows.It is noteworthy that the increase in foreign exchange market turnover
in India between April2004 and April 2007 was the highest amongst the 54 countries
covered in the latest TriennialCentral Bank Survey of Foreign Exchange and Derivatives
Market Activity conducted by theBank for International Settlements (BIS). According to
the survey, daily average turnover inIndia jumped almost 5-fold from US $ 7 billion in
April 2004 to US $ 34 billion in April 2007;global turnover over the same period rose by
only 66 per cent from US $ 2.4 trillion to US $ 4.0

trillion. Reflecting these trends, the share of India in global foreign exchange market
turnovertrebled from 0.3 per cent in April 2004 to 0.9 per cent in April 2007.Looking at
some of the comparable indicators, the turnover in the foreign exchange market hasbeen
an average of 7.6 times higher than the size of Indias balance of payments during last
fiveyears.With the deepening of foreign exchange market and increased turnover,ncome
ofcommercial banks through treasury operations has increased considerablyA look at the
segments in the Indian foreign exchange market reveals that the spot marketremains the
most important foreign exchange market segment accounting for about 50 per centof the
total turnover However, its share has seen a marginal decline in the recent past mainly
dueto a pick up in turnover in derivative segment. The merchant segment of the spot
market isgenerally dominated by the Government ofIndia, select public sector units, such
as Indian OilCorporation (IOC), and the FIIs. As the foreign exchange demand on
account of public sectorunits and FIIs tends to be lumpy and uneven, resultant demandsupply mismatches entailoccasional pressures on the foreign exchange market,warranting
market interventions by theReserve Bank to even out lumpy demand and supply.
However, as noted earlier, such

intervention is not governed by a predetermined target or band around the exchange

rate.Further,the inter-bank to merchant turnover ratio has almost halved from 5.2 during
1997-98 to 2.8during 2008-09 reflecting the growing participation in the merchant
segment of the foreignexchange market associated with growing trade activity, better
corporate performance andincreased liberalisation. Mumbai alone accounts for almost 80
per cent of the foreign exchangeturnover.The MethodologyIn the tradition of the asset
market approach to exchange rate determination, the exchange rate isviewed as the
relative price of national monies, determined by the relative supplies in relation
todemand. Thus, while the demand for exports may be formed by a host of underlying
real factors,the timing and magnitude of export proceeds flowing into the foreign
exchange market respondsto interest rate differentials, exchange rate expectations and
exchange market conditions, bothspot and forward, with little to do with the real factors
that caused the export shipment.Similarly, the decision to contract external commercial
borrowing may have been provoked byreal developments such as the need for capacity
expansion, but the timing of bringing in thefunds would depend on interest rate
differentials and their movements vis-a-vis the forwardpremia, current and expected
exchange rates and the like. In any economy, irrespective of thewedges between segments

of the financial market spectrum created by exchange controls andother barriers, market
agents hold a portfolio comprising, inter alia, stocks of domestic and

foreign monies. Given the relative rates of return and the degree of substitutibility
beweendomestic and foreign assets, they strive to achieve portfolio balance. In the face of
a exogenous,domestic monetary shock embodied in an excess supply of money, market
agents would reducedomestic money balances and seek to acquire foreign money
balances. In a freely floatingexchange rate regime, the price of the domestic money
would fall i.e., domestic interest rateswould decline and the exchange rate would
depreciate. Given the relationship between money,interest rates and exchange rates, the
decline in interest rates and exchange rates would cause thedemand for domestic money
balances to rise until monetary equilibrium is restored.On the other hand, in a fixed
exchange rate regime, domestic money balances would beexchanged for foreign goods,
services, financial assets and money balances until portfoliobalance is restored through
the monetary authority meeting the resultant increase in demand forforeign money by
losing reserves until monetary balance is restored. In the intermediate forms ofexchange
rate regimes that characterise the real world, a combination of the effects describedobtain.
Monetary authorities may, in pursuit of a longer term strategy, seek to contest these
shortrun market outcomes. By signaling their stance through various direct policy
instrumentsreflected in changes in the domestic component of base money and in foreign
exchange reservesand through indirect instruments such as changes in strategic interest
rates, monetary authoritiesmay attempt to induce shifts in the demand for and supply of
domestic and foreign moneybalances, and thereby change or even reinforce the market
view on the monetary conditions.The model developed here draws heavily upon
Weymark while taking into account the specificfeatures of the Indian economy. It is
drawn up under the assumptions that the demand for moneyis fairly stable, the emerging
role of interest rates as an argument in the money demandfunction-interest rates too seem
to exercise some influence on the decisions to hold money- theimportance of the
exchange rate objective of monetary policy in the context of the emerginglinkages
between money, foreign exchange and capital markets and a loose form of
purchasingpower parity which links domestic prices to foreign prices in a probabilistic
form for aneconomy with a growing degree of openness (supported by the use of the
REER as aninformation variable for exchange rate policy). The construction of the model
draws inspirationfrom the underscoring of the need for a multiple indicator approach and
the perceived utility of a

Monetary Conditions Index in a regime where targeting rate variables assumes

importanceThe model is set out as follows :(1) Mdt = a0 + a1*Pt + a2*Yt - a3*It + ut(2)
Pt = b0 + b1*Pt^+ b2*Et(3) It = It^+ E*(Et+1 -Et)(4) Mst = Ms(t-1) + h(DNDA +
DNFA)(5) DNFA = -ut *(DEt)where,Mdt = Demand for money;Pt = Index of wholesale
prices (domestic);Yt = Income/output, proxied by industrial production;It = Nominal
interest rate represented by the call money rate, monthly averages;Et = Nominal
exchange rate expressed in multilateral form i.e., nominal effectiveexchange rate (NEER)
of the rupee, 36 country bilateral weights;Ft = Forward exchange rate;Mst = Supply of
money;NDA = Net domestic assets;NFA = Net foreign assets;^ = Respective variables for
rest of the world;u = Policy authorities response coefficient;h = money multiplier;D =

changes in stocks or relevant variables;Equation (1) is the conventional money demand

function employed in India augmented toinclude the interest rate as an argument
signifying the opportunity cost of holding money. Outputrepresented by indices of
industrial production in the absence of monthly data on GDP isassumed to be exogenous.
Equation (2) represents the version of the functional relationshipbetween domestic prices
and foreign prices considered in this model: domestic prices aressumed to be responsive
to foreign prices in a functional form but purchasing power parity as a

rule is not imposed. Equation (2) essentially allows for the estimation of the exchange
rateimpact on domestic prices. Equation (3) is the uncovered interest rate parity (UCIP)
conditionwhich is set out as an underlying assumption relating to the substitutibility
between domestic andforeign assets rather than a relationship proposed for empirical
testing. It is presented as a part ofthe model specification to allow the model to be
identified. Equation (4) describes the standardmoney supply formation process under the
money multiplier approach, implying that anyincrease in nominal money stock could be
on account of the last periods money stock plus theincrease in net domestic assets and net
foreign assets of the monetary authority accruing to thecurrent periods money stock
through the money multiplier. Under the assumption that themoney market clears
continuously, the equilibrium condition would be reflected in the identityMs = Md.
Equation (5) represents the reaction function of the authorities. Under a freely
floatingexchange rate, the value of ut = 0.The monetary authority does not intervene in
the exchange market and hence there is no changein NFA and money supply. When the
authorities, on the contrary, peg the exchange rate at aparticular level (i.e. ut = ), there is
unlimited intervention and hence proportionate changes inNFA and money supply. (Here,
the general assumption is that the authorities intervene only bychanging NFA and not by
changing NDA; as Weymark (op.cit) has shown, compensatingvariations in NDA due to
sterilisation do not affect the monetary equilibrium condition.Furthermore, in India,
variations in domestic credit are not systematically used to influence theexchange rate of
the rupee). The value of ut in equation (5) thus gives an idea about the degree towhich
exchange rate is managed. ut can assume negative values when interventions are
usedaggressively to obtain an exchange rate change which is contrary to or significantly
larger thanmarket expectations.Following Weymark, the EMP can be derived asEMPt =
DEt + n DNFA where n = - 1/ [ b2+ a3]and IIA asIIAt = n DNFA / EMPtThe calculation
of EMP and IIA thus hinges critically upon the calculation of the elasticity nwhich, in
turn, depends upon estimates of the parameters b2 and a3 i.e., the coefficient of
theexchange rate as a determinant of the domestic price level and the interest elasticity of
the

demand for money respectively. These parameters can be obtained be estimating

Equations (1)and (2) of the model.EMP measures the excess demand/supply for/of
foreign exchange associated with the exchangerate policy. It does not measure the actual
exchange rate change warranted by conditions ofdemand and supply but instead the
degree of external imbalance and the presence/absence ofspeculative activity. The critical
indicator in the EMP is its sign. Negative values indicatedownward pressures on the
exchange rate while positive values reflect upward pressures whichholds irrespective of
the choice of the exchange rate regime. The IIA has a range from - to + .Under a freely

floating regime, IIA = 0 and under a fixed exchange rate regime, IIA = 1.
Underintermediate regimes IIA assumes values between 0 and 1. When the monetary
authority leanswith the wind, i.e., amplifies the exchange rate pressures generated by the
market, the IIAassumes values greater than 1. On the other hand, when the monetary
authority contests themarket view, the IIA is less than one.The Monetary Conditions
Index (MCI) which has come to be employed as an operating target ormore generally, as
an indicator of monetary conditions in countries forced to move away from amonetary
aggregates approach by the pace of financial innovations, can easily be seen to be amore
readily computable version of the EMP. It is a weighted aggregate of the exchange rate
andinterest rate channels of monetary policy, providing leading information about the
monetaryconditions since money stock variations impact upon the exchange rate and
interest rate with amuch reduced lag than upon prices and output. The manner in which
monetary policy should beadjusted to offset the deviation of monetary conditions from
the desired levels is addressedthrough targeting the weighted monetary conditions index
within a band, the band limits beingenforced by, or by the threat of, monetary policy
action. The weights assigned to the exchangerate and interest rate generally depend upon
their relative influence on output and prices and areusually derived by estimating a
money demand function in which the exchange rate and theinterest rate are present as
explanatory variables. Adjusting money stock to align the MCI with adesirable level
would constitute the appropriate stance of policy.

The EMP would indicate the extent of exchange market pressure on account of
monetarydisequilibria while MCI would directly show the monetary conditions
prevailing at any point oftime in relation to some base level monetary condition and
thereby help the authorities indeciding the degree and timing of monetary policy changes
that may be necessary to keep theEMP within manageable limits. A decline in the MCI
indicates tightening of monetaryconditions whereas an increase in the index reflects
easing.In this paper a standard MCI has been constructed representing a linear
combination of theinterest rate and exchange rate as follows :MCI = a* (It - Ib) + b* (Et Eb)It and Et represent interest rate and exchange rate at time t and Ib and Eb represent
interest rateand exchange rate as at some point which could be considered as equilibrium
(and hence baseperiod E and I). a and b represent the weights which are decided on the
basis of the respectiveinfluence of interest rate and exchange rate on the goal
variable.Estimation of EMP, IIA and the MCI for IndiaThe data used are as follows:
Month-end nominal money stock (M3), monthly indices ofwholesale price indices (WPI)
as representative of domestic price movements, monthly indicesof industrial production
(IIP) as the proxy for scale of economic activities in the absence ofmonthly data on
national income, nominal effective exchange rate (NEER) indices to reflect themovement
in the exchange value of the rupee vis-a-vis 36 major trading partners of India,monthly
average of inter-bank call money rates (CMR) as representative of the opportunity costof
money, and the weighted average of domestic CPIs of 36 major trading partners of
India(WOPI) to reflect the movement of international prices. For countries which do not
publish dataon intervention purchases and sales, changes in the levels of foreign
exchange assets areconsidered for empirical analysis. In the case of India, however,
monthly data on interventionpurchases and sales are published regularly by the RBI since

June 1995 and for the purpose ofestimating and comparing the estimates, both change in
reserve levels and net interventionpurchases/sales data have been considered.

All the equations for the basic model were estimated in log-linear form. Before
estimating thecoefficients of the two elevant equations for EMP and IIA, the stationarity
properties of thevariables were checked by using the Dickey-Fuller (DF) and the
Augmented Dickey-Fuller(ADF) tests.All the variables considered for estimating the two
equations turned out be integrated of orderone, [i.e. I(1)], indicating that some linear
combination of these variables may represent a longrun equilibrium relationship. (For the
DF and ADF test statistics ). In order to establish the longrun relationship among
variables in the money demand and PPP equations, Johansen and Juselius(JJ) type of
maximum likelihood tests of multiple co integration were conducted for the sampleperiod
April 1990 to March 1998. The eigen values and trace statistics for both money
demandand PPP relationships indicate the presence of two co integrated vectors as
reported below.Money demand function(1) LM3 = 4.04 + 0.80 LWPI + 1.00 LIIP - 0.17
LCMRPurchasing power parity relationship(2) LWPI = -9.04 + 3.43 LWOPI - 0.51
LNEERThe DF and ADF tests for errors indicate the errors to bestationary.DF and ADF
tests for errors. Without trend With trend DF ADF DF ADFResiduals of -5.71 -5.33 -5.77
-5.39MoneyDemandRelationshipResiduals of -2.15 -3.71 -2.90
-4.03PPPrelationshipRelevant coefficients from the above relationships are used to
estimate the exchangemarket pressure and degree of intervention as follows.EMPt =
DNEERt + u x DNFAWhere u = 1/ -(-0.51-0.17) = 1/0.68 = 1.4705882and

IIAt = u x DNFA / EMPt.For the MCI, the weights for exchange rates and interest rates
were estimated from thereduced form of Equations (1) and (2)(6) LM3 = 3.80 + 0.74
LWOPI + 1.38 LIIP - 0.05 LCMR - 0.35 LNEERThe eigen values and trace statistics
suggest the presence of two co integrating vectors. Theresiduals of the two vectors were
subjected to normality tests; in view of the relatively highercoefficient of variation of the
residuals of the second vector, the first vector was chosen forgenerating the MCI and is
reported above [Equation (6)]. The coefficients of LNEER and LCMRsuggest that the
weights could be as follows: a = 0.125, b= 0.875; a + b =1.References
http://www.rbi.org.in Auerbach, R. D. (1982), Money, Banking and Financial Markets,
New York:Macmillan. Basu, K. (1993), Lectures in Industrial Organization Theory,
Oxford: Blackwell Publishers. Basu, K. (2003), Globalization and the Politics of
International Finance, Journal ofEconomic Literature, vol. 41, 2003. Basu, K. and
Morita, H. (2006) International Credit and Welfare: A Paradoxical Bhanumurthy, N.
R. (2008), Microstructures in the Indian Foreign Exchange Markets, mimeo: Institute
of Economic Growth.

Q. 2 : Explain RBIs intervention in exchange rate management in India. (M.2011) OR

RBI is the apex body that intervenes and control foreign exchange in India. Discuss.
How does RBI intervene in the foreign exchange market.
Ans. A) RBIs INTERVENTION AND EXCHANGE RATE MANAGEMENT :-

OR

In 1939, the Exchange Control Department of RBI was set up. In order to
conserve the scarce foreign exchange reserves, the Foreign Exchange Regulation Act (FERA)
was passed in 1947.
India adopted fixed exchange rate of IMF upto 1971, whereby the Indian Rupee
external par value was fixed. In 1973, FERA was amended and it came in force on January 1st,
1974. It gave wide powers to RBI to administer exchange control mechanism properly.
In 1992, RBI introduced LERMS (Liberalised Exchange Rate Management
System) Under LERMS a dual exchange rate was fixed. The 1993-94 Budget made Indian
Rupee fully convertible on trade account. LERMS was withdrawn. Developing countries allowed
market forces to determine the exchange rate. Under flexible exchange rate system, if demand
for foreign currency is more than that of its supply, foreign currency appreciates and domestic
currency depreciates and vice versa. To minimise the disadvantages of flexible exchange rate,
most of the developing countries including India have adopted the concept of managed Flexible
Exchange Rate (MFER).
Under MFER, the Central bank intervenes to bring stability in exchange rate.
RBIs intervention involves purchase of foreign currency from market or release (sale) of foreign
currency in the market, to bring stability in exchange rates.
ROLE OF RBI IN FOREIGN EXCHANGE MARKET
The role of RBI in the foreign exchange market is revealed by the provisions of FERA (1973).
Administrative Authority
The RBI is the administrative authority for exchange control in India. The RBI has
been given powers to issue licences to those who are involved in foreign exchange
transactions.
Authorised Dealers
The RBI has appointed a number of authorised dealers. They are permitted to carry out ail
transactions involving foreign exchange. The above provision is laid down in Section 3 of FERA.
Issue Of Directions
The 'Exchange Control Manual' contains all directions and procedures given by RBI to
authorised dealers from time to time.
Fixation Of Exchange Rates :The RBI has the responsibility of fixing the exchange value of home currency in terms of other
currencies. This rate is known as official rate of exchange. All authorised dealers and money
lenders are required to follow this rate strictly in all their foreign exchange transactions.
Foreign Investments :-

Non-residents can make investments in India only after obtaining the necessary permission
from Central Government or RBI. Great investment opportunities are provided to non-resident
Indians.
Foreign Travel :Indian residents can get foreign exchange released from RBI upto a specified
amount for travelling abroad through proper application.

Import Trade
The RBI regulates import trade. Imports are permitted only against proper
licenses. The items of imports that can be imported freely are specified under Open General
Licence.
Export Trade
The RBI controls export trade. Export of gold and jewellery are allowed only with
special permission from RBI.
Gold. Silver. Currency Notes Etc.
In recent years, the limits fixed for bringing gold, silver, currency notes etc. has
been relaxed considerably.
Submission Of Returns
All foreign exchange transactions made by authorised dealers must be reported
to RBI. This enables the RBI to have a close watch on foreign exchange dealings in India.
Thus, from above points we can say that RBI is the apex bank that intervens,
supervises, controls the foreign exchange markets in order to create an stable and active
exchange market.
Q. 3 : Explain the exchange controls administered by RBI under FERA.
FERA act was administered by RBI to conserve exchange reserves. Explain. OR

OR

Write note on FERA I FEMA.

Ans. A) FERA AND EXCHANGE CONTROLS :In 1939, under the Defence of India Rules (DIR), the Exchange Control was
imposed. In 1973, FERA was amended. India has accepted a system of multilateral payments,
i.e., the rupee should be freely convertible to currencies of all member countries of IMF. But the
RBI adopted exchange controls under FERA, in order to conserve India's Foreign exchange
reserves.
Foreign exchange was rationed out strictly according to availability.
Purchase and Sale of foreign securities by Indians were strictly controlled.
All external payments had to be made through authorised dealers controlled by RBI.

Exporters who acquired foreign exchange had to surrender their earnings to authorised deale
rs and get rupees in exchange.
Imports were rigidly controlled and imports of unnecessary items were prohibited.
The RBI as the apex bank supervised and controlled the foreign exchange
market. The RBI decided the exchange rate of rupee in terms of pound sterling on a day to day
basis. It would sell pound sterling against specific demand and would also buy US dollar, pound
sterling, German mark and Japanese yen. In 1992, the Pound sterling was replaced by dollar as
intervention currency. Hence, RBI would sell only dollar and continue to buy Dollar, Pound, Mark
and Yen.
In New Industrial Policy of 1991, the government announced major concessions
to FERA companies.
FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)
The relaxation of FERA encouraged the inflow of foreign capital and the growth
of Multi National Corporations (MNC's) in India. FERA was replaced by FEMA in 1999.
Under FERA RBI's permission was necessary. Under FEMA, except for Section 3
(relates to foreign exchange) no other permission is required from RBI. The purpose of FEMA is
to facilitate external trade and payments and promote orderly development and maintenance of
foreign exchange market in India.
FEMA has simplified the provisions of FERA. The two key aspects of FEMA are
the relaxation of foreign exchange controls and move towards capital account convertibility. To
facilitate foreign trade restrictions drawals of foreign exchange for current and capital account
transactions have been removed. FEMA regulates both import and export trade methods of
payment.
If any person contravens any provisions of FEMA, he shall be liable to a penalty
upto twice the sum involved in such contravention. There would be no punishment by way of
imprisonment.

Q. 4: Distinguish between FERA and FEMA.

Ans. A. FERA V/S. FEMA

FERA
1. FERA means Foreign Exchange
Regulation Act.
2. RBIs permission was necessary in
respect of most of the regulations.
3. Any person who contravenes FERA is
subject to penalty and imprisonment.
4. All transactions with Non-residents were
prohibited.

FEMA
FEMA means Foreign Exchange
Management Act.
RBIs permission is necessary only for
Section 3.
Any person who contravenes is liable to
penalty but not imprisonment.
Dealings with Non-residents have been
substantially diluted.

The role of RBI in the exchange market is as follows :

Monitoring and management of exchange rates without a pre-determined target rate
or range with intermittent intervention as and when necessary has been the basis of
the Managed Float system followed in India.
A policy to build a higher level of foreign exchange reserves, which takes into
account not only anticipated current account deficits but also liquidity requirements
arising from unanticipated capital outflows.
A judicious policy for management of capital account transactions, with progressive
liberalisation of such transactions.
Balancing the external economy represented by the exchange rate and the internal
economy represented by interest rates, inflation, money supply, etc.