Throwing sand in the wheels to dampen exchange rate volatility more effective, says RBI study
Throwing sand in the wheels to dampen the exchange rate volatility is more effective than attempts to influence the level of the exchange through large interventions, according to a study by RBI staffers.
This observation comes in the backdrop of RBI’s intervention in the forex market to smoothen excessive volatility, with the rupee depreciating past the crucial 86 per dollar mark in the backdrop of a strengthening dollar, weakening Chinese Yuan and rising global crude oil prices, among others.
The study “Foreign Exchange Intervention: Efficacy and Trade-offs in the Indian Experience,” put together by RBI officials, including MD Patra (who demitted office as Deputy Governor on January 15th), Sunil Kumar, Joice John and Amarendra Acharya, found that the volatility of portfolio flows, induced by global spillovers, is the main source of exchange rate volatility in India.
“Foreign exchange interventions, both spot and forward, effectively counter capital flows volatility, with symmetric effects of purchases and sales.
The impact of gross spot intervention on exchange rate volatility indicates the existence of threshold effects, explaining the “leaning against the wind” phenomenon,” the authors said in the study, which has been published in RBI’s latest monthly bulletin.
The authors noted that several emerging market economies (EMEs) have opted for market-determined exchange rates – broadly classified as managed floats in de jure terms – to reap the equilibrating properties of freer exchange rates movements in the context of balance of payments disequilibrium.
The experience with floating exchange rates the world over has, however, been quite the converse, marked by idiosyncratic movements, overshoots hysteresis and several generations of currency crises, with adverse implications for domestic real economic activity.
Hence, EMEs and even several advanced economies (AEs) have employed foreign exchange interventions to curb excessive exchange rate volatility and thereby prevent macroeconomic and financial stability risks from materialising.
The results of the empirical analysis by the RBI officials shows that with the progressive liberalisation of current and capital transactions, the Indian economy has experienced bouts of exchange rate volatility, with destabilising consequences for real activity.
“It is the volatility of portfolio flows induced by risk-on-risk-off sentiments, mainly on account of global spillovers, that is the source of exchange rate volatility rather than differentials in inflation or interest rates,” they said.
