RBI views forex market intervention as real danger

D Subbarao says a failed defence of the exchange rate is worse than no defence

The Reserve Bank of India (RBI) has been intervening in the forex market to manage volatility. However, the move is fraught with risks and it is important to make sure that the intervention is successful. “There is the real danger that by intervening in the forex market, you could end up losing forex reserves, and not gaining on the currency,” said D Subbarao, governor of RBI at IMF conference on Rethinking Macro Policy II in Washington DC on Wednesday.

According to Subbarao, the lower your reserves dip, the more vulnerable you become. “And the vulnerability can become quite serious if your reserves go below the level markets perceive as necessary to regain market access,” he said.

It should also be clear that a failed defence of the exchange rate is worse than no defence at all, Subbarao added. So, when you are intervening in the forex market, it is important to ensure that your intervention is successful.

“When you are fighting currency appreciation, you are intervening in your own currency. Your capacity to do so is, at least in theory, unlimited, quite simply because you can print your own currency. But when you are fighting currency depreciation, you are intervening in a hard currency. Your capacity to intervene is, therefore, limited by the size of your forex reserves. What complicates the dilemma is that the market is aware of this,” said Subbarao.

Subbarao also said that moving towards full capital account convertibility has always been the policy goal. The only variable was the road map for getting there which, it was agreed, should be redefined from time to time, consistent with the evolving situation. But the crisis has, however, changed all this.

According to Subbarao, it shifted the debate from the strategy and timing for capital account convertibility, to questioning the very imperative for capital account convertibility. “The consensus that every country should eventually move towards a fully free capital account is now broken,” said Subbarao.

Subbarao said that the other thing in which the pre-crisis consensus is broken is the use of capital controls as a stabilisation tool.

“Before the crisis, the consensus was that capital controls are bad, always and everywhere. That consensus no longer holds. Received wisdom today is that capital controls are not only appropriate, but even desirable in certain circumstances,” said Subbarao.

According to him, the third issue on which the pre-crisis consensus has dissolved is foreign exchange intervention. “The pre-crisis consensus, at any rate among advanced economies, was that intervention in the forex market is sub-optimal. That consensus no longer holds, with even some advanced economies defending their currencies from the safe haven impact,” said Subbarao.

He added emerging markets have had long and varied experience of struggling with forex intervention. The policy dilemma in the event of receiving capital flows, beyond the country’s absorptive capacity, can be quite complex.