Intervention Linked To Reer Unfeasible

The Reserve Bank of India (RBI) has indicated that an intervention band for the foreign exchange market fixed around the real effective exchange rate (REER) might not be feasible. All the preconditions of capital account convertibility (CAC) need to be fulfilled for the success of such a band, says the RBI in the Report on Currency and Finance 1996-97.

While the RBI acknowledges the importance of having an exchange rate that adequately reflects underlying fundamentals in the context of a mobile capital account, it goes on to state that the success of an intervention band would be contingent upon the attainment of all the preconditions for capital account convertibility.

The report states, In the face of large destabilising capital flows and/or periodic deviations from norms suggested as pre-conditions, rigid pursuance of such a band could be costly and distortive. It also pointed out that, with increasing integration of the different segments of the Indian financial market and greater market orientation of each segment, exchange rate movement also reflect developments in the money and the stock markets.

The report points out that, with the various difficulties associated with the construction of several REER indicators, the apex banks intervention strategy should primarily be to ensure an orderly exchange market condition by containing excessive volatility. Moreover, it states that the conduct of exchange rate policy must not be guided primarily by developments in the capital account of the balance of payments.

The report of the committee on capital account convertibility had recommended a 5 per cent exchange rate band to serve as a guide to policy, identification of a neutral base and the exact lag structure, thereby indicating that the response of trade flows to REER movements would become relevant.

The rupee depreciated to Rs 38.99 on December 4, 1997, against Rs 35.8139 in April 1997, reflective of a correction of the cumulative real appreciation of the rupee. The trade-based REER which had appreciated 9.6 per cent by March 1997 over March 1993, rose further 3.1 per cent during April-August 1997 thanks to large capital inflows and subdued demand. In September, too, there was a correction in terms of a rupee depreciation by 1.5 per cent.

In recent years, there has been growing interest among foreign exchange dealers for trades in currencies of emerging market economies. This was due to the need for diversification of exchange rate risk in a globalised financial system and in view of the prospects of wider margins on inter-bank transactions in such economies.

In the current fiscal year (up to November 28, 1997), Indias foreign exchange reserves (consisting of foreign currency assets of the RBI, SDRs and gold) moved up by $1,696 million to $ 28,119 million mainly on account of purchase by the RBI through market interventions, notwithstanding the outflows by way of withdrawals under the

FCNR (A) scheme. In this period, foreign currency assets of the RBI increased by $2,016 million, value of the stock of gold held by the apex bank declined to $3,735 million on November 28, 1997 as against $4,054 million at end March 1997 almost entirely due to valuation loss resulting from movements in gold prices.