 "Forex interventions proven to mitigate capital flow volatility: RBI report")
Foreign exchange interventions, including spot and forward transactions, are effective in mitigating capital flow volatility, with purchases and sales yielding symmetric effects, according to a report by the Reserve Bank of India (RBI).
The report titled ‘Foreign Exchange Intervention: Efficacy and Trade-offs in the Indian Experience’ is authored by Michael Debabrata Patra, Sunil Kumar, Joice John and Amarendra Acharya.
Patra was a deputy governor of RBI whose term ended on January 14.
The views expressed in the article are of the authors and do not represent the views of the RBI.
The report further noted the detection of threshold effects in forex interventions.
It highlighted that efforts to “throw sand in the wheels” to reduce exchange rate volatility are more effective than large-scale interventions aimed at influencing the exchange rate level.
Also Read
“Foreign exchange interventions, both spot and forward, effectively counter capital flows volatility, with symmetric effects of purchases and sales,” the report said.
“We also detect threshold effects of forex interventions. Throwing sand in the wheels to dampen the exchange rate volatility is more effective than to influence the level of exchange through large interventions. This finding has important implications for the conduct of exchange rate policy in countries like India,” it added.
The report examined the effectiveness of the RBI’s forex interventions and found that the primary driver of exchange rate volatility in India is fluctuation in portfolio flows caused by global spillovers. Both spot and forward forex interventions were found to effectively mitigate capital flow volatility, with purchases and sales having symmetric effects.
Additionally, the impact of gross spot interventions on exchange rate volatility suggests the presence of threshold effects, which align with the “leaning against the wind” approach.
The empirical analysis of the report reveals that, with the gradual liberalisation of current and capital transactions, the Indian economy has experienced periods of exchange rate volatility. This led to destabilising effects on real economic activity.
The analysis identifies the primary source of this volatility as fluctuations in portfolio flows, driven by risk-on-risk-off sentiments. It is largely influenced by global spillovers, rather than differences in inflation or interest rates.
This finding carries significant implications for the formulation and conduct of exchange rate policy in countries like India.
The report highlighted that marrying foreign exchange interventions with inflation targeting has significantly strengthened emerging market economies’ (EMEs) macroeconomic policy framework. This has also led to the recognition of such interventions as a legitimate instrument in the macroeconomic toolkit of EMEs.