Why did RBI replace flexible exchange rate with de facto peg against dollar

In a series of recent articles, we pointed out that in 2022, the Reserve Bank of India (RBI) abandoned the flexible exchange rate regime that had been in place for three decades and replaced it with a de facto peg against the dollar. We emphasised how this change cost the economy, resulting in an uncompetitive exchange rate and lost exports, overly tight liquidity at a time of decelerating growth, and heightened risks of speculative attacks. This begs an important question: Why did the RBI change policy?

 

The RBI must come out with an official explanation, but until it does, we can only guess. But there are a few reasonable hypotheses. 

One common explanation is that it happened accidentally. That is to say, the RBI never meant to peg the exchange rate. Its real objective was to rebuild reserves after the country’s foreign exchange cushion had been eroded in the middle of 2022. So, when capital started to flow into the country again, attracted by India’s post-pandemic resurgence, the Central bank decided to buy up the dollars rather than allow the rupee to appreciate. 

There is clearly something to this hypothesis, as the RBI has often preferred to build reserves rather than allow appreciation. But the explanation is surely incomplete. For a start, it does not explain why the RBI has since 2022 intervened repeatedly on both sides of the market, not just to prevent appreciation but also to forestall depreciation. Nor does it explain why the RBI fought so hard to preserve the peg when depreciation pressures arose in late 2024, even at the cost of expending sizeable amounts of the country’s hard-won reserves. 

A second hypothesis is that the RBI was focused on combatting inflation, and worried that a depreciation would undermine their efforts. It is true that inflation remained above the 6 per cent limit for some time after the pandemic. It seems reasonable, then, to think that the RBI wanted an extra instrument in its anti-inflation fight, especially since part of the inflation problem in early 2022 was coming from abroad. 

But a peg would not have provided this instrument. Instead, the RBI would have needed to allow the exchange rate to appreciate, to reduce the rupee impact of higher foreign prices. In any case, the whole issue proved moot, as global petroleum and fertiliser prices came down by more than 30 per cent in the second half of 2022 and have not been a problem since. Accordingly, inflation concerns cannot explain why the rate was pegged since late 2022. 

Another hypothesis commonly advanced is political, namely that the government prefers a strong rupee. It is true that politicians of all stripes, in all countries, dislike falling currencies. But despite these preferences the RBI had nonetheless maintained the traditional semi-flexible rupee policy for three decades, including for seven years under the current government. So for this explanation to be valid, we would need to identify a major shift in politics that took place in late 2022. None seems obvious. 

 

Still, we are getting close to the nub of the issue. We need to find an important development in 2022 that would have caused the RBI to shift its exchange rate policy. We have already ruled out a political shift. But perhaps there is an economic one. A clue is provided by the figure which shows that External Commercial Borrowings (ECBs) surged starting in early 2023. But what is the link between ECBs and exchange rate policy? 

To answer this question, recall the economic situation in 2022. At that point, the critical issue facing the authorities was how to translate India’s post-pandemic resurgence into a sustained boom. To achieve this, investment needed to revive. And while many firms indeed had ambitious projects on the drawing board, particularly in infrastructure, they needed financing, preferably from foreign markets, which offer lower rates and longer maturities than domestic ones. In the middle of the year, however, these financing plans were suddenly threatened, when the US Federal Reserve began to increase interest rates sharply. Something needed to be done. One potential response was to peg the exchange rate, because that would reduce the risk of currency depreciation – a key component of the total effective cost of foreign borrowing. 

We don’t know, of course, whether this consideration was the main reason for the change in policy. 

But without doubt, reducing effective foreign borrowing costs was one of its main effects: Indeed, the cost reduction was so pronounced that ECBs took off despite dollar interest rates having risen substantially. By early 2025, the stock of ECB debt had grown to $273 billion, an increase of one- third in just two years. And looking at ECBs might well understate the total foreign currency liability exposure if Indian firms have raised money offshore in other ways. 

Even so, overall private investment did not take off. So, it is possible that the major effect of the “subsidy” — the reduction in exchange rate volatility — was that firms merely substituted foreign borrowing for domestic financing. 

What is certain is that the surge in ECBs had an unwelcome side-effect, namely that it increased the exposure of private firms to the risk of currency depreciation. And this put the RBI in a bind when the dollar began to rise on global foreign exchanges in October 2024. If it allowed the rupee to depreciate, this would put stress on firms, such as those in infrastructure, that had borrowed in dollars but were earning revenues in rupees. On the other hand, minimising the rupee’s depreciation against a rising dollar would cause the rupee to appreciate against third currencies such as the euro, squeezing the profitability of the vital export sector. 

In the event, the decision to defend the peg in October 2024 led to a serious erosion of India’s competitiveness, as the RBI itself noted in its latest bulletin. Moreover, the more recent attempt to control the pace and extent of the rupee’s decline has increased anxiety and accelerated the capital outflows. Reserves have consequently fallen by $70 billion in the past few months, around $6 billion just in the past week alone. 

The lessons are clear. Short-term solutions sometimes end up creating long-term problems, from which it is difficult to extricate.

Everyone knows the oft-quoted lines from Oscal Wilde’s The Importance of Being Earnest: “The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. Even these metallic problems have their melodramatic side.” Ironically, in this episode, it is the rupee not falling and remaining stubbornly stable that may have dramatic explanations and consequences.

 

The authors are, respectively, with the Madras Institute of Development Studies, JH Consulting, and the Peterson   Institute for International Economics