RBI's conflicting objectives: Focus on inflation, growth over exchange rate

Since November last year, the Reserve Bank of India (RBI) has allowed the rupee to weaken against the dollar, ending the effective peg that it had maintained for nearly two years. However, it has continued to intervene in the foreign-exchange (FX) market to limit the rupee’s decline, keeping it the least volatile major currency in Emerging Asia with a modest 3 per cent depreciation. This has, however, strained monetary policy and tightened liquidity at a time when the economy is weak and needs support.

 

To understand how this has happened, we must examine the link between monetary policy, currency management, and liquidity. The rupee weakens (or the dollar strengthens) when dollar supply in the FX market falls short of demand, such as when India’s diminishing growth prospects discourage capital inflows. To counter this, the RBI can sell dollars from its FX reserves, preventing or even limiting rupee depreciation.

 

However, it does not give dollars for free; it sells them for rupees. This absorbs rupees from the system, thereby tightening monetary conditions. The RBI conducts this transaction with banks. When a person asks a bank to exchange ₹1 lakh for dollars, the bank typically goes to the FX market, finds a seller, and matches the buyer with the seller. In this case, the bank acts as an intermediary, profiting from the spread between the buying and selling rates.

 

However, when a bank gets dollars from the RBI, the process changes. The bank must provide ₹1 lakh to pay for the dollars, but its assets mostly consist of loans and government securities. Only a small portion of bank deposits is held at the central bank due to the CRR (cash reserve ratio) mandate. This is what the bank uses to pay the RBI when the latter sells dollars. This means when banks buy dollars from the RBI on a large scale, their balance at the RBI can fall short of requirements, causing their liquidity to tighten. 

 

This is exactly what has been happening. For most of the past few years, the banking system had a healthy liquidity surplus. However, over the past few months, the RBI has sold large amounts of dollars, causing its FX reserves to drop sharply from $704 billion in September last year to $630 billion in January this year. As a result, liquidity in domestic banking has shrunk, and the system is now in a large deficit — ₹1-2 trillion.

 

To address this, the RBI has taken two approaches. On a daily basis, it has been lending funds to the banks. It has also repeatedly engaged itself in open-market purchase operations, buying government securities from banks to replenish their deposits at the RBI. These actions have ensured that banks have the necessary funds to conduct their business. However, this does not mean the RBI’s FX intervention has been without consequences.

 

This is evident in the graph, which shows the difference between the weighted average call rate (WACR) and the RBI’s policy repo rate. The WACR reflects banks’ borrowing costs in the overnight interbank market. When banks have a liquidity surplus, the WACR goes below the repo rate, resulting in a negative spread. However, as liquidity has tightened, particularly since November last year, the spread has become positive, indicating that banks facing a cash shortfall have struggled to secure the necessary funds.

 

This matters because the RBI has now signalled its intention to ease monetary conditions. On February 7, the central bank lowered the repo rate, citing weaker inflationary pressures and slowing growth. However, just days after the cut, it conducted a massive FX intervention to prevent the rupee’s depreciation. Though FX intervention data is released with a lag, anecdotal evidence suggests the RBI sold between $7 billion and $11 billion in only two days. This action tightened monetary conditions and raised the WACR.

 

In effect, the central bank has been sending mixed signals. Is the RBI truly committed to ease monetary conditions — or not? It is difficult to decipher from its actions.

 

For banks, the message is clear: As long as the RBI keeps liquidity tight and interbank lending conditions remain strained, they will be hesitant to lower their own interest rates. This reluctance means the RBI’s repo-rate cut will not get transmitted to the rest of the economy, and the monetary stimulus will fail to materialise. In short, the RBI’s exchange rate management strategy is undermining the effectiveness of its monetary policy.

 

The law mandates the RBI’s primary objective is maintaining price stability, keeping an eye on growth. It does not mention managing the exchange rate. It is time for the central bank to focus on managing inflation and growth, allowing the exchange rate to adjust based on fundamental factors.

 

The author is associate professor of economics, IGIDR, Mumbai