The economics of a 'strong rupee'

Our currency policy is costly for people and generates small benefits for a subset

Another column on the dollar-rupee! Isn’t everything hunky-dory, after $136 billion of inflows? Not really.  

Perhaps there was more of a rationale for doing such things in the past. But things have changed. The Reserve Bank of India (RBI) has gone up the escalatory ladder from spot market intervention to intervention in the currency derivatives market to complex financial engineering. Opacity is going up, costs are going up, and the chances of a big mess are going up.

From September, 1, 2023 to December 16, 2024, macroeconomic policy operated as a closely managed dollar-rupee (USD/INR) exchange rate. This phase was not formally announced by the RBI, but the pattern is visible in the data. The USD/INR volatility dropped to near-zero levels. But running an exchange rate policy involves economic tradeoffs. No country can simultaneously maintain an open capital account, a managed exchange rate, and an independent monetary policy. When the currency is managed, the central bank loses control over domestic interest rates. Administrative choices on the currency thus affect the broader macroeconomic system and the pursuit of domestic objectives. 

In a market economy, an exchange rate is a relative price. It links the purchasing power of two currencies across time and geography, reflecting the economic realities of both jurisdictions. Since 2015, India has operated under a legislatively mandated inflation-targeting framework with a target of 4 per cent. Advanced economies generally target an inflation rate of 2 per cent. A structural depreciation of the nominal exchange rate of roughly 2 per cent a year should then generally arise. 

The RBI tried to resist the rupee’s depreciation using spot market intervention. It then moved to using intervention in the forward market. But this became too hard and the central bank moved to financial engineering and an operation involving Foreign Currency Non-Resident (Bank) deposits. This, along with two other smaller schemes, generated a capital inflow of a little over $136 billion. We can separate this operation into its fiscal dimension and its macroeconomic consequences. 

The first part of the operation involves a state subsidy. The capital flow of $136 billion is brought in by providing currency hedging to commercial banks at no cost. A forward guarantee on the exchange rate creates a contingent liability for the state. If macroeconomic fundamentals guide the exchange rate to ₹110 per dollar in three years, the RBI will pay  ₹15 per dollar. This is a cost of approximately ₹2 trillion. 

The central bank will invest the incoming $136 billion in foreign assets and earn a return. The gap between the interest earned abroad and the losses on the promised hedging makes a net outcome. A central bank does not have its own independent money; its balance sheet is a consolidated part of the government finances. Financial losses on the central bank balance sheet reduce the transfer of seigniorage income to the government. This functions as a quasi-fiscal cost. A subsidy is extended to foreign capital providers, which alters the fiscal position. Parliament does not vote on this expenditure, yet there are large but less visible fiscal implications. 

The second part of the operation relates to domestic monetary stability. When $136 billion flows into the Indian economy, it increases the local supply of dollars. This generates pressure on the rupee to appreciate. An appreciating currency alters the competitiveness of the tradable sector. It affects exporters and domestic producers who compete with imported goods. To limit this appreciation, the central bank buys the incoming foreign exchange. 

This ricochets into monetary policy. When the central bank purchases dollars, it injects rupee liquidity into the domestic financial system. An increase in liquidity pushes short-term interest rates down. The Indian economy currently faces inflationary pressures. These conditions normally require tight monetary policy. The exchange rate intervention, however, adds liquidity to the market, which influences interest rates. The objective of exchange rate management therefore directly conflicts with the primary mandate of the 4 per cent inflation target. 

Such tricks have been done before. India Development Bonds 1991 raised an estimated 0.6 per cent of gross domestic product. Resurgent India Bonds of 1998 raised 1 per cent, and India Millennium Deposits 2000 raised 1.2 per cent of GDP. The 2013 FCNR(B) exercise raised 1.4 per cent of GDP. The 2026 FCNR(B) raised 3.5 per cent of GDP. The scale, the opacity, the complexity have gone up. 

John Maynard Keynes suggested that economists could be “humble, competent people, on a level with dentists”. The organising concept of central banking in successful economies is harmonious, predictable behaviour. The market should understand the reaction function of the authorities, as happens in a simple inflation-targeting system. The central bank ideally should never make headlines, it should quietly ensure macroeconomic stability. 

The RBI has escalated through spot market to forward market trading to more fancy footwork of gifting currency protection to banks. We are struggling to artificially remove the local monetary impact of an artificial capital inflow. But would all this deliver the goods? It is doubtful. None of these tricks change anything about the state of the Indian economy. The economic forces of the world economy are large, as was pointed out in a recent column by Ajay Shah. The daily inflow and outflow across India’s borders is $11 billion. The global daily trading volume on the rupee is $140 billion. Throwing just $2 billion a day at the problem for 250 days will burn through $500 billion. 

We should instead take one step back and ask the foundational question: All this drama is in return for what? Recent research by Hande et al. (2026, https://bit.ly/4dlXP5d) indicates that the natural annualised volatility of the USD/INR exchange rate, without intervention, is approximately 7.5 per cent a year. The apparatus of intervention generates a realised volatility of roughly 5 per cent a year. We suffer fiscal risk, distorted monetary policy, instability, and constraints on financial development, which impact the people through inferior economic growth. In return, we get a 2.5 percentage point reduction in currency volatility, which benefits a small set of business users. 

The fiscal cost of FCNR(B) reflects the cost that policymakers force the Indian people to pay for delaying the perception problems that they will face when INR hits a century.  

Time to revisit and reconsider the policy.

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The writer is an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant