RBI forex operations · GS-III
Why India should resist the temptation to defend the rupee at any cost, Raghuram Rajan explains ↗
Consider the following statements regarding RBI's foreign exchange market intervention under India's managed-float exchange rate regime:
- When the RBI sells US dollars from its foreign exchange reserves to support the rupee, it simultaneously reduces domestic rupee liquidity in the banking system, creating a potential conflict between currency stabilisation and domestic monetary management.
- Under a managed-float regime, a central bank is obligated to defend a pre-announced exchange rate band, and allowing the currency to move outside that band constitutes a breach of its statutory mandate.
- Currency depreciation driven by structural factors such as elevated crude oil import costs can provide a competitiveness benefit to export-oriented sectors by making domestically-produced goods relatively cheaper for foreign buyers.
Which of the statements given above is/are correct?
Explanation
Statement 1 is correct. When the RBI sells foreign currency (dollars) to support the rupee, it receives rupees in return, withdrawing those rupees from circulation. This reduces domestic banking-system liquidity, which may necessitate offsetting open-market operations — a well-recognised tension in forex intervention management. Statement 2 is incorrect and reflects a common misconception. India operates a managed-float (also called a 'dirty float') regime, NOT a fixed exchange rate or a target-zone/band system. Under a managed float, there is no pre-announced band or level that the central bank is legally obligated to defend; instead, the RBI intervenes at its discretion to contain excessive volatility and prevent disorderly market conditions. The RBI has no statutory obligation to hold any specific rate. Statement 3 is correct. A weaker currency does raise the domestic-currency cost of imports (aggravating the oil import bill) but simultaneously makes exports cheaper in foreign-currency terms, improving the competitiveness and volume potential of export sectors — this is the standard expenditure-switching effect of depreciation that is central to open-economy macroeconomics.