RBI Intervention in Foreign Exchange Market Submitted By: Avinash N Anuj Goyal Mr Siddharth Sham Chandak Rajavageeshwaran
IntroductionThe Reserve Bank of India (RBI) is the nation’s central bank. Since 1935, when it began itsoperations, it has stood at the centre of India’s financial system, with a fundamental commitmentto maintaining the nation’s monetary and financial stability.Main FunctionsMonetary Authority: ∑ Formulates, implements and monitors the monetary policy. ∑ Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.Regulator and supervisor of the financial system: ∑ Prescribes broad parameters of banking operations within which the countrys banking and financial system functions. ∑ Objective: maintain public confidence in the system, protect depositors interest and provide cost-effective banking services to the public.Manager of Foreign Exchange ∑ Manages the Foreign Exchange Management Act, 1999. ∑ Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.Issuer of currency: ∑ Issues and exchanges or destroys currency and coins not fit for circulation. ∑ Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.Developmental role ∑ Performs a wide range of promotional functions to support national objectives.Related Functions ∑ Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker. ∑ Banker to banks: maintains banking accounts of all scheduled banks.
RBI as Manager of Foreign ExchangeWith the transition to a market-based system for determining the external value of the Indianrupee, the foreign exchange market in India gained importance in the early reform period. Inrecent years, with increasing integration of the Indian economy with the global economy arisingfrom greater trade and capital flows, the foreign exchange market has evolved as a key segmentof the Indian financial market.ApproachThe Reserve Bank plays a key role in the regulation and development of the foreign exchangemarket and assumes three broad roles relating to foreign exchange: v regulating transactions related to the external sector and facilitating the development of the foreign exchange market v Ensuring smooth conduct and orderly conditions in the domestic foreign exchange market v Managing the foreign currency assets and gold reserves of the countryToolsThe Reserve Bank is responsible for administration of the Foreign Exchange ManagementAct,1999 and regulates the market by issuing licences to banks and other select institutions to actas Authorised Dealers in foreign exchange. The Foreign Exchange Department (FED) isresponsible for the regulation and development of the market.On a given day, the foreign exchange rate reflects the demand for and supply of foreignexchange arising from trade and capital transactions. The RBI’s Financial Markets Department(FMD) participates in the foreign exchange market by undertaking sales / purchases of foreigncurrency to ease volatility in periods of excess demand for/supply of foreign currency.The Department of External Investments and Operations (DEIO) invests the country’s foreignexchange reserves built up by purchase of foreign currency from the market. In investing itsforeign assets, the Reserve Bank is guided by three principles: Safety, Liquidity and Return.
**** (The details of exactly how the intervention is carried out are not publicinformation. However, the broad outlines are easy to discern by reading publicly-available documents.)Evolution of Indian Foreign Exchange MarketThe evolution of India’s foreign exchange market may be viewed in line with the shifts in India’sexchange rate policies over the last few decades. With the breakdown of the Bretton WoodsSystem in 1971 and the floatation of major currencies, the conduct of exchange rate policy poseda serious challenge to all central banks world wide as currency fluctuations opened uptremendous opportunities for market players to trade in currencies in a borderless market. Inorder to overcome the weaknesses associated with a single currency peg and to ensure stabilityof the exchange rate, the rupee, with effect from September 1975, was pegged to a basket ofcurrencies. The impetus to trading in the foreign exchange market in India since 1978 whenbanks in India were allowed to undertake intra-day trading in foreign exchange. The exchangerate of the rupee was officially determined by the Reserve Bank in terms of a weighted basket ofcurrencies of India’s major trading partners and the exchange rate regime was characterised bydaily announcement by the Reserve Bank of its buying and selling rates to the AuthorisedDealers (ADs) for undertaking merchant transactions. The spread between the buying and theselling rates was 0.5 percent and the market began to trade actively within this range and theforeign exchange market in India till the early 1990s,remained highly regulated with restrictionson external transactions, barriers to entry, low liquidity and high transaction costs. The exchangerate during this period was managed mainly for facilitating India’s imports and the strict controlon foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) hadresulted in one of the largest and most efficient parallel markets for foreign exchange in theworldAs a stabilisation measure, a two step downward exchange rate adjustment in July 1991effectively brought to close the regime of a pegged exchange rate. Following therecommendations of Rangarajan’s High Level Committee on Balance of Payments, to movetowards the market-determined exchange rate, the Liberalised Exchange Rate ManagementSystem (LERMS) was introduced in March 1992, was essentially a transitional mechanism and adownward adjustment in the official exchange rate and ultimate convergence of the dual rates
was made effective and a market-determined exchange rate regime was replaced by a unifiedexchange rate system in March 1993, whereby all foreign exchange receipts could be convertedat market determined exchange rates. On unification of the exchange rates, the nominal exchangerate of the rupee against both the US dollar as also against a basket of currencies got adjustedlower. Thus, the unification of the exchange rate of the Indian rupee was an important steptowards current account convertibility, which was finally achieved in August 1994, when Indiaaccepted obligations under Article VIII of the Articles of Agreement of the IMF.With the rupee becoming fully convertible on all current account transactions, the risk bearingcapacity of banks increased and foreign exchange trading volumes started rising. This wassupplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with theGovernment to remove market distortions and deepen the foreign exchange market. Severalinitiatives aimed at dismantling controls and providing an enabling environment to all entitiesengaged in foreign exchange transactions have been undertaken since the mid-1990s.The focushas been on developing the institutional framework and increasing the instruments for effectivefunctioning, enhancing transparency and liberalising the conduct of foreign exchange business soas to move away from micro management of foreign exchange transactions to macromanagement of foreign exchange flows. Along with these specific measures aimed at developingthe foreign exchange market, measures towards liberalising the capital account were alsoimplemented during the last decade. Thus, various reform measures since the early1990s havehad a profound effect on the market structure, depth, liquidity and efficiency of the Indianforeign exchange market.Sources of Supply and DemandThe major sources of supply of foreign exchange in the Indian foreign exchange market arereceipts on account of exports and invisibles in the current account and inflows in the capitalaccount such as foreign direct investment (FDI), portfolio investment, external commercialborrowings (ECB) and non-resident deposits. On the other hand, the demand for foreignexchange emanates from imports and invisible payments in the current account, amortisation of ECB(including short-term trade credits) and external aid, redemption of NRI deposits and out flows onaccount of direct and portfolio investment. In India, the Government has no foreign currency
account, and thus the external aid received by the Government comes directly to the reserves and theReserve Bank releases the required rupee funds. Hence, this particular source of supply of foreignexchange is not routed through the market and as such does not impact the exchange rate. During lastfive years, sources of supply and demand have changed significantly, with large transactionsemanating from the capital account, unlike in the 1980s and the 1990s when current accounttransactions dominated the foreign exchange market. The behaviour as well as the incentive structureof the participants who use the market for current account transactions differs significantly fromthose who use the foreign exchange market for capital account transactions. Besides, the change inthese traditional determinants has also reflected itself in enhanced volatility in currency markets. Itnow appears that expectations and even momentary reactions to the news are often more important indetermining fluctuations in capital flows and hence it serves to amplify exchange rate volatility(Mohan, 2006a). On many occasions, the pressure on exchange rate through increase in demandemanates from “expectations based on certain news”. Sometimes, such expectations are destabilisingand often give rise to self-fulfilling speculative activities. The role of the Reserve Bank comes intofocus when it has to prevent the emergence of destabilising expectations and recourse is undertakenin such ocassions to direct purchase and sale of foreign currencies, sterilisation through open marketoperations, management of liquidity under liquidity adjustment facility (LAF), changes in reserverequirements and signaling through interest rate changes. In the last few years the demand/supplysituation is affected by hedging activities through various instruments that have been made availableto market participants to hedge their risks
India’s Foreign Exchange Reserves INDIA’S FOREIGN EXCHANGE RESERVES End Foreign Exchange Reserves (` billion) Foreign Exchange Reserves (US $ million) Total Movement of SDRs Gold Foreign Reserve Total SDRs Gold Foreign Reserve Total Foreign in ForeignMonth # Currency Tranche (2+3+ # Currency Tranche (7+8+ Exchange Exchange Assets Position 4+5) Assets Position 9+10) Reserves Reserves in IMF in IMF (in SDR (in SDR million) million)* 1 2 3 4 5 6 7 8 9 10 11 12 13Mar-01 0.11 127 1845 29 2001 2 2,725 39,554 616 42,897 34,034 5,306Mar-02 0.50 149 2491 30 2670 10 3,047 51,049 610 54,716 43,876 9,842Mar-03 0.19 168 3415 32 3615 4 3,534 71,890 672 76,100 55,394 11,518Mar-04 0.10 182 4662 57 4901 2 4,198 1,07,448 1,311 1,12,959 76,298 20,904Mar-05 0.20 197 5931 63 6191 5 4,500 1,35,571 1,438 1,41,514 93,666 17,368Mar-06 0.12 257 6473 34 6764 3 5,755 1,45,108 756 1,51,622 1,05,231 11,565Mar-07 0.08 296 8366 20 8682 2 6,784 1,91,924 469 1,99,179 1,31,890 26,659Mar-08 0.74 401 11960 17 12380 18 10,039 2,99,230 436 3,09,723 1,88,339 56,449Mar-09 0.06 488 12301 50 12839 1 9,577 2,41,426 981 2,51,985 1,68,544 -19,795Mar-10 226 812 11497 62 12597 5,006 17,986 2,54,685 1,380 2,79,057 1,83,803 15,259Mar-11 204 1026 12249 132 13610 4,569 22,972 2,74,330 2,947 3,04,818 1,92,254 8,451Mar-12 229 1383 13305 145 15061 4,469 27,023 2,60,069 2,836 2,94,397 1,90,045 -2,209– : Negligible.# : Gold has been valued close to international market price.* : Variations over the previous March.Note : 1. Gold holdings include acquisition of gold worth US$ 191 million from the Government during 1991-92, US$ 29.4 million during1992-93, US$ 139.3 million during 1993-94, US$ 315.0 million during 1994-95 and US$ 17.9 million during 1995-96. On the otherhand, 1.27 tonnes of gold amounting to `435.5 million (US$11.97 million), 38.9 tonnes of gold amounting to `14.85 billion (US$ 376.0million) and 0.06 tonnes of gold amounting to `21.3 million (US$ 0.5 million) were repurchased by the Central Government onNovember 13, 1997, April 1, 1998 and October 5, 1998 respectively for meeting its redemption obligation under the Gold BondScheme.2. Conversion of foreign currency assets into US dollar was done at exchange rates supplied by the IMF up to March 1999. EffectiveApril 1, 1999, the conversion is at New York closing exchange rate.3. Foreign currency assets excludes US$ 250.00 million (as also its equivalent in Indian Rupee) invested in foreign currencydenominated bonds issued by IIFC (UK) since March 20, 2009, excludes US$ 380.00 million since September 16, 2011, US$ 550.00million since February 27, 2012 and US$ 673.00 million since 30th March 2012.
A Sketch of the ProblemLet me begin by outlining, in purely intuitive terms, what the problem is. Suppose there are twocurrencies, the domestic one, henceforth, rupees, and the foreign one, dollars. Let the demandcurve for dollars be described by the line AB in Figure 1 and the supply curve by the upwardsloping line. If this were a competitive market the equilibrium exchange rate or, equivalently, theprice of dollars would be p*, as shown.Now suppose, for whatever reason, the central bank wants to devalue the currency to theexchange rate p**. 6 If this is to be done not by law or diktat but by market intervention, anatural way to achieve this is for the central bank to demand CD dollars. This ‘quantityintervention’ would push the demand curve out to A’B’ and raise the price of dollars to p**.
This, in a nutshell, is what India’s RBI and legions of central banks in developing countries do.Note that in the process the central bank would end up acquiring CD dollars and releasing CDmultiplied by p** rupees onto the market, thereby raising tricky questions of inflationarypressures and the need to sterilize. That this is a natural way of thinking about how to influenceexchange rates is clear from textbook descriptions of what central banks do under ‘managed’ or‘dirty’ float. “[The method whereby] the central banks step in and buy and sell currencies toprevent them from falling or rising in value beyond predetermined limits have also been used.”In a competitive market of this kind, there is no advantage to an intervention where the extent ofdemand for dollars is made contingent on the price. As long as the new demand curve goesthrough point D the net effect is the same. If, for instance, the central bank decides to buy lessdollars if the price is low so that the new aggregate demand curve is given by the broken line inFigure 1, which goes through D, the final equilibrium is still at price p** and the amount ofdollars acquired by the central bank is still CD.At first sight this seems natural enough. If the demand for dollars is the same at the equilibriumprice, in this case p**, then the fact that demand would be different at out-of-equilibrium pricescan surely not influence the equilibrium price. This logic, however, is true only for purelycompetitive markets.
Foreign Exchange InterventionIn the post-Asian crisis period, particularly after 2002-03, capital flows into India surged creatingspace for speculation on Indian rupee. The Reserve Bank intervened actively in the forex marketto reduce the volatility in the market. During this period, the Reserve Bank made directinterventions in the market through purchases and sales of the US Dollars in the forex marketand sterilised its impact on monetary base. The Reserve Bank has been intervening to curbvolatility arising due to demand-supply mismatch in the domestic foreign exchange marketSales in the foreign exchange market are generally guided by excess demand conditions that mayarise due to several factors. Similarly, the Reserve Bank purchases dollars from the market whenthere is an excess supply pressure in market due to capital inflows. Demand-supply mismatchproxied by the difference between the purchase and sale transactions in the merchant segment ofthe spot market reveals a strong co-movement between demand-supply gap and intervention bythe Reserve Bank . Thus, the Reserve Bank has been prepared to make sales and purchases offoreign currency in order to even out lumpy demand and supply in the relatively thin foreignexchange market
and to smoothen jerky movements. However, such intervention is generally not governed by anypredetermined target or band around the exchange rate (Jalan, 1999).The volatility of Indian rupee remained low against the US dollarthan against other majorcurrencies as the Reserve Bank intervened mostly through purchases/sales of the US dollar.Empirical evidence in the Indian case has generally suggested that in the present day managedfloat regime of India, intervention has served as a potent instrument in containing the magnitudeof exchange rate volatility of the rupee and the intervention operations do not influence as muchthe level of rupeeThe intervention of the Reserve Bank in order to neutralise the impact of excess foreignexchange inflows enhanced the RBI’s Foreign Currency Assets (FCA) continuously. In order tooffset the effect of increase in FCA on monetary base, the Reserve Bank had mopped up theexcess liquidity from the system through open market operation (Chart 2.3). It is, however,pertinent to note that Reserve Bank’s intervention in the foreign exchange market has beenrelatively small in terms of volume (less than 1 per cent during last few years), except during2008-09. The Reserve Bank’s gross market intervention as a per cent of turnover in the foreignexchange market was the highest in 2003-04 though in absolute terms the highest interventionwas US$ 84 billion in 2008-09 (Table 2.3). During October 2008 alone, when the contagion ofthe global financial crisis started affecting India, the RBI sold US$ 20.6 billion in the foreignexchange market. This was the highest intervention till date during any particular month.
Trends in Exchange RateA look at the entire period since 1993 when we moved towards market determined exchangerates reveals that the Indian Rupee has generally depreciated against the dollar during the last 15years except during the period 2003 to 2005 and during 2007-08 when the rupee had appreciatedon account of dollar’s global weakness and large capital inflows . For the period as a whole,1993-94 to 2007-08, the Indian Rupee
has depreciated against the dollar. The rupee has also depreciated against other majorinternational currencies. Another important feature has been the reduction in the volatility of theIndian exchange rate during last few years. Among all currencies worldwide, which are not on anominal peg, and certainly among all emerging market economies, the volatility of the rupee-dollar rate has remained low. Moreover, the rupee in real terms generally witnessed stability overthe years despite volatility in capital flows and trade flows
The various episodes of volatility of exchange rate of the rupee have been managed in a flexibleand pragmatic manner. In line with the exchange rate policy, it has also been observed that theIndian rupee is moving along with the economic fundamentals in the post-reform period.Thus, ascan be observed maintaining orderly market conditions have been the central theme of RBI’sexchange rate policy. Despite several unexpected external and domestic developments, India’sexchange rate performance is considered to be satisfactory. The Reserve Bank has generallyreacted promptly and swiftly to exchange market pressuresthrough a combination of monetary, regulatory measures along with direct and indirectinterventions and has preferred to withdraw from the market as soon as orderly conditions arerestored.Moving forward, as India progresses towards full capital account convertibility and gets moreand more integrated with the rest of the world, managing periods of volatility is bound to posegreater challenges in view of the impossible trinity of independent monetary policy, open capitalaccount and exchange rate management. Preserving stability in the market would require more
flexibility, adaptability and innovations with regard to the strategy for liquidity management aswell as exchange rate management. Also, with the likely turnover in the foreign exchange marketrising in future, further development of the foreign exchange market will be crucial to managethe associated risks.Current Rupee Market StructureWhile analysing the exchange rate behaviour, it is also important to have a look at the marketmicro structure where the Indian rupee is traded. As in case of any other market, trading inIndian foreign exchange market involves some participants, a trading platform and a range ofinstruments for trading. Against this backdrop, the current market set up is given below.Market Segments and PlayersThe Indian foreign exchange market is a decentralised multiple dealership market comprisingtwo segments – the spot and the derivatives market. In a spot transaction, currencies are traded atthe prevailing rates and the settlement or value date is two business days ahead. The two-dayperiod gives adequate time for the parties to send instructions to debit and credit the appropriatebank accounts at home and abroad. The derivatives market encompasses forwards, swaps, andoptions. As in case of other Emerging Market Economies (EMEs), the spot market remains animportant segment of the Indian foreign exchange market.With the Indian economy gettingexposed to risks arising out of changes in exchange rates, the derivative segment of the foreignexchange market has also strengthened and the activity in this segment is gradually rising.Players in the Indian market include (a) Authorised Dealers (ADs),mostly banks who areauthorised to deal in foreign exchange , (b) foreign exchange brokers who act as intermediariesbetween counterparties, matching buying and selling orders and (c) customers – individuals,corporate, who need foreign exchange for trade and investment purposes. Though customers area major player in the foreign exchange market, for all practical purposes they depend upon ADsand brokers. In the spot foreign exchange market, foreign exchange transactions were earlierdominated by brokers, but the situation has changed with evolving market conditions as now thetransactions are dominated by ADs. The brokers continue to dominate the derivatives market.
The Reserve Bank like other central banks is a market participant who uses foreign exchange tomanage reserves and intervenes to ensure orderly market conditions.The customer segment of the spot market in India essentially reflects the transactions reported inthe balance of payments – both current and capital account. During the decade of the 1980s and1990s, current account transactions such as exports, imports, invisible receipts and paymentswere the major sources of supply and demand in the foreign exchange market.Over the last fiveyears, however, the daily supply and demand in the foreign exchange market is beingincreasingly determined by transactions in the capital account such as foreign direct investment(FDI) to India and by India, inflows and outflows of portfolio investment, external commercialborrowings (ECB) and its amortisations, non-resident deposit inflows and redemptions.It needs to be observed that in India, with the government having no foreign currency account,the external aid received by the Government comes directly to the reserves and the RBI releasesthe required rupee funds. Hence, this particular source of supply of foreign exchange e.g.external aid does not go into the market and to that extent does not reflect itself in the truedetermination of the value of the rupee.The foreign exchange market in India today is equipped with several derivative instruments.Various informal forms of derivatives contracts have existed since time immemorial though theformal introduction of a variety of instruments in the foreign exchange derivatives market startedonly in the post reform period, especially since the mid-1990s. These derivative instruments havebeen cautiously introduced as part of the reforms in a phased manner, both for product diversityand more importantly as a risk management tool. Recognising the relatively nascent stage of theforeign exchange market then with the lack of capabilities tohandle massive speculation, the ‘underlying exposure’ criteria had been imposed as aprerequisite.
Foreign Exchange Market TurnoverThe depth and size of foreign exchange market is gauged generally through the turnover in themarket. Foreign exchange turnover considers all the transactions related to foreign currency, i.e.purchases, sales, booking and cancelation of foreign currency or related products. Forex turnoveror trading volume, which is also an indicator of liquidity in the market, helps in price discovery.In the literature, it is held that the foreign exchange market turnover may convey importantprivate information about market clearing prices, thus, it could act as a key variable whilemaking informed judgment about the future exchange rates.Trading volumes in the Indianforeign exchange market has grown significantly over the last few years. The daily averageturnover has seen almost a ten-fold rise during the 10 year period from 1997-98 to 2007- 08from US $ 5 billion to US $ 48 billion (Table 3.1). The pickup has been particularly sharp from2003-04 onwards since when there was a massive surge in capital inflows.It is noteworthy that the increase in foreign exchange market turnover in India between April2004 and April 2007 was the highest amongst the 54 countries covered in the latest TriennialCentral Bank Survey of Foreign Exchange and Derivatives Market Activity conducted by theBank for International Settlements (BIS). According to the survey, daily average turnover inIndia jumped almost 5-fold from US $ 7 billion in April 2004 to US $ 34 billion in April 2007;global turnover over the same period rose by only 66 per cent from US $ 2.4 trillion to US $ 4.0
trillion. Reflecting these trends, the share of India in global foreign exchange market turnovertrebled from 0.3 per cent in April 2004 to 0.9 per cent in April 2007.Looking at some of the comparable indicators, the turnover in the foreign exchange market hasbeen an average of 7.6 times higher than the size of India’s balance of payments during last fiveyears.With the deepening of foreign exchange market and increased turnover,ncome ofcommercial banks through treasury operations has increased considerablyA look at the segments in the Indian foreign exchange market reveals that the spot marketremains the most important foreign exchange market segment accounting for about 50 per centof the total turnover However, its share has seen a marginal decline in the recent past mainly dueto a pick up in turnover in derivative segment. The merchant segment of the spot market isgenerally dominated by the Government ofIndia, select public sector units, such as Indian OilCorporation (IOC), and the FIIs. As the foreign exchange demand on account of public sectorunits and FIIs tends to be lumpy and uneven, resultant demand-supply mismatches entailoccasional pressures on the foreign exchange market,warranting market interventions by theReserve Bank to even out lumpy demand and supply. However, as noted earlier, such
intervention is not governed by a predetermined target or band around the exchange rate.Further,the inter-bank to merchant turnover ratio has almost halved from 5.2 during 1997-98 to 2.8during 2008-09 reflecting the growing participation in the merchant segment of the foreignexchange market associated with growing trade activity, better corporate performance andincreased liberalisation. Mumbai alone accounts for almost 80 per cent of the foreign exchangeturnover.The MethodologyIn the tradition of the asset market approach to exchange rate determination, the exchange rate isviewed as the relative price of national monies, determined by the relative supplies in relation todemand. Thus, while the demand for exports may be formed by a host of underlying real factors,the timing and magnitude of export proceeds flowing into the foreign exchange market respondsto interest rate differentials, exchange rate expectations and exchange market conditions, bothspot and forward, with little to do with the real factors that caused the export shipment.Similarly, the decision to contract external commercial borrowing may have been provoked byreal developments such as the need for capacity expansion, but the timing of bringing in thefunds would depend on interest rate differentials and their movements vis-a-vis the forwardpremia, current and expected exchange rates and the like. In any economy, irrespective of thewedges between segments of the financial market spectrum created by exchange controls andother barriers, market agents hold a portfolio comprising, inter alia, stocks of domestic and
foreign monies. Given the relative rates of return and the degree of substitutibility beweendomestic and foreign assets, they strive to achieve portfolio balance. In the face of a exogenous,domestic monetary shock embodied in an excess supply of money, market agents would reducedomestic money balances and seek to acquire foreign money balances. In a freely floatingexchange rate regime, the price of the domestic money would fall i.e., domestic interest rateswould decline and the exchange rate would depreciate. Given the relationship between money,interest rates and exchange rates, the decline in interest rates and exchange rates would cause thedemand for domestic money balances to rise until monetary equilibrium is restored.On the other hand, in a fixed exchange rate regime, domestic money balances would beexchanged for foreign goods, services, financial assets and money balances until portfoliobalance is restored through the monetary authority meeting the resultant increase in demand forforeign money by losing reserves until monetary balance is restored. In the intermediate forms ofexchange rate regimes that characterise the real world, a combination of the effects describedobtain. Monetary authorities may, in pursuit of a longer term strategy, seek to contest these shortrun market outcomes. By signaling their stance through various direct policy instrumentsreflected in changes in the domestic component of base money and in foreign exchange reservesand through indirect instruments such as changes in strategic interest rates, monetary authoritiesmay attempt to induce shifts in the demand for and supply of domestic and foreign moneybalances, and thereby change or even reinforce the market view on the monetary conditions.The model developed here draws heavily upon Weymark while taking into account the specificfeatures of the Indian economy. It is drawn up under the assumptions that the demand for moneyis fairly stable, the emerging role of interest rates as an argument in the money demandfunction-interest rates too seem to exercise some influence on the decisions to hold money- theimportance of the exchange rate objective of monetary policy in the context of the emerginglinkages between money, foreign exchange and capital markets and a loose form of purchasingpower parity which links domestic prices to foreign prices in a probabilistic form for aneconomy with a growing degree of openness (supported by the use of the REER as aninformation variable for exchange rate policy). The construction of the model draws inspirationfrom the underscoring of the need for a multiple indicator approach and the perceived utility of a
Monetary Conditions Index in a regime where targeting rate variables assumes importanceThe model is set out as follows :(1) Mdt = a0 + a1*Pt + a2*Yt - a3*It + ut(2) Pt = b0 + b1*Pt^+ b2*Et(3) It = It^+ E*(Et+1 -Et)(4) Mst = Ms(t-1) + h(DNDA + DNFA)(5) DNFA = -ut *(DEt)where,Mdt = Demand for money;Pt = Index of wholesale prices (domestic);Yt = Income/output, proxied by industrial production;It = Nominal interest rate represented by the call money rate, monthly averages;Et = Nominal exchange rate expressed in multilateral form i.e., nominal effectiveexchange rate (NEER) of the rupee, 36 country bilateral weights;Ft = Forward exchange rate;Mst = Supply of money;NDA = Net domestic assets;NFA = Net foreign assets;^ = Respective variables for rest of the world;u = Policy authorities response coefficient;h = money multiplier;D = changes in stocks or relevant variables;Equation (1) is the conventional money demand function employed in India augmented toinclude the interest rate as an argument signifying the opportunity cost of holding money. Outputrepresented by indices of industrial production in the absence of monthly data on GDP isassumed to be exogenous. Equation (2) represents the version of the functional relationshipbetween domestic prices and foreign prices considered in this model: domestic prices aressumed to be responsive to foreign prices in a functional form but purchasing power parity as a
rule is not imposed. Equation (2) essentially allows for the estimation of the exchange rateimpact on domestic prices. Equation (3) is the uncovered interest rate parity (UCIP) conditionwhich is set out as an underlying assumption relating to the substitutibility between domestic andforeign assets rather than a relationship proposed for empirical testing. It is presented as a part ofthe model specification to allow the model to be identified. Equation (4) describes the standardmoney supply formation process under the money multiplier approach, implying that anyincrease in nominal money stock could be on account of the last periods money stock plus theincrease in net domestic assets and net foreign assets of the monetary authority accruing to thecurrent periods money stock through the money multiplier. Under the assumption that themoney market clears continuously, the equilibrium condition would be reflected in the identityMs = Md. Equation (5) represents the reaction function of the authorities. Under a freely floatingexchange rate, the value of ut = 0.The monetary authority does not intervene in the exchange market and hence there is no changein NFA and money supply. When the authorities, on the contrary, peg the exchange rate at aparticular level (i.e. ut = ¥), there is unlimited intervention and hence proportionate changes inNFA and money supply. (Here, the general assumption is that the authorities intervene only bychanging NFA and not by changing NDA; as Weymark (op.cit) has shown, compensatingvariations in NDA due to sterilisation do not affect the monetary equilibrium condition.Furthermore, in India, variations in domestic credit are not systematically used to influence theexchange rate of the rupee). The value of ut in equation (5) thus gives an idea about the degree towhich exchange rate is managed. ut can assume negative values when interventions are usedaggressively to obtain an exchange rate change which is contrary to or significantly larger thanmarket expectations.Following Weymark, the EMP can be derived asEMPt = DEt + n DNFA where n = - 1/ [ b2+ a3]and IIA asIIAt = n DNFA / EMPtThe calculation of EMP and IIA thus hinges critically upon the calculation of the elasticity nwhich, in turn, depends upon estimates of the parameters b2 and a3 i.e., the coefficient of theexchange rate as a determinant of the domestic price level and the interest elasticity of the
demand for money respectively. These parameters can be obtained be estimating Equations (1)and (2) of the model.EMP measures the excess demand/supply for/of foreign exchange associated with the exchangerate policy. It does not measure the actual exchange rate change warranted by conditions ofdemand and supply but instead the degree of external imbalance and the presence/absence ofspeculative activity. The critical indicator in the EMP is its sign. Negative values indicatedownward pressures on the exchange rate while positive values reflect upward pressures whichholds irrespective of the choice of the exchange rate regime. The IIA has a range from -¥ to + ¥.Under a freely floating regime, IIA = 0 and under a fixed exchange rate regime, IIA = 1. Underintermediate regimes IIA assumes values between 0 and 1. When the monetary authority leanswith the wind, i.e., amplifies the exchange rate pressures generated by the market, the IIAassumes values greater than 1. On the other hand, when the monetary authority contests themarket view, the IIA is less than one.The Monetary Conditions Index (MCI) which has come to be employed as an operating target ormore generally, as an indicator of monetary conditions in countries forced to move away from amonetary aggregates approach by the pace of financial innovations, can easily be seen to be amore readily computable version of the EMP. It is a weighted aggregate of the exchange rate andinterest rate channels of monetary policy, providing leading information about the monetaryconditions since money stock variations impact upon the exchange rate and interest rate with amuch reduced lag than upon prices and output. The manner in which monetary policy should beadjusted to offset the deviation of monetary conditions from the desired levels is addressedthrough targeting the weighted monetary conditions index within a band, the band limits beingenforced by, or by the threat of, monetary policy action. The weights assigned to the exchangerate and interest rate generally depend upon their relative influence on output and prices and areusually derived by estimating a money demand function in which the exchange rate and theinterest rate are present as explanatory variables. Adjusting money stock to align the MCI with adesirable level would constitute the appropriate stance of policy.
The EMP would indicate the extent of exchange market pressure on account of monetarydisequilibria while MCI would directly show the monetary conditions prevailing at any point oftime in relation to some base level monetary condition and thereby help the authorities indeciding the degree and timing of monetary policy changes that may be necessary to keep theEMP within manageable limits. A decline in the MCI indicates tightening of monetaryconditions whereas an increase in the index reflects easing.In this paper a standard MCI has been constructed representing a linear combination of theinterest rate and exchange rate as follows :MCI = a* (It - Ib) + b* (Et - Eb)It and Et represent interest rate and exchange rate at time t and Ib and Eb represent interest rateand exchange rate as at some point which could be considered as equilibrium (and hence baseperiod E and I). a and b represent the weights which are decided on the basis of the respectiveinfluence of interest rate and exchange rate on the goal variable.Estimation of EMP, IIA and the MCI for IndiaThe data used are as follows: Month-end nominal money stock (M3), monthly indices ofwholesale price indices (WPI) as representative of domestic price movements, monthly indicesof industrial production (IIP) as the proxy for scale of economic activities in the absence ofmonthly data on national income, nominal effective exchange rate (NEER) indices to reflect themovement in the exchange value of the rupee vis-a-vis 36 major trading partners of India,monthly average of inter-bank call money rates (CMR) as representative of the opportunity costof money, and the weighted average of domestic CPIs of 36 major trading partners of India(WOPI) to reflect the movement of international prices. For countries which do not publish dataon intervention purchases and sales, changes in the levels of foreign exchange assets areconsidered for empirical analysis. In the case of India, however, monthly data on interventionpurchases and sales are published regularly by the RBI since June 1995 and for the purpose ofestimating and comparing the estimates, both change in reserve levels and net interventionpurchases/sales data have been considered.
All the equations for the basic model were estimated in log-linear form. Before estimating thecoefficients of the two elevant equations for EMP and IIA, the stationarity properties of thevariables were checked by using the Dickey-Fuller (DF) and the Augmented Dickey-Fuller(ADF) tests.All the variables considered for estimating the two equations turned out be integrated of orderone, [i.e. I(1)], indicating that some linear combination of these variables may represent a longrun equilibrium relationship. (For the DF and ADF test statistics ). In order to establish the longrun relationship among variables in the money demand and PPP equations, Johansen and Juselius(JJ) type of maximum likelihood tests of multiple co integration were conducted for the sampleperiod April 1990 to March 1998. The eigen values and trace statistics for both money demandand PPP relationships indicate the presence of two co integrated vectors as reported below.Money demand function(1) LM3 = 4.04 + 0.80 LWPI + 1.00 LIIP - 0.17 LCMRPurchasing power parity relationship(2) LWPI = -9.04 + 3.43 LWOPI - 0.51 LNEERThe DF and ADF tests for errors indicate the errors to bestationary.DF and ADF tests for errors. Without trend With trend DF ADF DF ADFResiduals of -5.71 -5.33 -5.77 -5.39MoneyDemandRelationshipResiduals of -2.15 -3.71 -2.90 -4.03PPPrelationshipRelevant coefficients from the above relationships are used to estimate the exchangemarket pressure and degree of intervention as follows.EMPt = DNEERt + u x DNFAWhere u = 1/ -(-0.51-0.17) = 1/0.68 = 1.4705882and
IIAt = u x DNFA / EMPt.For the MCI, the weights for exchange rates and interest rates were estimated from thereduced form of Equations (1) and (2)(6) LM3 = 3.80 + 0.74 LWOPI + 1.38 LIIP - 0.05 LCMR - 0.35 LNEERThe eigen values and trace statistics suggest the presence of two co integrating vectors. Theresiduals of the two vectors were subjected to normality tests; in view of the relatively highercoefficient of variation of the residuals of the second vector, the first vector was chosen forgenerating the MCI and is reported above [Equation (6)]. The coefficients of LNEER and LCMRsuggest that the weights could be as follows: a = 0.125, b= 0.875; a + b =1.References ∑ http://www.rbi.org.in ∑ Auerbach, R. D. (1982), Money, Banking and Financial Markets, New York:Macmillan. ∑ Basu, K. (1993), Lectures in Industrial Organization Theory, Oxford: Blackwell Publishers. ∑ Basu, K. (2003), ‘Globalization and the Politics of International Finance,’ Journal ofEconomic Literature, vol. 41, 2003. ∑ Basu, K. and Morita, H. (2006) ‘International Credit and Welfare: A Paradoxical ∑ Bhanumurthy, N. R. (2008), ‘Microstructures in the Indian Foreign Exchange Markets,’ ∑ mimeo: Institute of Economic Growth.