The widespre ad misconception that the Reserve Bank of India’s (RBI) “intervention” (selling dollars), in India’s inter-bank “foreign exchange” (forex) market, by itself, depletes India’s dollar reserves, needs to be cleared. Not one dollar of reserve is, or can be, depleted by RBI’s intervention alone. RBI’s exchange control regulations disable every “player” of the forex market (RBI itself can be a player by intervening) and all banks licensed by RBI to remit forex out of India in a vacuum.
Forex outgo takes place only for import (goods or services) transactions, or for transactions approved under the Foreign Exchange Management Act, 1999 (FEMA), administered by the RBI. But why does RBI intervene at all? Under Section 40 of the RBI Act, 1934, which continues to operate till date, the RBI is required to sell and buy forex to/from banks (authorised persons) at a specific rate to be decided by the Central Government having regard to India’s obligations to the International Monetary Fund (IMF)! This rate is the prime determinant of the rupee’s external value.
Once RBI fixes the benchmark, the inter-bank forex market moves and operates within a range. RBI does not fix the benchmark on a daily basis, but when it intervenes, the benchmark is fixed. Now turn to the mechanism of intervention. Assume today the rupee is trading at about Rs.94.70/dollar. Assume forex reserves today are 670 billion dollars. Assume also that the RBI intends today to strengthen the r up e e a little, say, to around Rs.93.50/dollar. Then, in order to achieve this objective, the RBI may supply (sell) dollars to a bank operating in India’s inter-bank forex market. This is called RBI’s intervention.
Normally the intervention takes place through large PSU banks. So, if today the RBI sells, say 10 billion dollars to a bank, India’s forex reserves will drop to $660 billion dollars from $670 billion. But then, the PSU bank will now be sitting on a $10 billion dollar long position which it cannot hold overnight without RBI’s specific prior approval. Under RBI regulations, at the close of business hours each day, every bank has to be square or near square (limit fixed by RBI) in its forex positions – long or short.
These 10 billion dollars, or a part thereof, can be used by the PSU bank for commercial transactions with the bank’s customers, like for example, for import of goods or services. The $10 billion, or a part thereof, can also be used by the bank for dollar-rupee speculative trading during the course of the day in the inter-bank forex market in India, subject to daylight limit, as may be clamped by the RBI for the bank. The $ 10 billion, or a part thereof, can further be used (bought) by another bank, either for commercial purposes or for dollar-rupee speculative trading within the Indian forex market.
At the close of business hours, assume hypothetically that the PSU bank is left with 7 out of 10 billion dollars. These 7 billion dollars will have to be sold back to the RBI in terms of exchange control regulations, unless the RBI specifically permits otherwise. It may be noted that the RBI monitors overnight open positions, long or short, of each bank strictly. Each bank is required to remain within the limit set by the RBI. Therefore, India’s forex reserves as at the close of the day will become 667 billion dollars, resulting in a depletion of $3 billion reserves.
An important point to grasp is that dollar/rupee speculative trade within the Indian forex market during the day does not deplete the forex reserves of India. Participating banks lose or gain rupees, not dollars. The upshot of the hypothetical example is that with the forex market in India loaded with 10 billion extra dollars during the day (RBI’s intervention), the dollar/rupee market is bound to drop (rupee gaining) with excess artificial supply of dollars.
How much the market actually drops during the day will depend upon demand and supply of dollars within the Indian forex market; it will also depend on the risk-bearing capacity of the bank’s forex trader. These have nothing to do with the international forex market. Herein lies the source of a rampant misconception. The dollar/rupee market rate may, in the hypothetical example as considered, move from Rs.94.70 to Rs.93.50 per dollar during the course of the day. The entire world, India included, would then think, grossly erroneously, that RBI has burnt $3 billion to defend the rupee. Rupee has been defended no doubt, but the $3 billion outgo from India has zero connection with RBI’s intervention.
Those dollars would have gone out anyway. They arise out of either import licenses granted by the Commerce Ministry or the outward remittance licenses granted by RBI. So, RBI’s intervention, by itself to defend the rupee, does not, and cannot, deplete forex reserves of India. India’s forex regulations continue to be impregnable; and the RBI monitors and enforces them strictly. May the RBI keep intervening in India’s forex market in India’s overall economic interest. May the rupee stabilise and gain gradually.
(The writer is a Senior Advocate, Supreme Court of India, and former Additional Solicitor-General of India who worked as a forex trader with both a PSU bank as well as a foreign bank.)