Why Central Banks Intervene and Why the FX Rate Matters for the RBI

Central banks in emerging market economies have sought to strengthen their ability to withstand exchange rate volatility induced by global spillovers travelling at high speed through the conduit of capital flows. Several have done so by resorting to capital controls, which have constrained their external balance sheets to a third of the size of those of advanced economies, despite much faster growth in trade. 

Most emerging market economies have, however, been motivated to accumulate foreign exchange reserves in order to throw sand in the wheels of capital flows. What was a slow build-up accelerated into a surge since 2004. It is no surprise that of the $13 trillion stocked until today, three-fifths are held by emerging market economies.

These countries intervene regularly in foreign exchange markets and have developed institutional formats for such actions. These interventions tend to impact the path of the exchange rate because they are not routinely sterilised, and also because the size of interventions is significant relative to market turnover. They are backed by elaborate reporting requirements on foreign exchange market participants, which confer an information advantage in inferring the aggregate order flow in the market and in deciphering signals in the noise. The impact of these interventions gets amplified by the application of supporting prudential regulations and capital flow measures or the threat thereof.

In fact, as the Bank for International Settlements (BIS) points out, emerging market economies have innovated by marrying inflation-targeting monetary policy regimes with foreign exchange interventions. The clarity in the assignment of policy instruments among goals has greatly fortified the effectiveness and independence of the monetary policy of these countries in the pursuit of domestic aspirations of growth and price stability. The abiding consideration is that exchange rate volatility is nowadays a high-intensity event; while volatility spillovers can be global, the responsibility for financial stability is national.

Managing exchange rates and accumulating reserves are seen to have benefits that overwhelm the costs and are, therefore, clearly preferred policy options, including in terms of the credibility earned. In the emerging market context, foreign exchange interventions are deployed with candour and often as the first line of defence to moderate exchange rate fluctuations, correct misalignments, address disorderly market conditions, and supply liquidity to the market.

Rather than pseudo-ethical considerations still being mooted by the IMF, operational issues such as timing, frequency, amounts, instruments, currency pairs, locations both onshore and offshore, and counterparties are the main decision drivers. In several realms, foreign exchange interventions help to calibrate liquidity management in consonance with the monetary policy stance. The RBI’s recent buy-sell swap is a case in point. The experience has been that these interventions provide breathing space for deeper adjustments in the orthodox monetary policy strategy and/or structural policy responses. 

Why the RBI should Secure Exchange Rate Stability
As mentioned earlier, globally mobile capital flows dominate foreign exchange markets and drive exchange rates. What is driving them is the heightened uncertainty through which the world is passing. Financial markets are on edge and continue to front run and second guess national policy authorities on the size and timing of the latter’s moves.

To illustrate, frenzy rose to a flashpoint on August 5, 2024, following the rate hike by the Bank of Japan on July 31 and the release of US non-farm payrolls data on August 2. A bloodbath reminiscent of Black Monday of 1987 was unleashed across financial markets worldwide as yen carry trade unwound. The fear gauge — the CBOE Volatility Index or VIX — jumped more than 50%, its highest level since 2020. About half of Yen carry trade was unwound. Leveraged positions were, however, rebuilt and risk taking resumed. Once again, on a single data release on September 3, 2024 — the US Institute of Supply Management (US ISM) manufacturing index — recessionary fears resurfaced, setting off a rout in US equity markets that quickly spread to Asia and Europe. This time, exchange rate depreciations were larger than in August, barring in Japan where market expectations of monetary policy tightening and suspected intervention led to appreciation.

In both episodes, the rupee was among the least volatile currencies. The Trump tariff announcements in early 2025 had a similar effect of churning the cauldron. Markets are continually recalibrating albeit in a disorderly manner with every incoming data. Buffering up with reserves to hedge against uncertainty is the way angels would want to tread. This is the principal reason why the exchange rate’s stability matters for the RBI.

India's Exposure
An India-specific reason for preserving rupee stability is that although India is the world’s fifth largest reserves holder, its gross foreign liabilities, both debt and equity, exceed its reserves quite substantially—by over 10% of GDP. There is also a sense that equity liabilities in this net international investment position, as it is called, are understated due to the use of historical prices and exchange rates. 

At current exchange rates, India’s portfolio investment liabilities could well be close to or a little over $1 trillion, dwarfing the holdings of foreign exchange reserves by the RBI. Accordingly, the country as a whole is exposed to exchange rate risk. Someone will have to pay for exchange rate volatility. If bouts of volatility are large and prolonged, illiquidity can easily mutate into insolvency. In a crisis, all capital flows are callable, and the responsibility for remaining standing on the burning deck eventually devolves on the sovereign.

Yet another reason is that about 40% of India’s CPI comprises imported items. Although exchange rate pass-through into inflation has been declining over time, episodes of high volatility result in fuller pass through, setting up a challenge for the conduct of monetary policy.

Third, there is the issue of exchange rate changes and their pass-through into export prices. This tracks the old orthodoxy that exchange rate depreciation renders exports cheaper to the foreign buyer and, other things remaining the same, increases sales in overseas markets. For most of India’s exports, however, competitive conditions prevail in markets abroad. Prices are set by the buyer or in tight competition with numerous sellers. Accordingly, market share is preserved and expanded only by quality improvements in a price-taking environment.

As a consequence, it is empirically observed in the data that real exchange rate elasticity of exports has been declining over time. Competitive depreciation by maintaining an undervalued exchange rate just does not work anymore. In fact, if the Big Mac index of the magazine The Economist is taken as a measure of purchasing power parity or fair value, the rupee is undervalued by nearly 60% against the US dollar. The IMF staff also assesses the rupee to be undervalued by a range with a mid-point of 9% on the basis of its norm for India’s current account deficit. And yet, India’s merchandise exports rose just 2.4% during April-December 2025-26 as against China’s 6.6%, despite the yuan being less undervalued (by 40%) by the Big Mac index. Obviously, there are other factors at work.

This article is Part III of a six-part weekly series on exchange-rate policy and financial stability by Dr Michael Debabrata Patra.

Part I set out the competing narratives on the rupee and the case for exchange-rate stability. Click here.
Part II examined why floating exchange rates have often amplified crises in emerging economies. Click here.
Part IV will set out a proposal for strengthening the RBI’s foreign exchange intervention toolkit and reserve strategy.
Part V will assess why the IMF’s evolving surveillance and labelling practices risk undermining exchange-rate stability rather than preserving it.
Part VI will bring the argument full circle, asking what India’s fundamentals imply for the rupee, stability and policy credibility in an uncertain world.