India’s Foreign Exchange Market: Navigating Volatility with Strategic Intervention

The IMF paper evaluates foreign exchange intervention (FXI) in India using the Integrated Policy Framework, finding it effective during severe economic shocks but of limited utility in stable market conditions. FXI is recommended as a complementary tool to mitigate inflation and output trade-offs when financial stress heightens market frictions.

The IMF working paper, authored by Jesper Lindé, Patrick Schneider, Nujin Suphaphiphat, and Hou Wang, and developed under the Asia and Pacific Department of the IMF, explores the effectiveness of foreign exchange intervention (FXI) in India through the lens of the Integrated Policy Framework (IPF). The study highlights FXI's potential as a tool to balance inflation and output trade-offs, especially during significant economic disruptions and temporary shallowness in FX markets. However, it also underscores the limited benefits of FXI during stable market conditions with sufficient liquidity. India’s foreign exchange market has grown substantially over the years, with an average daily turnover of 122 billion dollars in 2022, driven by offshore derivatives, particularly non-deliverable forwards (NDFs). Offshore transactions accounted for over 60% of total OTC volumes, with London as a key trading hub. Despite a generally liquid market, moments of financial stress, such as the global financial crisis and the COVID-19 pandemic, have highlighted episodes of market illiquidity. The Reserve Bank of India (RBI) has intervened regularly in spot and forward markets, aiming to stabilize the rupee and mitigate excessive volatility. While such interventions align with global practices, the scale of India’s FXI has often been more aggressive, particularly post-COVID, as reflected in its increasing share of gross spot transactions.

Identifying the Right Conditions for Intervention

The IPF offers a systematic framework to determine when FXI can complement traditional monetary tools like interest rate adjustments. For FXI to be effective, the framework identifies three critical frictions: shallow FX markets, substantial unhedged foreign currency liabilities, and risks of inflation expectations becoming unanchored. India’s context reveals limited unhedged liabilities and relatively stable inflation expectations, suggesting minimal need for FXI under normal circumstances. However, the analysis acknowledges the episodic shallowness of India’s FX market during global financial stress, highlighting the need for careful policy calibration.

Contrasting Scenarios: Normalcy Versus Crisis

The study uses quantitative modeling to simulate two hypothetical scenarios. The first scenario envisions global inflationary pressures and modest domestic shocks. Here, India’s FX market remained sufficiently liquid, and inflation expectations stayed anchored. The RBI’s reliance solely on interest rate adjustments was adequate to manage inflation without exacerbating the output gap. FXI in this context was deemed ineffective, as the benefits of currency stabilization were marginal compared to the costs. The second scenario, however, simulated global financial market turmoil coupled with significant risk-off shocks, causing capital outflows and a sharp depreciation of the rupee. In this case, the FX market turned shallow, and FXI played a critical role in mitigating the adverse effects on domestic demand and inflation.

FXI’s Role During Severe Financial Shocks

Under the second scenario, the model demonstrated that FXI, equivalent to 2.5% of GDP, helped stabilize inflation and eased pressure on the policy rate, leading to better outcomes for both inflation and output. By moderating the exchange rate depreciation, FXI reduced the risk of inflationary spirals and allowed the RBI to adopt a less aggressive interest rate policy, which in turn supported domestic economic activity. This scenario highlights FXI's potential to alleviate macroeconomic trade-offs during severe financial stress, making it a valuable complement to monetary policy.

Balancing Policy Tools for Stability

The study emphasizes that while FXI can be a useful policy tool, its use should be judicious and targeted at addressing specific shocks. Indiscriminate reliance on FXI could hinder the development of FX markets and create moral hazard by encouraging firms to neglect currency risk management. Furthermore, frequent interventions might blur the primary objectives of monetary policy, reducing its credibility and effectiveness. For India, the findings suggest that FXI is best reserved for extreme scenarios where market frictions are pronounced, and the risks to inflation and financial stability are significant. The research provides crucial insights into India’s economic resilience and the role of FXI in managing external shocks. It underlines the importance of balancing policy tools to achieve macroeconomic stability without undermining market development. The study also offers valuable lessons for other emerging economies with similar vulnerabilities, emphasizing the need for a calibrated approach to FXI that considers the specific characteristics of domestic and global financial markets. Going forward, the paper suggests exploring additional policy scenarios, including the impact of less anchored inflation expectations and forward guidance by major central banks. Such analyses could further refine the application of the IPF and enhance its relevance for emerging markets navigating complex economic challenges. For India, the key takeaway is the importance of maintaining a robust and well-regulated FX market while leveraging FXI strategically to address severe external shocks. This balance is critical for sustaining economic growth and ensuring financial stability in an increasingly interconnected global economy.