term project:spidi2.iimb.ac.in/~networth/ccs/2005/580 ccs... · web viewmonetary policy works...

CONTEMPORARY CONCERNS STUDY

STUDY OF MONETARY POLICY VIS-À-VIS EXCHANGE RATES AND RELATED IMPACT ON

EXCHANGE RATE RISKS AND FOREX MARKETS

IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE

CCS COURSE IN THE POST GRADUATE PROGRAMME FOR MANAGEMENT

TO

PROF. SHYAMAL ROY

ONAUGUST 29, 2006

BY

MOHIT GUPTA (0511102)

Contemporary Concerns Study

SHUBHANKAR NAYAK (0511119)

INDIAN INSTITUTE OF MANAGEMENT, BANGALORE

Authors: Mohit Gupta, Shubhankar Nayak of 50


ACKNOWLEDGEMENTS

WE WOULD LIKE TO EXTEND OUR SINCEREST GRATITUDE TO PROFESSOR SHYAMAL ROY FOR GIVING US THE OPPORTUNITY TO WORK ON THIS PROJECT. HE HAS BEEN OUR CONSTANT SOURCE OF GUIDANCE THROUGHOUT THE COURSE OF THE PROJECT. WE HOPE THAT THIS CONTEMPORARY CONCERNS STUDY IS A PROPER REFLECTION OF OUR EFFORTS AND IMBIBED INSIGHTS ON EXCHANGE RATE MANAGEMENT IN INDIA AND RELATED CONCERNS.



OBJECTIVES OF STUDY

Monetary policy of an economy outlines the broad direction of the economy in terms of

domestic growth, prices, movement of interest rates and exchange rates. These variables have

ripple effects on various stakeholders in the economy. With global integration of Indian

economy, Exchange Rate movements are playing an important role through their

direct/indirect effects on the economy. The objective of our study is twofold: (1) To analyze

the various policy measures/options that Reserve Bank can take in influencing exchange rate

movements. (2) To focus on RBI’s current stance on exchange rates and Forex reserves, and

the effectiveness of its policy measures.



TABLE OF CONTENTS

SERIAL NO. TITLE PAGE NO.

1. EXECUTIVE SUMMARY 5

2. LITERATURE SURVEY, DATA SOURCES, AND METHODOLOGY

7

3. INTRODUCTION TO MONETARY POLICY 94. ANALYSIS OF BALANCE OF PAYMENTS 115. EXCHANGE RATE MANAGEMENT BY RBI 176. EFFECTIVENESS OF RBI INTERVENTION 277. ANALYSIS OF FOREX RESERVE MANAGEMENT 298. MANAGERIAL IMPLICATIONS 369. CONCLUSION & LIMITATIONS OF STUDY 3710. APPENDICES 3911. REFERENCES 48



EXECUTIVE SUMMARY

“Monetary policy making has become a delicate balancing act between the imperatives of domestic

economic, financial and monetary concerns and the evolving international situation that we have to

observe closely on a real time basis and to take it as a given” –Rakesh Mohan, Deputy Governor, RBI

Monetary Policy of an economy is the policy statement through which the Central bank of an

economy seeks to ensure price stability amidst factors like money supply, interest rates, and

inflation. In the Indian context, the post-liberalization era of 1991 onwards has seen a

paradigm shift the operations of Reserve Bank of India (RBI)1 in the face of surges in capital

flows, integration of India with world trade and finance, and hence the external sector of

India. The aim of our study was: 1) To analyze the policy targets of RBI amidst the

conflicting goals of price, interest rates, and exchange rates stabilization 2) To analyze the

nature and efficacy of RBI’s intervention in the Forex markets and hence the movement of

exchange rates 3) To perform a cost-benefit analysis of optimality of India’s burgeoning

Forex reserves.

In order to meet the challenges thrown by financial liberalization and the growing

complexities of monetary management, the Reserve Bank switched from a monetary

targeting framework to a multiple indicator approach from 1998-992. Short-term interest

rates have emerged as the key indicators of the monetary policy stance. India’s current

exchange rate policy has been focused on managing volatility without a fixed rate target. We

feel that RBI is targeting a stable real effective exchange rate (REER), and is using interest

rates as a policy tool to adjust these forces in the economy.

The Balance of Payment analysis showed that there is also an increasing influence of

capital flows in determining exchange rate movements as against trade deficits and

economic growth in the earlier years. While this positively reflects the integration of India

with global markets, the quality of the capital flows can be questioned considering the

volatile Portfolio investments. RBI intervenes in the Forex markets through direct

purchase/sale of dollars through sterilized intervention in its aim of avoiding volatility in

rupee movements in either direction. Our study showed the pros/cons of this strategy and

1 RBI is the Central Bank of India and announces its policy statement twice a year2 Financial Sector Reforms and Monetary Policy – Rakesh Mohan


Contemporary Concerns Study over the last 3-4 years, RBI hasn’t even gone for a complete sterilization. Moreover, the

intervention of RBI in the Forex markets can be questioned as a circular effect which has not

stabilized and it had to continuously intervene in the Forex markets. This poses questions on

the stability of the underlying economy and its transmission mechanisms vis-à-vis increased

capital flows.

One of the direct effects of the exchange rate management has been the build up of India’s

foreign exchange reserves which is now the sixth largest in the world. While there is no doubt

about the economic importance of Forex reserves, especially for a developing economy like

India, we have analyzed the optimality of India’s foreign exchange reserves. Our Analysis

shows RBI is maintaining excess forex reserves irrespective of method taken for calculating

optimal forex reserves level. There is a trade off in maintaining huge reserves. On the flip

side there is maintenance cost incurred by RBI which is due to interest rate differentials

between US and IND. But maintaining reserves help it in insulating external sector and

Indian export competitiveness by intervening in forex markets as and when required. Also

since most of the reserves are of portfolio nature, which are volatile therefore it also justifies

current level of reserves. We also looked into alternate possibilities of utilizing India’s

foreign reserves in infrastructure financing and domestic growth.

The ultimate success of monetary policy could be judged in terms of inflation conditions and

RBI’s ability to maintain stable conditions in the financial markets. The inflation record over

the past five years is satisfactory as compared to other developing economies. The Reserve

Bank has so far been able to balance its objectives of exchange rate and monetary policy

objectives by choosing an intermediate exchange rate regime coupled with partial sterilized

intervention.



LITERATURE SURVEY, DATA SOURCES, AND METHODOLOGY

External sector discussed by Dr. Shyamal Roy3 in his book “Macroeconomic Policy

Environment” provided the basic framework of the CCS. The chapter starts off by discussing

the importance of external sector for an economy. Various variants of exchange rate i.e.

fixed, flexible and managed float are discussed. Balance of Payment (BOP) is then analyzed

and is linked to exchange rate determination. The important point discussed is that unlike in

the fixed exchange rate system where macro economic adjustments take place through money

supply changes, in a purely flexible exchange rate system adjustment takes place through

changes in exchange rates. In managed float RBI allows exchange rate to be market

determined and intervenes if it gets disorderly. The chapter highlights the importance of

financial sector reforms and finally ends with discussion about recent forex reserves.

In the chapter Exchange rate determination and forecasting, Prof. P G Apte4 discusses two

important theories namely Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) in

detail. The chapter mentions that PPP holds only in long run and when real exchange rate is

stationary over the time horizon. Thus, utility of PPP is negligible for managers in taking

quick decisions. Interest Rate Parity predicts exchange rate on the basis of interest rates

differentials and holds true to prevent arbitrage opportunities.

Dr. Y V Reddy5 in his speech “India’s Foreign exchange reserves – Policy, Status and issues

BIS Review 30/2002”, mentions three motives of storing forex reserves. These are

Transaction motive (to handle international trade), speculative motive (to gain by favorable

exchange rate movements) and precautionary motive (to store reserves as cushion against

sudden demand supply mismatches). He mentions that primarily it’s the precautionary motive

which is dominant in most of the cases for storing excess reserves.

3 Dr. Shyamal Roy is a Professor of Economics and Agricultural Economics at IIMB.4 Prof. P G Apte is teaching international Finance course at IIMB for number of years. 5 Governor, Reserve Bank Of India


Contemporary Concerns Study Mr. Vijay Joshi in his paper “The Real Exchange rate, Fiscal deficits and capital flows: A

Refutation6,” estimates the real impact of storing huge excess reserves in terms of lost GDP

growth rate as an opportunity costs. This paper calculates the GDP which would have

resulted by investing full amount of forex reserves over the years 1991-2000. We have used

this framework to come up with similar cost paid in terms of lost GDP growth rate for the last

five years.

Sumon Kumar Bhaumik and Hiranya Mukhopadhyay in their paper " RBI’s Intervention in

Foreign Exchange Market: An Econometric Analysis" address the issue of circular nature of

RBI's intervention in forex markets. They say that intervention affects the exchange rate in

two ways, first, by affecting the extent of excess demand in the foreign exchange market, and

thereafter through a complex interplay of the macroeconomic variables. The subsequent

empirical results indicate that the effect of RBI’s intervention in the foreign exchange market

is at best unclear. Specifically, given the time span of the data, the RBI’s interventions in the

market seem to have been ineffective.

Data Sources

RBI site provided the base for most of the data required for carrying out mathematical

modeling. The data was collected from RBI bulletins. In addition to this Money & Finance

journal published by ICRA was also referred for taking key information. Central Statistical

Organization’s website was used for taking price levels (WPI and CPI). US fed reserve

website was used for getting important information like yield of US t bills and spot rates.

Indianstat.com was used to gather important macroeconomic related data for over several

years. Finance ministry website was also used for getting relevant information for the CCS.

Methodology

The CCS project first began with reading of basic articles and chapters to get an in-depth

understanding of monetary policy operations and related levers. This was followed by a phase

of creating mathematical models for exchange rate determination and frameworks for

arriving at key conclusions like costs of maintaining excess reserves etc. Our guide Dr.

Shyamal Roy provided great help in finalizing the models and frameworks. In addition to this

several articles from leading publications like Economic & Political Weekly also provided

6 Economic and Political Weekly, March 2004


Contemporary Concerns Study required inputs for these frameworks. Data was collected from related online resources and

journals and models were tasted to verify the hypothesis. Finally based on this analysis key

interpretations were drawn.

INTRODUCTION TO MONETARY POLICY

Monetary policy works through change in money supply. This leads to impact on financial

variables, aggregate demand and finally GDP and prices. Monetary policy can target money

supply, interest rates or exchange rates to achieve goals. However it is not possible to achieve

all three at one go. The broad objective of monetary policy in India seems to be price

stability and sustained growth in output.

Monetary Policy Transmission Mechanism7

The efficacy of monetary policy depends on both stability of money demand and supply

function. On demand side key variable is income velocity of money while on supply side its

RBI’s ability to control monetary base and coefficient of money multiplier. All of these

variables are unstable. This coupled with the fact that monetary policy effects are seen after a

lag necessitates pre-emptive action from RBI.

Monetary policy is closely linked with the fiscal policy because excessive borrowing from

the market may force RBI to increase the money supply to arrest the increase in interest rates.

But it may lead to inflation. Therefore there is constant trade off between whether to let

7 Reference Taken from Dr. Shyamal Roy’s Text Book, Macroeconomic Policy Environment


Change in money supply

Interest Rates Asset Prices Exchange Rates

Consumption Spending (C) Investment Spending (I)

GDP Prices

Contemporary Concerns Study prices or interest rates let loose. In India, primary motive of monetary policy is price

stabilization. With increasing integration of Indian economy with other countries exchange

rate stability is also assuming considerable importance. Through this CCS we intend to study

the later part of monetary policy objective i.e. exchange rate stabilization and related issues

like benefits and cost analysis.



ANALYSIS OF BALANCE OF PAYMENTS

Balance of Payment statements (BOP) is basically a statement of the difference between the

supply and demand of foreign exchange. If the supply of foreign exchange is greater than the

demand for foreign exchange, Rupee will be under upward pressure and vice-versa. Hence,

analysis of BOP statements and their trends8 is critical to understanding the determination of

exchange rates.9

The last two years have seen significant changes in India’s BOP position which could signal

greater external sector vulnerability.

Current Account Balance10

Current Account Balance

-8-6-4-202468

2001 2002 2003 2004 2005 2006

Time Period

% o

f GDP

Current AccountBalance % GDP

Trade Balance

Invinsible Balance

India’s current account balance witnessed a deficit in 2004-05 and 2005-06 after three years

of rising current account surplus. This was driven by a large merchandise trade deficit

reaching 5.5% of GDP in 04-05 and expected to touch nearly 6.5% of GDP in 05-06. The

invisible balance growth (33% in 05-06) has been driven by services (esp. Software) export

growth and private transfers.

The sustainability of current account deficit (CAD) is situation-specific.

Positive Factors: Firstly, Non-oil imports have been driven primarily by imports of

capital goods and mainly export-related items. The rising import trends are, therefore,

8 The Report takes all trends over the last 6 year period 2001-20069 Page 213, “Macroeconomic Policy Environment”, Prof. Shyamal Roy, IIMBangalore10 Current Account Balance = Trade Account + Invisibles Account


Contemporary Concerns Study reflective of enhanced domestic activity and demand from exports. Secondly, the

financing of the current account has not posed any challenge as it has been financed

through normal capital flows without recourse to foreign exchange reserves.

Negative Factors: Uncertain international crude prices and expected moderation in

domestic as well as global growth in 2006-07 raise concerns about sustainability of the

CAD.

Trade Account Balance11

Merchandise Exports and Imports

0

50000

100000

150000

200000

2001 2002 2003 2004 2005 2006

mlli

on $ Imports

Exports

Both merchandise imports and exports have seen huge growth spurts in 2004-05 and 2005-

06. This is attributable to India’s resurgent competitiveness in the manufacturing sector,

rising international commodity prices, conducive macroeconomic policies, and a global

demand recovery. While a widening trade deficit is a cause of concern (primarily attributable

to rising crude oil prices), the quality of imports/exports have improved over the years

Trend Analysis of Imports and Exports

Year 2001 2002 2003 2004 2005 2006GDP 445181 483032 516212 605000 689108 735852Imports 57912 56277 64464 80177 118961 156334% of GDP 13.01% 11.65% 12.49% 13.25% 17.26% 21.25%Exports 45452 44703 53774 64723 80831 104780% of GDP 10.21% 9.25% 10.42% 10.70% 11.73% 14.24%

*Merchandise exports/imports

India has become relatively more outward-oriented in the last five years which is reflected

in the growing contribution of Exports to India’s GDP. Long-term sustainability of inflow of

dollars is dependent on the contributions from the manufacturing sector. Private Transfers,

11 Trade Account = Merchandise only


Contemporary Concerns Study which are a big component of Invisibles flow, can be volatile. Due to the rising imports, the

current account balance has not played a significant role in the recent burgeoning of Forex

reserves. We feel that despite the rising import bills, the fact that Capital goods and Export-

related item imports still constitute nearly 40% of imports augurs well for India’s productive

capacity.

Capital Account Balance12

Break up of Capital Account

-5000

0

5000

10000

15000

20000

2001 2002 2003 2004 2005 2006

Time Period

Mill

ion

$

Foreign Investments

Banking Capital

Rupee Debt Service

Other Capital

Loans

The Capital Account Balance has shown an increasing trend since 2003. However,

considering the diversity in the composition of Capital Account in terms of stable/volatile

capital flows, it is important to analyze the trends in various components of Capital account

balance.

Foreign Investment

Direct Vs Portfolio

0

5000

10000

15000

20000

2001 2002 2003 2004 2005 2006

Portfolio

Direct

FI is of two kinds: Portfolio and FDI. Foreign Institutional Investments (FII) led the

growth in net capital inflows, accounting for nearly 72% of FI flows over the last 3 years.

The periods April-May 2005 and recently April-June 2006 saw significant off take of

12 Capital Account = FI + Loans + Banking Capital + Rupee Debt Service + Other Capital


Contemporary Concerns Study volatile capital from Indian equity markets by the FII’s due to rising oil prices and the

resulting global uncertainty and the upturn in the interest rate cycle

Capital inflows through the issuances of American depository receipts (ADRs)/global

depository receipts (GDRs) increased substantially in lieu of booming stock markets.

In comparison to FII flows, the more permanent FDI flows were stagnant in the period

2003-05, but have made a strong comeback in 05-06 (FDI inflows witnessed a 43% yoy

growth while outflows remained at last year’s levels).

The rise in sectoral hikes in telecom (49% to 74%), and in air transport services (40% to

49%) resulted in significant interest in these sectors.

Outward FDI flow, on account of increasing M&A activities, has also increased smartly

over the last 2 years.

Indian Capital markets are one of the most sophisticated in the world today and the

interest shown by FII’s to put significant moneys into India has aided in its development.

But FII’s are basically looking at arbitrage opportunities in various markets, purely on

basis of trading margins. This money is very volatile, and can/has caused distress in

Indian markets on with drawl of funds.

Banking Capital

Banking Capital Vs NRI

-4000-2000

0

2000400060008000

1000012000

2001 2002 2003 2004 2005 2006

Banking Capital

NRI

NRI deposits witnessed a comeback in 05-06 after significant outflows in 04-05 reflecting the

re-alignment of returns on NRI deposits and global interest rates.

Loans



Break up of Loans

-4000

-2000

0

2000

4000

6000

8000

2001 2002 2003 2004 2005 2006

External Assistance

CommercialBorrowings

Short Term

The short term capital flows have risen over the last 5 years due to the borrowing

requirements of India to finance its excess import bill, due to rising oil prices. In 2005 short

term borrowings as a percentage of reserves stood at 4.3%. The short term borrowings should

be kept at low levels.

Strong domestic investment demand and favorable financing conditions abroad led to a

stupendous ECB outflow of $6 billion in 2005 following the deficits of the previous years

(due to repayment of borrowings out of Forex reserves). As expected, this jump slowed down

in 2006 albeit still a sizeable $1.6 billion of ECB.

How robust are India’s Balance of Payments?

The four set of balances shown below in charts, capture the robustness of balance of

payments by de-emphasizing the volatile components.

Current Account Balance

-15000

-10000

-5000

0

5000

10000

15000

2001 2002 2003 2004 2005 2006

Time Period

Mill

ion

$

Current AccountBalance

Balance on Goods and Services Only (BOGS)

-35000

-30000

-25000

-20000

-15000

-10000

-5000

0

Time Period

Mill

ion

$

Balance on Goodsand Services Only

*BOGS = Current Account Balance - Transfers -Investment Income



Trade Balance

-60000

-40000

-20000

02001 2002 2003 2004 2005 2006

Time Period M

illio

n $

Trade Balance

Basic Balance

-4000-2000

02000400060008000

1000012000

2001 2002 2003 2004 2005 2006

Time Period

Mill

ion

$

Basic Balance

*Basic Balance = Current Account Balance + Long term capital (FDI+ECB+External Assistance)

The charts clearly show that all the four balances have worsened in the last two years, the

reasons for which have been cited in the earlier part of the report. The overall BOP has

remained positive over this period due to huge capital account surpluses. Thus, overall, the

BOP position has kept an upward pressure on the Rupee over this period and Rupee has

indeed appreciated by nearly 8% over the last five years. The Foreign exchange reserves

have also more than doubled over the last six years. Refer Appendix1 for a check on the

quality of India’s foreign exchange reserves, isolating the short-term volatile components of

reserves from the sustainable long-term ones. The Exchange Rate Policy of RBI will throw

further light into the movement of exchange rates.

The important question to answer is:

Does RBI intervene in exchange rate determination despite having a market-determined

exchange rate policy on paper, and what variables/parameters does the RBI target, if at all?



EXCHANGE RATE MANAGEMENT BY RBI

The central banks the world over have chosen to manage exchange rate regimes, the degree

of management varying from economy to economy depending upon macroeconomic policy

objectives, the state of development and the integration of financial markets. Exchange rate

policies and real exchange rates are increasingly viewed as critical determinants of a

country’s performance from the view point of boosting export-led growth through structural

- adjustment programmes. When not fully flexible, as in most developing countries, nominal

exchange rates are often formulated by governments with a view to target some real exchange

rate13.

India switched to a floating exchange rate regime in 1993 after a transitional phase of dual

exchange rates for two years. After the unification of exchange rates, India witnessed large

capital flows and improvements in the current account. This exerted an upward pressure on

the Rupee. To maintain the competitiveness of Indian exports, RBI decided to absorb the

excess flows into reserves by buying dollars in the Forex market. However, buying of dollars

led to inflation.14 RBI responded to this by altering the short and medium term interest rates.

The central principle of exchange rate management has been to dampen oscillations in the

short run around the fundamental path and to ensure a reasonably stable real effective

exchange rate (targeting of REER).

Theories behind Exchange Rate DeterminationThere are two theories which explain exchange rate movements:

Purchasing Power Parity theory

Interest Rate Parity theory13 RN Agarwal, “Exchange Rate Determination in India Endogenising Foreign Capital Flowsand Some Entities of the Monetary Sector”14 Buying dollars increases the Net Foreign Currency Assets on a Central Bank’ s balance sheets and hence the Monetary Base.


Contemporary Concerns Study Let us analyze the two theories with empirical data in the Indian context

Purchasing Power Parity theory

Purchasing power parity (PPP) is one of the simplest methods of analyzing exchange rate

movements. It says that relative change in exchange rate of country A with respect to country

B should be in tandem with the change in price levels in two countries.

PPP holds good in a world when there are no transport and other trading costs, no trade

barriers, all goods are tradable and consumers in all countries have identical tastes. PPP holds

good in long run (horizon of 15-20 years) and when real exchange rate is relatively stationary

over the horizon. In short run its validity is questionable, and depends on question how

rapidly prices of goods and services adjust to real and monetary disturbances. Here we intend

to check whether PPP holds for a horizon of last 5 years with monthly frequency.

Model:

St (B/A) = current spot rate

St-1(B/A) = previous spot rate

Pt= WPI index of country A at time t

Pt-1= WPI index of country A at time t-1

P*t = WPI index of country B at time t

P*t-1 = WPI index of country B at time t-1

For this model to hold true we should get a=0 and b=1 as a result of regression.

Please refer to Regression model so achieved in Appendix 2. This model clearly shows that

over short time horizons of 5 years and with high frequency time series data (monthly) PPP

model does not hold (b is not 1, shown in highlighted cell). Due to lack of data available for

longer time horizons (15-20 years) we were not able to test applicability of PPP in long term.

PPP holds over a time period if the long run real exchange rate is stationary. We have plotted

the real exchange rate for USD/INR for last 5 years and it shows that real exchange rate has

not been stationary which also raises doubt about the applicability of PPP for forecasting

exchange rates.


ln St (B/A) - ln St-1(B/A) = a + b [ ln (Pt/P*t) – ln (P t-1/P*

t-1)]


Real Exchange Rate Movement

0

10

20

30

40

50

60

1 6 11 16 21 26 31 36 41 46 51 56 61

Real Exchange Rate

Real exchange rate (USD/INR) movement over last 5 years

The above trend can be due to real shocks like productivity improvements, resource

discoveries and movements in terms of trade over the given time period.

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

1 6 11 16 21 26 31 36 41 46 51 56 61Change in USD/INRSpot

Change in RelativePrice level

Changes in USD/INR Exchange rate and relative price ratio

The above graph shows that volatility in relative price index ratio between India and US is

not in sync with that of USD/INR spot prices. This also leads to failure of PPP model in short

run.

At best PPP model can be used to predict exchange rates with some reasonable accuracy

over very long horizons. Corporate risk managers have little use for such long-run views;

they need to guess currency movements from day-to-day, week-to-week and month-to-month

basis. Thus, PPP holds little value for business managers.

Interest Rate Parity theory

This theory proposes that interest rate differentials between two countries should be able to

explain the exchange rates between two countries. In equilibrium, interest rate differential


Contemporary Concerns Study and expected exchange rate changes should bear a relation. Mathematically we can say

following model should hold:

Where n= the time period in months

iA= the interest rate in

country A, home country

iB= the interest rate in

country B, foreign country

Fn(B/A)= n months forward of

exchange rate (number of units of

A per unit of B)

S(B/A)= spot exchange rate

(number of units of A per unit of B)

To test whether the forward rates

mentioned above are true indictor of

the actual spot rate n months after, we took data from July 2004 to June 2005. We regressed

the monthly actual spot rates in these months against the three estimates for this spot rate

derived from one, three and six months forward premium. The table used is as follows:

We ran a regression with column 1 as dependent variable and three estimates for the same

given by column 2, 3 and 4 as independent variable. The model turned out to be quite


Actual

spot1

month3

month6

monthJune '05 43.51 45.33 45.57 45.3

May'05 43.69 45.76 45.63 46.65

Apr'05 43.65 46.03 46.19 47.95

Mar'05 43.75 45.57 45.61 48.04

Feb'05 43.64 46.56 46.91 48.94

Jan'05 43.69 46.09 48.32 48.31

Dec'04 43.58 47.23 48.36 46.67

Noc'04 44.75 48.5 49.19 44.87

Oct'04 45.45 48.66 48.7 44.31

Sep'04 46.16 49.41 46.91 43.9

Aug'04 46.34 49.16 44.23 45.63

Jul'04 46.45 47.44 44.06 47.85

(1+niA)/(1+niB) = Fn(B/A)/S(B/A)

Contemporary Concerns Study significant with R^2 value of 88%. The results are shown in Appendix 3. The equation so

derived is as follows:

We can conclude from the regression that interest parity can be used to predict exchange

rates with reasonable accuracy.

What are the Exchange Rate Policy Options for RBI?RBI uses both direct and indirect intervention to manage the exchange rate. Prices, interest

rates, and money supply in the home and foreign country are important variables to explain

the behaviour of bilateral exchange rate. Other significant variables are balance of payments

items like current and capital account balances and foreign exchange reserves. The most

frequently used tool is direct intervention in the foreign exchange market through purchases

and sales in the intervention currency (i.e. US dollars) in both spot and forward markets. This

is often combined with indirect intervention, viz. quantitative restrictions, reserve

requirements and interest rate changes to smoothen temporary mismatches between demand

and supply of foreign currency.

The Rupee has been under upward pressure over the last few years, and RBI has had to take

actions to stem the appreciation of the rupee to prevent adverse effects on competitiveness of

India’s exports. RBI has three options under these circumstances. As part of our study, we

have tried to analyze the costs and benefits of each of the options in a broader context of

Indian macro-economic situation.

Option 1: RBI intervention without sterilizationAppreciation of rupee has been caused by the excess supply of dollars in the market. Hence

RBI will start buying dollars from the market to remove the excess supply and thereby

stabilize the rupee. However, going back to RBI’s balance sheets, dollar purchase will

increase the Net Foreign Currency Assets of RBI and hence the Monetary base. Assuming a

stable multiplier, Money Supply in the economy will increase which could be inflationary.

Inflation, above a certain minimum level, can be very costly to the economy. Besides

inflationary costs, RBI also bears the opportunity cost lost of keeping excess foreign reserves


Spot ratet = 23.09349 + 0.7593(forward ratet-1) – 0.3208 (forward ratet-3) +

0.0135 (forward ratet-6)

Contemporary Concerns Study which typically yield lower return.15 The benefit as compared to other option of “intervention

with sterilization” would be the lowering of interest liabilities on the G-secs to be issued for

the purpose of sterilization.

Costs Inflation and Opportunity cost on holding excess reserves

Benefits Savings on Interest rate liabilities

Opportunity cost of excess reserves (Refer Section on optimality of reserves)

Benefits: Savings on Interest liabilities

Appendix 4 gives the interest expense of RBI in the OMO for sterilization purposes16. RBI

has spent 1090, 1985, and 2435 crores respectively in 2003-04, 2004-05, 2005-06 for its

OMO. Option 1 will indirectly lead to savings in these expenses.

Inflation costs

Increase in Money supply (M3) through purchase of dollars by RBI in Option 1 should lead

to rising inflationary levels in the economy. However empirical data17 shows that there is a

weak correlation between changes in money supply and changes in WPI. This provides an

important insight there is an excess capacity in the Indian economy which can absorb the

increase in Money supply without fuelling inflation.

Considering this empirical data, it is obvious that the inflation costs of Option 1 might not

actually be true as the economy can absorb the excess money supply. Hence, this suggests

that RBI need not undertake sterilization and incur heavy interest expense costs as Inflation

costs are unfounded.

(Refer Option 3 for details about RBI Intervention.)

Option 2: RBI intervention with sterilization18

Option2 basically involves purchase of dollars by RBI in the market (to absorb the excess

supply of dollars) and accompanied by selling G-secs in the market to counter the inflationary

expectations of buying dollars in the first place. This is called sterilized intervention. While

Option 2 looks very strong on paper, it has practical limitations as well as costs of

sterilization.

15 Cost of excess reserves has been dealt with in a separate section16 OMO for sterilization purpose as growth in Money supply has been in line with expectations over the last 5 years17 Assuming a 1 month lag between Money supply changes and effects on Inflation measure (WPI)18 Page 194, “Macroeconomic Policy Environment”, Prof. Shyamal Roy, IIMBangalore


Contemporary Concerns Study The original problem of Supply of $ > Demand of $ is not solved by sterilized

intervention. The underlying reason for excess supply of foreign exchange is due to

expectation of better returns in India, which in turn is captured by the interest rate

differentials between India and rest of the world. The solution to the underlying problem

could be increase in broad money supply, which will soften the interest rates, and hence

drive away the dollar inflow. However sterilized intervention keeps the broader money

supply at the same level, and hence does not solve the underlying problem of excess

supply of foreign exchange over demand for the same. Infact sale of G-sec actually

hardens the interest rates due to absorption of liquidity from the system.

Sterilization exercise is also limited by limitations of G-secs on RBI’s books and hence

cannot be a long-term sustainable exercise.

Costs of sterilization: Refer Appendix 4 detailing the costs of sterilization to RBI which

runs to the tune of 5510 crores for the last three financial years.

Opportunity cost of excess reserves (Refer Section on optimality of reserves)

Option 3: RBI non-interventionIn this Option, RBI chooses not to intervene in the Forex market and keep a completely

market-determined exchange rate. The effects of this option can be understood by analyzing

the effect of RBI non-intervention on (1) Nominal exchange rates and (2) REER.

Method of Study 1: We have taken data for the last 24 months (April 2004 to March 2006) for

analysis purpose as shown in Appendix 5:

Suggested Model:

To this model, we substitute Market Purchases/Sales excluding RBI Purchases/Sales to arrive

at the new spot rates w/o RBI intervention

Observation: The model gives different significance levels depending on the chosen time

horizon as shown the chart given below19:

19 The months referred are in 2004 and the model takes data points from 2004 to March 2006.


Model significance in different time periods

0.00%

10.00%

20.00%

30.00%

40.00%

Time Period

R^2

R 2̂

R^2 7.57% 20.72%24.71%28.23%26.58%29.08%37.16%

Oct Nov Dec Jan Feb Mar Apr

Spot rates = 42.55928 + (0.000204)* Total $ purchases + (-0.00017) *

Total $ sales


We have taken the Model giving 37% R^2 significance to predict the spot rates. The results

are shown in Appendix 5 in the end. Rupee has depreciated nominally by 2.81% against the

dollar from March 2004 to March 2006. Without RBI intervention, Rupee would have

appreciated by 0.83% against the dollar. This reflects a (2.81+.83= 3.64%) effect of RBI

intervention to keep the Rupee undervalued. Rupee appreciation would have led to fall in

export demand slightly as well as increase in import demand due to cheaper imports which

would negatively impacted the current account deficit.

Nominal Exchange Rate Movements

Apr'05

May'05

June

'05

July'

05

Aug'05

Sep'05Oct'

05

Nov'05

Dec'05

Jan'0

6

Feb'06

Mar'06

Time Period

USD

/INR With RBI

intervention

Without RBIintervention

Method of Study 2: We have taken data for the last 12 months (April 2005 to March 2006) for

analysis purpose as shown in Appendix 6:

Suggested Model

Assumption: US inflation rates have been taken as dummy for calculation of REER

We ran the regression of current REER against the inflation figures for India and US and spot

rates between India and US.

Model R^2 = 67%


REER = 127.2966 + -0.28356*(US PPI) + 0.687935*(IND WPI) + -2.33931*(Spot rates)

Contemporary Concerns Study To calculate the new REER without RBI intervention we substitute the values for new spot

rates obtained in previous Method 1. This yields REER of 105.12 in March 2006 without RBI

interventions.

Hence RBI intervention led to REER appreciation by only .86% in the last 12 months from

April 2005 to March 2006. However without RBI intervention REER would have appreciated

by 4.14% in the same period. Hence we can conclude that RBI is targeting a stable REER and

has been successful in keeping REER stable so as not to hurt export competitiveness of India.

Which Option is RBI pursuing?RBI has been going for Option2 i.e. sterilized intervention in Forex markets. However the

degree of sterilization has been going down over the years as shown in the table below.

Year

Net Purchase

of $ by RBI

(Crores)

Sale of G-Secs by RBI

(Crores)Percentage Sterilization

2002-03 81229.2 55031.8 67.75%

2003-04 132559.20 41598.01 31.38%

2004-05 90683.71 2899.24 3.20%

2005-06 35421.53 3912.71 11.05%

The priorities set by RBI for its conflicting goals of interest rate, money supply, and

exchange rate stabilization has been Price and Exchange rate stabilization. It has used short-

term and medium-term interest rates as tools to achieve this target. Hence, RBI decides on a

broad money supply target based on expected GDP growth and acceptable inflation and sets

money supply based on that. The average annual Money supply growth over the five years

from 2001-2005 has been 14.44%, which is close to the targets RBI must have set of 12-13%

(GDP growth 7-8% + Inflation 5%). After that RBI intervenes in the Forex market to avoid

undue volatility in the exchange rates. While India’s trade relations have diversified a lot over

the years, we feel Indian rupee is still pegged to the Dollar rate. This is also supported by

both short-term and long-term empirical data on volatility of exchange rates against various

currencies as shown in the Appendix 7. The nominal USD/INR spot rates show remarkably

stable trend with a variance of only 0.77 compared to other currencies.



Targeting REER


REER Trends

98100102104106

Time Period

REE

R REER

Open Market Operations of RBI

-8000-6000-4000-2000

0200040006000

1 2 3 4 5 6 7 8 9 10 11 12

Time Period

Net

Pur

chas

e of

G-s

ec

Series1

The two black ellipses show that when REER was appreciating in the March-June 2005-06 period, RBI responded by buying dollars to keep the REER down.

The two red ellipses show that when REER was depreciating in the October-December 2005-06 period, RBI responded by selling dollars to keep the REER up. Hence RBI is targeting REER.


EFFECTIVENESS OF RBI INTERVENTION20

RBI has been intervening in the Forex markets both under cases of upward and downward

pressure on the Indian rupee. When rupee was under downward pressure, RBI either

intervened directly by selling dollars in the Forex market or indirectly by increasing the

domestic interest rates through policy tools like cash reserve ratio, bank rates, and repo

rates21.Under crisis situation such as November 1997 and May-June 1998 (Pokhran blasts),

RBI resorted to heavy selling of dollars and thus direct interference. Conversely, when the

Indian rupee has been under upward pressure (especially over the last few years), RBI has

resorted to net purchase of dollars in the Forex market to prevent a sharp appreciation of the

Indian rupee to maintain export competitiveness of India. However, there is a strong debate in

the academic circle regarding the efficacy of RBI’s intervention.

Secondary effects of RBI intervention

20 “RBI’s Intervention in Foreign Exchange Market An Econometric Analysis” – Sumon Kumar Bhaumik, Hiranya Mukhopadhyay21 RBI is increasingly resorting to only Repo rates as its indirect policy tool and has kept the bank rates and cash reserve ratios stable.


RBI purchases dollars to prevent appreciation of rupee

Increase in supply of bondsIncrease in MB Increase in Money supply


Model, Refer to Appendix 8

Coefficient 1: Captures the contemporaneous impact of the bank’s intervention in the market

Coefficient 2: Captures previous intervention of bank in the foreign exchange market

Expectation: If RBI buys dollars, then rupee should depreciate and Change in spot rates

should be positive (coefficient 1 should be positive). Empirical data shown in Appendix 8

suggests instead a slightly negative coefficient 1 for both the 12 month and 24 month period.


Impact on interest ratesImpact on interest rates

Impact on nominal exchange rates

Change in spot rates = (coefficient 1) * (Net dollar purchase of RBI in period

t) + (coefficient 2) * (Net dollar purchase of RBI in period t-1)

Purchase of dollars by RBI leads to primary effect of rupee depreciation

Upward pressure on India’s GDP

Rise in GDP partially crowded out

Increase in effective demand in the economy

As rupee depreciates, India’s trade balance improves

Assuming Money supply held constant through sterilization, interest rates rise


Hence RBI intervenes continuously in the Forex market in the same direction over a longer

period of time. This could suggest that the Indian Forex markets and its macro-economic

system to be still not very stable because the Coefficient 1 is slightly negative when it is

expected to be positive for a stable underlying economy and Forex markets.

ANALYSIS OF FOREX RESERVE MANAGEMENT

Reserves are external assets that are readily available to and controlled by monetary

authorities for direct financing of external payments imbalances, for indirectly regulating the

magnitude of such imbalances through intervention in exchange markets to effect currency

exchange rate, and/or for other purposes.22

With global markets opening up, developing countries are facing extreme volatility of capital

flows, which forces them to maintain excess forex reserves for necessary cushion. India also

has seen huge build up of reserves. The level of foreign exchange reserves has steadily

increased from US$ 5.8 billion as at end-March 1991 to US$ 113.0 billion by end-March

2004 and further to US$ 141.5 billion by end-March 2005. It stood at US$ 151.6 billion as at

end-March 2006 Movement in Reserves23

(US $ million)

Date FCA SDR GOLD RTP

Forex

Reserves

31-Mar-04 107,448 2 (1.6) 4,198 1,311 112,959

30-Sep-04 114,083 1 (1.0) 4,192 1,303 119,579

31-Mar-05 135,571 5 (3.0) 4,500 1,438 141,514

22 Balance of Payment Manual, and Guidelines on Foreign Exchange reserve management23 RBI Forex reserves report, 2006


Rise in income leads to higher imports and trade balance dampens

Inflow of dollars from foreign investors rises

Dampens the initial depreciation by putting an upward pressure on rupee

Contemporary Concerns Study 30-Sep-05 136,920 4 (3.0) 4,712 1,423 143,058

31-Mar-06 145,108 3 (2.0) 5,755 756 151,622

1. FCA (Foreign Currency Assets): FCA is maintained as a multicurrency portfolio, comprising

major currencies, such as, US dollar, Euro, Pound sterling, Japanese yen, etc. and is valued in US

dollars.

2. SDR: Values in SDR have been indicated in parentheses.

3. Gold: Physical stock has remained unchanged at approximately 357 tonnes.

4. RTP refers to Reserve Tranche Position in IMF

Need for Forex Reserves Three motives can be thought of behind holding huge forex reserves.24 These are

Transaction Motive: International trade gives rise to currency flows and this makes it

necessary for banks to hold forex reserves

Speculative Motive: Here the objective is to gain by exchange rate movements by holding

forex reserves. This is generally left to individuals/corporate.

Precautionary Motive: This is the main motive quoted behind central bank’s huge

reserves. It is viewed as “war chest”. Reserves are instruments to maintain or manage the

exchange rate and also helps in orderly management of capital inflow and outflow. It can

be positively related to cost of covering unplanned deficit and negatively related to return

from alternative assets. Thus it helps in maintaining demand and supply of foreign

currencies and preserve confidence in carrying out external transactions.

Optimal Level of Reserves Adequacy of reserves has emerged as an important parameter in gauging its ability to absorb

external shocks. With the changing profile of capital flows, the traditional approach of

assessing reserve adequacy in terms of import cover has been broadened to include a number

of parameters which take into account the size, composition and risk profiles of various types

of capital flows as well as the types of external shocks to which the economy is vulnerable.

The High Level Committee on Balance of Payments, which was chaired by Dr. C.

24 Y V Reddy: India’s Foreign exchange reserves – Policy, Status and issues BIS Review 30/2002


Contemporary Concerns Study Rangarajan, erstwhile Governor of Reserve Bank of India, had suggested that, while

determining the adequacy of reserves, due attention should be paid to payment obligations, in

addition to the traditional measure of import cover of 3 to 4 months. In 1997, the Report of

Committee on Capital Account Convertibility under the chairmanship of Mr.S.S.Tarapore

suggested measures of adequacy of reserves which, in addition to trade- based indicators, also

included money-based and debt-based indicators.

Here we will be analyzing the optimality of reserves based on import cover, incorporating the

possibility of lead lags and debt based indicators.

Method1: Import Cover

This method assesses the optimality of reserves in terms of number of months of imports (by

value) reserves can sustain. Six months of import cover is considered optimal.

2001-02 2002-03 2003-04 2004-05 2005-06

Forex Levels 264036 361470 490129 619116 676387

Total Imports 274778 297206 359108 478302 620827

Import Cover (Months) 11.53 14.59 16.38 15.53 13.07

Required cover for 6 month 137389 148603 179554 239151 310414

Excess Reserves 126647 212867 310575 379965 365974

* All values are in Rs Crores

This clearly shows India is maintain excess reserves and is in quite a comfortable position

from covering import perspective.

Method2: Incorporating the possibility of leads and lags

2001-02 2002-03 2003-04 2004-05

FER 264036 361470 490129 619116

Total Imports 274778 297206 359108 478302

Total Exports 209018 255137 293367 361879

Annual Debt Service Payment 2458 2303 1756 1858

Reserves Reqd ( 3 month cover+

50%

of debt service + 1 month of

110240 121482 145028 190520


Contemporary Concerns Study import and Export)

Excess Reserves 153796 239988 345101 428596


This considers the fact that export receipts can be delayed or even advanced through recourse

to export the credit facilities. Thus import cover is calculated after incorporating the

possibility of lead and lags in the initial cover. (It becomes more robust measure as compared

to simple import cover). However this measure also shows that excess reserves are being

maintained.

Method3: Debt Based Indicators:

These indicators are useful for gauging risks associated with adverse developments in

international capital markets. It provides a measure of how quickly a country would be forced

to adjust in face of capital market distortion. Studies show that it could be single most

indicator of reserves adequacy in countries with significant but uncertain access to capital

market.

2001-02 2002-03 2003-04 2004-05

Foreign Exchange Reserves

(FER)

54106 76100 112959 141514

Short term debt 2745 4669 4431 7524

short term debt as % of FER 5.07 6.14 3.92 5.32

Portfolio Inflows 2,021 979 11378 8,907

Cumulative Inflows 22,300 23,279 34,657 43,564

ST Debt + Cumulative flows (VI) 25,045 27,948 39,088 51,088

VI as % of FER 46.29 36.73 34.60 36.10

Required FER for 60% 41742 46580 65147 85147

Excess FER (In Million $) 12364 29520 47812 56367

Excess FER (In Crores) 59967.02 140220 217546.12 256471.37

This also shows that reserves are in excess of what is required.

Cost of maintaining forex reservesThere is a huge opportunity cost incurred by country because of the forgone chance of

investing the excess reserves in India rather than giving credit to outside. To quantify the cost


Contemporary Concerns Study incurred we assume that all the reserves handled are in USD. Interest rate differentials for 90

days t-bills between US and India were calculated for coming at opportunity cost figure.

2001-02 2002-03 2003-04 2004-05

US T-bills (3 months) 1.61 1.01 1.37 3.15

Indian T Bills (91 days) 6.88 5.73 4.63 4.89

Interest differential 5.27 4.72 3.26 1.74

Excess Reserves (Import Cover) 126647 212867 310575 379965

Excess FER (Lead & Lag) 59967.02 140220 217546.12 256471.37

Excess Reserves (Debt Based) 153796 239988 345101 428596

Excess cost of Reserves(method 1) 26697.19 40189.29 40498.98 26445.564

Excess cost of Reserves(method 2) 12641.05 26473.536 28368.014 17850.407

Excess cost of reserves (method 3) 32420.23 45309.813 45001.181 29830.311


Cost of Reserves

0

10000

20000

30000

40000

50000

2001-02 2002-03 2003-04 2004-05

Year

Valu

e in

cro

res

Import CoverWith Lead and Lag

Debt Based Indicator

Though forex reserves have increased in 2004-05 as compared 2003-04 but there is decrease

in the cost of reserves mainly due to drastic decrease in the interest rate differential between

US and India.

As shown above, RBI is maintaining excess forex reserves. There is also a huge cost incurred

for the same but this has to be traded off with the benefits of usage of reserves as

precautionary motive and stabilize inflows and outflows of the capital. Huge forex reserves if

not mopped by RBI partially or fully will lead to appreciation of domestic currency. This will

affect the competitiveness of the Indian exports. Also as the chart below shows most of the

forex reserves belong to portfolio investments. Since these are volatile reserves RBI cannot


Contemporary Concerns Study bank on them and sudden outflow of these due to unforeseen event or better opportunity

elsewhere will jeopardize the balance in external sector.

Direct Vs Portfolio

0

5000

10000

15000

20000

2001 2002 2003 2004 2005 2006

Portfolio

Direct

RBI can either a) stop accumulate dollars which will lead to appreciation of INR in real

terms and will impact the export competitiveness. b) Keep on buying reserves and increase

the monetary base, which in turn will lead to inflationary pressures and may impact the

economic growth c) buy reserves but simultaneously sterilize the same (partial or fully) with

selling of G sec. This will check the monetary inflation but will also lead to excess cost of

coupon payments on Open market operations for selling G secs. RBI over years as mentioned

in earlier sections seems to follow partial or full sterilization.

Impact on GDP growth rate25

We can also analyze the impact of maintaining excess reserves in terms of its impact on GDP

growth rate. Here we try to calculate the new GDP growth rate had all the forex reserves were

used in investment in the economy. Following table shows the calculations.

I/Y NFA/Y I*/Y G(%) I/Delta Y G*(%)

2001 23.8 1.31228 25.1123 6 3.96667 6.33083

2002 22.6 2.434 25.034 5.6 4.03571 6.20312

2003 24.8 3.29031 28.0903 4 6.2 4.5307

2004 26.3 5.19355 31.4936 8.2 3.20732 9.81928

2005 30.1 3.79607 33.8961 7.6 3.96053 8.55848

I = Investment spending in an year

Y= GDP in the year

NFA= Increase in forex reserves over previous year

I*/Y= column 1 + column2

25 The Real Exchange rate, Fiscal deficits and capital flows: A Refutation, Vijay Joshi, EPW, March 2004


Contemporary Concerns Study G=Approximate GDP growth rate in the year

I/Delta Y = this gives the indication of what’s the investment required for per unit percentage

of GDP growth rate (col 1/col 4)

G* = New GDP growth rate had all the forex reserves were invested. (col 3/col 5)

The data clearly shows that GDP growth rate would have been approximately 7.1% per

annum as compared to 6.28% in actual terms (if entire forex reserves were invested with

same efficiency). This is also an indicative of cost of holding excess forex reserves.

Alternative use of forex reserves Country is taking steps towards full capital account convertibility. One of the

prerequisites for the same is availability for sufficient forex reserves which will help in

facing sudden fluctuations in exchange rates and external demand and supply of goods

and services.

Forex can also be used in infrastructure development through import of goods and

services. This idea was proposed by planning commission deputy chairman Mr. Montek

Singh Ahluwalia. He said that investing approximately 5 billion annually for next 3 years

will bridge critical gaps in infrastructure. But RBI says that this will lead to increased

money supply and thus inflation in addition to widening of fiscal deficit. Mr. Montek

Singh proposed monetization, FRBM act and using imports can be used to tackle the

fiscal deficit problem. This will not work if majority of imports are in rupee term.

Funding long term strategic infrastructure on forex reserves (much of which is volatile

FII) is not a viable option. Rather than putting forex for infrastructure financing focus

should be on reducing government deficit and also realign expenditure on priority sectors.

Currently interest payments, wages and subsidies nearly take almost 50% of Government

spending leaving too little for spending on infrastructure.26 In addition to this Government

should try to implement Public Private Partnership (PPP) model which is so successful in

South Asian countries and UK. For this it is imperative to relax norms and regulatory

framework. Private players should be provided with incentives and loans at cheap rates. 26 IMF chief cautions against using forex reserves, Rodrigo de Rato, 2005



MANAGERIAL IMPLICATIONS

With growing importance of external sector and integration of Indian economy with global

trends, manager’s interest stems from desire to know what the monetary policy signals about

the exchange rate. Managers must understand the mechanics of external sector to formulate

business/investment strategies.

In the short run, managers should be alert about the state of economy and make intelligent

judgment on how policies may impact revenue and cost figures. In the long run these

variables do behave consistently and are governed by fundamentals of economy. Thus

managers should take a long term perspective and not get swayed by short term temporary

events.

In the Indian context, our study on policy measures of RBI revealed that RBI has been

continuously intervening in the Forex markets, and responding to global interest rate changes.

Some of these measures are short term and are not in line with the growth of domestic

economy. Hence managers should not base their business/investment decisions on these short

term measures



CONCLUSION

1. The conflicting goals of RBI are domestic growth with price and exchange rate stability.

With the opening of Indian economy, RBI faces twin imperatives of domestic growth in

line with Indian economy’s fundamentals, and alignment of exchange rates with external

sector. On a fundamental basis, the decision to harden/soften interest rates should be

dependent on the state of domestic economy (For example an over heated economy

justifies a interest rate hike). Short-term fluctuations and two-ways movement of volatile

money alone should not make the central bank to keep adjusting the domestic interest

rates.

2. In the context of above point, the recent hike of interest rates by India in response to Fed

rate hikes is questionable. We feel that the autonomous component of Investments driven

by long-term outlook of Indian economy play an important role in fuelling GDP growth

and short term capital outflow based on arbitrage will not hurt the Investor sentiments as

long as they are convinced about the Indian growth story. Hence, the credibility of RBI’s

monetary policy comes into the picture. We feel RBI should not respond to short-term

portfolio investments fluctuation as it loses the belief of Investors in the long-term growth

outlook of the economy.


Contemporary Concerns Study 3. Findings of BOP analysis: The Balance of Payment analysis showed that there is an

increasing influence of capital flows in determining exchange rate movements as against

trade deficits and economic growth in the earlier years. While this positively reflects the

integration of India with global markets, the quality of the capital flows can be questioned

considering the volatile Portfolio investments. Sustainability of Current Account deficit

on the back of volatile capital account balance may not sustainable.

4. RBI has been performing sterilized intervention in the Forex markets but the degree of

sterilization has diminished over the last few years. This is advisable as empirical data

showed that there is excess capacity in the Indian economy which can absorb the increase

in Money supply without fuelling inflation rates adversely. We feel that inflationary

trends in India look stable over a long-term and short-term price fluctuations should not

be the reason for a sterilized intervention.

5. We feel RBI is targeting Real Effective Exchange Rate (REER) as a policy measure and

uses Money supply and Interest rates as a policy tool. The efficacy of REER as a solitary

target is questionable. REER is based on the Purchasing Power Parity theory, which is

based on tradable goods. However, the ratio of trade to Forex market turnover is

decreasing over the years and increasingly interest rate differentials between countries

represent flow of arbitrage money across them and hence make the exchange rates

volatile.

6. RBI’s intervention in the Forex markets has been circular and it has had to constantly

intervene in the Forex markets to stabilize the exchange rates. This could suggest that the

underlying Forex markets and macro-economic system is still not as efficient

7. Our Analysis shows RBI is maintaining excess forex reserves irrespective of method

taken for calculating optimal forex reserves level. There is a trade off in maintaining huge

reserves. On the flip side there is maintenance cost incurred by RBI which is due to

interest rate differentials between US and IND. But maintaining reserves helps it in

insulating external sector and Indian export competitiveness against sudden shocks. Also

since most of the reserves are of portfolio nature which is volatile therefore it also

justifies current level of reserves. Hence, we feel that current level of reserves is

necessary. RBI should not follow sterilization at least to full extent of purchase of forex

because there is excess capacity in economy and its not overheating therefore inflationary

fears are not so realistic.



Limitations of our study1. The analysis and the subsequent insights have been drawn from a time horizon of past 2-5

years. We feel extensive data over the last 15 years will reveal useful trends and policy

directions of RBI and help understanding its rationale behind Interventions in the Forex

markets and priorities.

2. While analyzing the pros/cons of sterilized intervention, we have assumed the Open

Market Operations (OMO) of RBI have been for sterilization purposes. The broad money

supply growth over the last five years have been approximately in line with GDP growth

and inflation expectations, hence all the OMO interventions have been assumed to be for

sterilized intervention.

3. All the models used in our study have tried to incorporate the variables expected to

influence the dependent variable. However, one inherent drawback in applying theoretical

models in a specific context, say a developing country like India may not hold true for

practical purposes. There are numerous variables which affect exchange rates, and hence

there is an inherent limitations of analysis based on application of models.

APPENDICES

(1) Quality and Composition of India’s Foreign Exchange Reserves

(US $

million)

Date FCA SDR GOLD RTPForex

Reserves31-Mar-04 107,448 2 (1.6) 4,198 1,311 112,95930-Sep-04 114,083 1 (1.0) 4,192 1,303 119,57931-Mar-05 135,571 5 (3.0) 4,500 1,438 141,51430-Sep-05 136,920 4 (3.0) 4,712 1,423 143,05831-Mar-06 145,108 3 (2.0) 5,755 756 151,622



Short Term Reserves

-5000

0

5000

10000

15000

20000

2001 2002 2003 2004 2005 2006

Rupee Debt Service

NRI Deposits

Portfolio Investments

Short Term Loans

Short Term Reserves

Long Term Reserves

-4000-2000

0

2000400060008000

1000012000

2001 2002 2003 2004 2005 2006

FDI

ECB

External Assistance

Long Term Reserves

* The short-term reserves have grown by nearly 300% over the last 3 years, on the back of

huge growth in portfolio investments. The quality of Forex reserves in the short term can be

unstable on with drawl on funds by foreign funds.

(2) Purchasing Power Parity

SUMMARY OUTPUT

Regression Statistics Multiple R 0.179538619 R Square 0.032234116 Adjusted R Square 0.015831304 Standard Error 0.011211897 Observations 61 ANOVA

df SS MS FSignificance

F Regression 1 0.000247033 0.000247033 1.965157966 0.166201935


Contemporary Concerns Study Residual 59 0.007416692 0.000125707 Total 60 0.007663725

CoefficientsStandard

Error t Stat P-value Lower 95% Upper 95%

Intercept-

0.000495055 0.001444395-

0.342741907 0.733010765-

0.003385283 0.002395173

X Variable 1-

0.138053554 0.098480186-

1.401840921 0.166201935-

0.335111949 0.059004841

(3) Interest Rate Parity

SUMMARY OUTPUT


Df SS MS F Significance


Contemporary Concerns Study F

Regression 3 14.22145444 4.740484812 20.90338775 0.000384512 Residual 8 1.814245564 0.226780695 Total 11 16.0357


Error t Stat P-value Lower 95% Upper 95%

Intercept 23.09348953 11.3098807 2.041886218 0.075452617-

2.987142116 49.17412118X Variable 1 0.759298302 0.129764827 5.851341396 0.000382196 0.460060075 1.058536528

X Variable 2-

0.320798097 0.086111653-

3.725373824 0.005826286-

0.519371924 -0.12222427

X Variable 3 0.013461164 0.113390722 0.118714863 0.90842807-

0.248018309 0.274940637

(4) Cost of Sterilization to RBI in Open Market Operations (OMO)* All values in Rs. Crores

2003-04

Purchase Sale Net CumulativeInterest Rates

Interest Expense

2003-04

April 2003 — 14.98 -14.98 -14.98 0.05 -0.06May 2003 — 5501.96 -5501.96 -5516.94 0.05 -22.99June 2003 — 43.26 -43.26 -5560.2 0.05 -23.17July 2003 — 87.6 -87.6 -5647.8 0.05 -23.53

August 2003 — 11421.9 -11421.9 -17069.7 0.045 -64.01September 2003 — 5082.78 -5082.78 -22152.48 0.045 -83.07



October 2003 — 13855.13-

13855.13 -36007.61 0.045 -135.03November 2003 — 81.1 -81.1 -36088.71 0.045 -135.33December 2003 — 150.33 -150.33 -36239.04 0.045 -135.90January 2004 — 5198.39 -5198.39 -41437.43 0.045 -155.39February 2004 — 35.03 -35.03 -41472.46 0.045 -155.52

March 2004 — 125.55 -125.55 -41598.01 0.045 -155.99 -1090.00

2004-05


Interest Expense

2004-05


August 2004 — 125.19 -125.19 -42382.77 0.045 -158.94September 2004 — 146 -146 -42528.77 0.045 -159.48

October 2004 — 115.22 -115.22 -42643.99 0.0475 -168.80November 2004 — 361.34 -361.34 -43005.33 0.0475 -170.23December 2004 — 502.96 -502.96 -43508.29 0.0475 -172.22January 2005 — 534.03 -534.03 -44042.32 0.0475 -174.33February 2005 — 96.53 -96.53 -44138.85 0.0475 -174.72

March 2005 — 358.4 -358.4 -44497.25 0.0475 -176.13 -1985.25

2005-06


Interest Expense

2005-06


August 2005 — 121.19 -121.19 -46724.8 0.05 -194.69September 2005 — 255.85 -255.85 -46980.65 0.05 -195.75

October 2005 — 123.68 -123.68 -47104.33 0.0525 -206.08November 2005 — 107.92 -107.92 -47212.25 0.0525 -206.55December 2005 — 29.51 -29.51 -47241.76 0.0525 -206.68January 2006 — 674.41 -674.41 -47916.17 0.055 -219.62


Contemporary Concerns Study February 2006 215 522.56 -307.56 -48223.73 0.055 -221.03

March 2006 525 711.23 -186.23 -48409.96 0.055 -221.88 -2435.16

(5) Exchange Rate determination without RBI intervention

A B C D E F G H I

MonthPurchase(T

otal)Sales(Tot

al)

RBI Purcha

se

RBI Sale

s

Purchase

excluding RBI

Sales excluding RBI

USD/INR

USD/INR w/o RBI

intervention

45.26 Mar'04 44964 44500 6170.5 2789 38793.5 41711 43.39 43.37Apr'04 42188 44416 10758.5 3332 31429.5 41084 44.41 41.98

May'04 40919 39557 3219.53439.

5 37699.5 36117.5 45.56 44.10

June'04 41263 39672 969.5 1383 40293.538289.0

5 45.98 44.26

July'04 41327 39733 01179.

5 41327 38553.5 46.45 44.43Aug'04 32978 31936 5 880.5 32973 31055.5 46.34 44.00


Contemporary Concerns Study Sep'04 35847 34803 143 124 35704 34699 46.16 43.94Oct'04 34393 32414 5 104 34388 32310 45.45 44.07Nov'04 45881 46133 3791.5 0 42089.5 46133 44.75 43.29

Dec'04 53392 50918 1501.5108.2

2 51890.550809.7

8 43.58 44.50Jan'05 40825 39284 0 0 40825 39284 43.69 44.20Feb'05 54260 54234 4974 0 54260 49260 43.64 43.38Mar'05 55030 53317 6030 0 49000 47287 43.75 43.48Apr'05 33756 32917 0 0 28782 32917 43.65 43.84May'05 45285 44865 0 0 45285 44865 43.69 44.16

June'05 41386 42199 0103.6

4 4138642095.3

6 43.51 43.84July'05 45616 46102 2473 0 41824.5 43629 43.49 43.51Aug'05 53768 54874 2003 451 51765 54423 44.04 43.86Sep'05 37890 37976 0 0 37890 37976 43.99 43.82Oct'05 61735 62521 0 0 61735 62521 45.11 44.51Nov'05 53982 52389 0 0 53982 52389 45.94 44.65

Dec'05 66058 64735 06541.

5 6605858193.5

2 45.07 46.13Jan'06 66402 65002 0 0 66402 65002 44.07 45.04Feb'06 45122 46463 2614 0 42508 46463 44.44 43.32Mar'06 75144 77530 8149 0 66995 77530 44.61 43.03

*All Values in Million $

Column A: Month

Column B: Total Purchase of USD in the Forex market

Column C: Total Purchase of USD in the Forex market

Column D: RBI purchase of USD in the market

Column E: RBI sale of USD in the market

Column F: Purchases excluding RBI purchases

Column G: Sales excluding RBI sales

Column H: USD/INR spot rates

Column I: USD/INR spot rates w/o RBI intervention

(6) Effect of RBI intervention on REER


REER (1)US PPI

(2)IND WPI

(3)

Actual Spot Rates

(4)New Spot Rates (5)

New REER from

Model (6)100.59 196.13 191.60 43.65 43.84 100.93102.24 196.07 192.10 43.69 44.16 100.55103.74 194.10 193.20 43.51 43.84 102.62105.10 194.07 194.60 43.49 43.51 104.35104.05 192.97 195.30 44.04 43.86 104.34104.27 196.33 197.20 43.99 43.82 104.77102.87 198.10 197.80 45.11 44.51 103.07101.79 194.17 198.20 45.94 44.65 104.13100.66 193.65 197.20 45.07 46.13 100.14101.73 200.60 196.30 44.07 45.04 100.09101.88 198.70 196.40 44.44 43.32 104.72101.46 200.68 196.80 44.61 43.03 105.12


Column 1: REER (36 country Trade Based)

Column 2: US Inflation (PPI)

Column 3: India Inflation (WPI)

Column 4: Actual Spot Rates

Column 5: New Spot Rates

Column 6: New REER from regression model

(7) Volatility of Indian rupee against 4 major currencies (US Dollar, Euro,

British pound, Japanese Yen)

INR USD Euro Pound

INR - 0.773655 5.589214 12.2762

Variance of daily spot rates over last 1 year (August 2005 to August 2006)

(8) Effectiveness of RBI intervention: Model Regression outputs

24 Month period (April 2004 to March 2006)

SUMMARY OUTPUT

Regression Statistics Multiple R 0.382223 R Square 0.146094


Contemporary Concerns Study Adjusted R^2 0.06477 Standard Error 0.616523 Observations 24 ANOVA


F Regression 2 1.36566 0.6828 1.796441 0.19045994 Residual 21 7.98212 0.3801 Total 23 9.34778


Error t Stat P-value Lower 95%Upper 95%

Intercept 0.056565 0.1395 0.4055 0.689222-

0.233540005 0.3466703

X Variable 1 -2.8E-05 4.3E-05-

0.6452 0.525758-

0.000116667 6.141E-05

X Variable 2 -7.3E-05 4.8E-05-

1.5344 0.139859-

0.000172761 2.606E-05

12 Month period (April 2005 to March 2006)

SUMMARY OUTPUT



F Regression 2 0.957712 0.478856 1.348445 0.30745 Residual 9 3.196055 0.355117 Total 11 4.153767


Error t Stat P-value Lower 95%Upper 95%


Contemporary Concerns Study Intercept 0.000812 0.177654 0.004569 0.996454 -0.40107 0.402693X Variable 1 -5.8E-05 5.57E-05 -1.04188 0.324644 -0.00018 6.8E-05X Variable 2 -6.6E-05 6.36E-05 -1.03633 0.327088 -0.00021 7.79E-05

REFERENCES

Books

Professor Shyamal Roy, “Macroeconomic Policy Environment”

Professor P.G. Apte, “International Financial Management”

Papers , Articles & Annual Report (RBI)

Sumon Kumar Bhaumik, Hiranya Mukhopadhyay: “RBI’s Intervention in Foreign

Exchange market: An Econometric Analysis”

Vijay Joshi: “The Real Exchange Rate, Fiscal Deficits and Capital Flows: A Refutation”

Economic Political Weekly, March 2004: “Exchange Rate: Firm Trends”

Economic Political Weekly, January 2004: “Foreign Exchange: Managing Plenty”

Ajay Shah, Ila Patnaik, “India’s experience with capital flows: The elusive quest for a

sustainable current account deficit”


Contemporary Concerns Study Rakesh Mohan, Deputy Governor RBI, “Globalisation, financial markets and the

operation of monetary policy in India”

R K Pattnaik, Muneesh Kapur, S C Dhal, "Exchange Rate Policy and Management: The

Indian Experience"

Navin Kumar Gupta, Vikas Gupta: “Management of foreign exchange in India, How

effective it is?” (CCS report IIM Bangalore)

Kiran Agarwal, Manish Panasari: “ Optimal Level of Foreign Exchange Reserves in

India” (CCS report IIM Bangalore)

Mr. Arun Bharat Ram, Past President, CII, Panel Discussion on “India’s Foreign

Exchange Reserves: When is Enough – Enough?”

N.K. Unnikrishnan and P.R. Ravi Mohan, “Exchange Rate Dynamics: An Indian

Perspective”, RBI Publications

Sitikantha Pattanaik and Satyananda Sahoo, “The effectiveness of intervention in India:

An empirical assessment”, RBI Publications

Articles from ICRA Bulletin, Money and Finance

Annual Reports of RBI

Websites

www.bulletin.rbi.org.in

www.federalreserve.gov

http://www.econstats.com

http://eaindustry.nic.in

http://www.bls.gov

www.indiastat.com

www.epw.org.in

http://www.rgemonitor.com/


http://www.bulletin.rbi.org.in/

http://www.epw.org.in/

http://www.indiastat.com/

http://www.bls.gov/

http://eaindustry.nic.in/

http://www.econstats.com/

http://www.federalreserve.gov/

term project:spidi2.iimb.ac.in/~networth/ccs/2005/580 ccs... · web viewmonetary policy works...

Documents