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RBI Intervention in Foreign Exchange Market

RBI Intervention in Foreign Exchange Market Submitted By: Avinash N Anuj Goyal Mr Siddharth Sham Chandak

Submitted By:

Avinash N Anuj Goyal Mr Siddharth Sham Chandak Rajavageeshwaran

Introduction

The Reserve Bank of India (RBI) is the nation’s central bank. Since 1935, when it began its operations, it has stood at the centre of India’s financial system, with a fundamental commitment to maintaining the nation’s monetary and financial stability.

Main Functions

Monetary 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 country's 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 Exchange

With the transition to a market-based system for determining the external value of the Indian rupee, the foreign exchange market in India gained importance in the early reform period. In recent years, with increasing integration of the Indian economy with the global economy arising from greater trade and capital flows, the foreign exchange market has evolved as a key segment of the Indian financial market.

Approach

The Reserve Bank plays a key role in the regulation and development of the foreign exchange market 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 country

Tools The Reserve Bank is responsible for administration of the Foreign Exchange Management Act,1999 and regulates the market by issuing licences to banks and other select institutions to act as Authorised Dealers in foreign exchange. The Foreign Exchange Department (FED) is responsible for the regulation and development of the market.

On a given day, the foreign exchange rate reflects the demand for and supply of foreign exchange arising from trade and capital transactions. The RBI’s Financial Markets Department (FMD) participates in the foreign exchange market by undertaking sales / purchases of foreign currency 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 foreign exchange reserves built up by purchase of foreign currency from the market. In investing its foreign 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 public information. However, the broad outlines are easy to discern by reading publicly- available documents.)

Evolution of Indian Foreign Exchange Market

The evolution of India’s foreign exchange market may be viewed in line with the shifts in India’s

exchange rate policies over the last few decades. With the breakdown of the Bretton Woods

System in 1971 and the floatation of major currencies, the conduct of exchange rate policy posed

a serious challenge to all central banks world wide as currency fluctuations opened up

tremendous opportunities for market players to trade in currencies in a borderless market. In

order to overcome the weaknesses associated with a single currency peg and to ensure stability

of the exchange rate, the rupee, with effect from September 1975, was pegged to a basket of

currencies. The impetus to trading in the foreign exchange market in India since 1978 when

banks in India were allowed to undertake intra-day trading in foreign exchange. The exchange

rate of the rupee was officially determined by the Reserve Bank in terms of a weighted basket of

currencies of India’s major trading partners and the exchange rate regime was characterised by

daily announcement by the Reserve Bank of its buying and selling rates to the Authorised

Dealers (ADs) for undertaking merchant transactions. The spread between the buying and the

selling rates was 0.5 percent and the market began to trade actively within this range and the

foreign exchange market in India till the early 1990s,remained highly regulated with restrictions

on external transactions, barriers to entry, low liquidity and high transaction costs. The exchange

rate during this period was managed mainly for facilitating India’s imports and the strict control

on foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had

resulted in one of the largest and most efficient parallel markets for foreign exchange in the

world

As a stabilisation measure, a two step downward exchange rate adjustment in July 1991

effectively brought to close the regime of a pegged exchange rate. Following the

recommendations of Rangarajan’s High Level Committee on Balance of Payments, to move

towards the market-determined exchange rate, the Liberalised Exchange Rate Management

System (LERMS) was introduced in March 1992, was essentially a transitional mechanism and a

downward 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 unified exchange rate system in March 1993, whereby all foreign exchange receipts could be converted at market determined exchange rates. On unification of the exchange rates, the nominal exchange rate of the rupee against both the US dollar as also against a basket of currencies got adjusted lower. Thus, the unification of the exchange rate of the Indian rupee was an important step towards current account convertibility, which was finally achieved in August 1994, when India accepted 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 bearing capacity of banks increased and foreign exchange trading volumes started rising. This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with the Government to remove market distortions and deepen the foreign exchange market. Several initiatives aimed at dismantling controls and providing an enabling environment to all entities engaged in foreign exchange transactions have been undertaken since the mid-1990s.The focus has been on developing the institutional framework and increasing the instruments for effective functioning, enhancing transparency and liberalising the conduct of foreign exchange business so as to move away from micro management of foreign exchange transactions to macro management of foreign exchange flows. Along with these specific measures aimed at developing the foreign exchange market, measures towards liberalising the capital account were also implemented during the last decade. Thus, various reform measures since the early1990s have had a profound effect on the market structure, depth, liquidity and efficiency of the Indian foreign exchange market.

Sources of Supply and Demand

The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and invisibles in the current account and inflows in the capital account such as foreign direct investment (FDI), portfolio investment, external commercial borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign exchange 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 on account 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 the Reserve Bank releases the required rupee funds. Hence, this particular source of supply of foreign exchange is not routed through the market and as such does not impact the exchange rate. During last five years, sources of supply and demand have changed significantly, with large transactions emanating from the capital account, unlike in the 1980s and the 1990s when current account transactions dominated the foreign exchange market. The behaviour as well as the incentive structure of the participants who use the market for current account transactions differs significantly from those who use the foreign exchange market for capital account transactions. Besides, the change in these traditional determinants has also reflected itself in enhanced volatility in currency markets. It now appears that expectations and even momentary reactions to the news are often more important in determining 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 demand emanates from “expectations based on certain news”. Sometimes, such expectations are destabilising and often give rise to self-fulfilling speculative activities. The role of the Reserve Bank comes into focus when it has to prevent the emergence of destabilising expectations and recourse is undertaken in such ocassions to direct purchase and sale of foreign currencies, sterilisation through open market operations, management of liquidity under liquidity adjustment facility (LAF), changes in reserve requirements and signaling through interest rate changes. In the last few years the demand/supply situation is affected by hedging activities through various instruments that have been made available to 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 Foreign

Month

#

Currency

Tranche

(2+3+

#

Currency

Tranche

(7+8+

Exchange

Exchange

Assets

Position

in IMF

4+5)

Assets

Position

in IMF

9+10)

Reserves

(in SDR

Reserves

(in SDR

million)

million)*

1

2

3

4

5

6

7

8

9

10

11

12

13

Mar-

                       

01

0.11

127

1845

29

2001

2

2,725

39,554

616

42,897

34,034

5,306

Mar-

                       

02

0.50

149

2491

30

2670

10

3,047

51,049

610

54,716

43,876

9,842

Mar-

                       

03

0.19

168

3415

32

3615

4

3,534

71,890

672

76,100

55,394

11,518

Mar-

                       

04

0.10

182

4662

57

4901

2

4,198

1,07,448

1,311

1,12,959

76,298

20,904

Mar-

                       

05

0.20

197

5931

63

6191

5

4,500

1,35,571

1,438

1,41,514

93,666

17,368

Mar-

                       

06

0.12

257

6473

34

6764

3

5,755

1,45,108

756

1,51,622

1,05,231

11,565

Mar-

                       

07

0.08

296

8366

20

8682

2

6,784

1,91,924

469

1,99,179

1,31,890

26,659

Mar-

                       

08

0.74

401

11960

17

12380

18

10,039

2,99,230

436

3,09,723

1,88,339

56,449

Mar-

                       

09

0.06

488

12301

50

12839

1

9,577

2,41,426

981

2,51,985

1,68,544

-19,795

Mar-

                       

10

226

812

11497

62

12597

5,006

17,986

2,54,685

1,380

2,79,057

1,83,803

15,259

Mar-

                       

11

204

1026

12249

132

13610

4,569

22,972

2,74,330

2,947

3,04,818

1,92,254

8,451

Mar-

                       

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 during 1992-93, US$ 139.3 million during 1993-94, US$ 315.0 million during 1994-95 and US$ 17.9 million during 1995-96. On the other hand, 1.27 tonnes of gold amounting to `435.5 million (US$11.97 million), 38.9 tonnes of gold amounting to `14.85 billion (US$ 376.0 million) and 0.06 tonnes of gold amounting to `21.3 million (US$ 0.5 million) were repurchased by the Central Government on November 13, 1997, April 1, 1998 and October 5, 1998 respectively for meeting its redemption obligation under the Gold Bond Scheme.

2.

Conversion of foreign currency assets into US dollar was done at exchange rates supplied by the IMF up to March 1999. Effective

April 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 currency

 

denominated bonds issued by IIFC (UK) since March 20, 2009, excludes US$ 380.00 million since September 16, 2011, US$ 550.00 million since February 27, 2012 and US$ 673.00 million since 30th March 2012.

A Sketch of the Problem

A Sketch of the Problem Let me begin by outlining, in purely intuitive terms, what the

Let me begin by outlining, in purely intuitive terms, what the problem is. Suppose there are two currencies, the domestic one, henceforth, rupees, and the foreign one, dollars. Let the demand curve for dollars be described by the line AB in Figure 1 and the supply curve by the upward sloping line. If this were a competitive market the equilibrium exchange rate or, equivalently, the price of dollars would be p*, as shown.

Now suppose, for whatever reason, the central bank wants to devalue the currency to the exchange rate p**. 6 If this is to be done not by law or diktat but by market intervention, a natural way to achieve this is for the central bank to demand CD dollars. This ‘quantity intervention’ 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 CD multiplied by p** rupees onto the market, thereby raising tricky questions of inflationary pressures and the need to sterilize. That this is a natural way of thinking about how to influence exchange 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 to prevent 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 of demand for dollars is made contingent on the price. As long as the new demand curve goes through point D the net effect is the same. If, for instance, the central bank decides to buy less dollars if the price is low so that the new aggregate demand curve is given by the broken line in Figure 1, which goes through D, the final equilibrium is still at price p** and the amount of dollars 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 equilibrium price, in this case p**, then the fact that demand would be different at out-of-equilibrium prices can surely not influence the equilibrium price. This logic, however, is true only for purely competitive markets.

Foreign Exchange Intervention

In the post-Asian crisis period, particularly after 2002-03, capital flows into India surged creating space for speculation on Indian rupee. The Reserve Bank intervened actively in the forex market to reduce the volatility in the market. During this period, the Reserve Bank made direct interventions in the market through purchases and sales of the US Dollars in the forex market and sterilised its impact on monetary base. The Reserve Bank has been intervening to curb volatility arising due to demand-supply mismatch in the domestic foreign exchange market

mismatch in the domestic foreign exchange market Sales in the foreign exchange market are generally guided

Sales in the foreign exchange market are generally guided by excess demand conditions that may arise due to several factors. Similarly, the Reserve Bank purchases dollars from the market when there is an excess supply pressure in market due to capital inflows. Demand-supply mismatch proxied by the difference between the purchase and sale transactions in the merchant segment of the spot market reveals a strong co-movement between demand-supply gap and intervention by the Reserve Bank . Thus, the Reserve Bank has been prepared to make sales and purchases of foreign currency in order to even out lumpy demand and supply in the relatively thin foreign exchange market

and to smoothen jerky movements. However, such intervention is generally not governed by any predetermined

and to smoothen jerky movements. However, such intervention is generally not governed by any predetermined target or band around the exchange rate (Jalan, 1999).

The volatility of Indian rupee remained low against the US dollarthan against other major currencies 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 managed float regime of India, intervention has served as a potent instrument in containing the magnitude of exchange rate volatility of the rupee and the intervention operations do not influence as much the level of rupee

The intervention of the Reserve Bank in order to neutralise the impact of excess foreign exchange inflows enhanced the RBI’s Foreign Currency Assets (FCA) continuously. In order to offset the effect of increase in FCA on monetary base, the Reserve Bank had mopped up the excess 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 been relatively small in terms of volume (less than 1 per cent during last few years), except during 2008-09. The Reserve Bank’s gross market intervention as a per cent of turnover in the foreign exchange market was the highest in 2003-04 though in absolute terms the highest intervention was US$ 84 billion in 2008-09 (Table 2.3). During October 2008 alone, when the contagion of the global financial crisis started affecting India, the RBI sold US$ 20.6 billion in the foreign exchange market. This was the highest intervention till date during any particular month.

Trends in Exchange Rate A look at the entire period since 1993 when we moved

Trends in Exchange Rate A look at the entire period since 1993 when we moved towards market determined exchange

rates reveals that the Indian Rupee has generally depreciated against the dollar during the last 15

years except during the period 2003 to 2005 and during 2007-08 when the rupee had appreciated

to 2005 and during 2007-08 when the rupee had appreciated on account of dollar’s global weakness

on 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 major international currencies.

has

depreciated

against

the

dollar.

The

rupee

has

also

depreciated

against

other

major

international currencies. Another important feature has been the reduction in the volatility of the

Indian exchange rate during last few years. Among all currencies worldwide, which are not on a

nominal 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 over

the years despite volatility in capital flows and trade flows

The various episodes of volatility of exchange rate of the rupee have been managed in

The various episodes of volatility of exchange rate of the rupee have been managed in a flexible and pragmatic manner. In line with the exchange rate policy, it has also been observed that the Indian rupee is moving along with the economic fundamentals in the post-reform period.Thus, as can be observed maintaining orderly market conditions have been the central theme of RBI’s exchange rate policy. Despite several unexpected external and domestic developments, India’s exchange rate performance is considered to be satisfactory. The Reserve Bank has generally reacted promptly and swiftly to exchange market pressures through a combination of monetary, regulatory measures along with direct and indirect interventions and has preferred to withdraw from the market as soon as orderly conditions are restored.

Moving forward, as India progresses towards full capital account convertibility and gets more and more integrated with the rest of the world, managing periods of volatility is bound to pose greater challenges in view of the impossible trinity of independent monetary policy, open capital account and exchange rate management. Preserving stability in the market would require more

flexibility, adaptability and innovations with regard to the strategy for liquidity management as well as exchange rate management. Also, with the likely turnover in the foreign exchange market rising in future, further development of the foreign exchange market will be crucial to manage the associated risks.

Current Rupee Market Structure While analysing the exchange rate behaviour, it is also important to have a look at the market micro structure where the Indian rupee is traded. As in case of any other market, trading in Indian foreign exchange market involves some participants, a trading platform and a range of instruments for trading. Against this backdrop, the current market set up is given below.

Market Segments and Players

The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments – the spot and the derivatives market. In a spot transaction, currencies are traded at the prevailing rates and the settlement or value date is two business days ahead. The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad. The derivatives market encompasses forwards, swaps, and options. As in case of other Emerging Market Economies (EMEs), the spot market remains an important segment of the Indian foreign exchange market.With the Indian economy getting exposed to risks arising out of changes in exchange rates, the derivative segment of the foreign exchange 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 are authorised to deal in foreign exchange , (b) foreign exchange brokers who act as intermediaries between counterparties, matching buying and selling orders and (c) customers – individuals, corporate, who need foreign exchange for trade and investment purposes. Though customers are a major player in the foreign exchange market, for all practical purposes they depend upon ADs and brokers. In the spot foreign exchange market, foreign exchange transactions were earlier dominated by brokers, but the situation has changed with evolving market conditions as now the transactions 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 to manage reserves and intervenes to ensure orderly market conditions.

The customer segment of the spot market in India essentially reflects the transactions reported in the balance of payments – both current and capital account. During the decade of the 1980s and 1990s, current account transactions such as exports, imports, invisible receipts and payments were the major sources of supply and demand in the foreign exchange market.Over the last five years, however, the daily supply and demand in the foreign exchange market is being increasingly 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 commercial borrowings (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 releases the 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 true determination 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 the formal introduction of a variety of instruments in the foreign exchange derivatives market started only in the post reform period, especially since the mid-1990s. These derivative instruments have been cautiously introduced as part of the reforms in a phased manner, both for product diversity and more importantly as a risk management tool. Recognising the relatively nascent stage of the foreign exchange market then with the lack of capabilities to handle massive speculation, the ‘underlying exposure’ criteria had been imposed as a prerequisite.

Foreign Exchange Market Turnover The depth and size of foreign exchange market is gauged generally through the turnover in the market. 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 turnover or 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 important private information about market clearing prices, thus, it could act as a key variable while making informed judgment about the future exchange rates.Trading volumes in the Indian foreign exchange market has grown significantly over the last few years. The daily average turnover has seen almost a ten-fold rise during the 10 year period from 1997-98 to 2007- 08 from US $ 5 billion to US $ 48 billion (Table 3.1). The pickup has been particularly sharp from 2003-04 onwards since when there was a massive surge in capital inflows.

since when there was a massive surge in capital inflows. It is noteworthy that the increase

It is noteworthy that the increase in foreign exchange market turnover in India between April 2004 and April 2007 was the highest amongst the 54 countries covered in the latest Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity conducted by the Bank for International Settlements (BIS). According to the survey, daily average turnover in India 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 turnover trebled 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 has been an average of 7.6 times higher than the size of India’s balance of payments during last five years.With the deepening of foreign exchange market and increased turnover,ncome of commercial banks through treasury operations has increased considerably

banks through treasury operations has increased considerably A look at the segments in the Indian foreign

A look at the segments in the Indian foreign exchange market reveals that the spot market

remains the most important foreign exchange market segment accounting for about 50 per cent

of

the total turnover However, its share has seen a marginal decline in the recent past mainly due

to

a pick up in turnover in derivative segment. The merchant segment of the spot market is

generally dominated by the Government ofIndia, select public sector units, such as Indian Oil Corporation (IOC), and the FIIs. As the foreign exchange demand on account of public sector

units and FIIs tends to be lumpy and uneven, resultant demand-supply mismatches entail occasional pressures on the foreign exchange market,warranting market interventions by the Reserve 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 2.8 during 2008-09 reflecting the growing participation in the merchant segment of the foreign exchange market associated with growing trade activity, better corporate performance and increased liberalisation. Mumbai alone accounts for almost 80 per cent of the foreign exchange turnover.

for almost 80 per cent of the foreign exchange turnover. The Methodology In the tradition of

The Methodology In the tradition of the asset market approach to exchange rate determination, the exchange rate is viewed as the relative price of national monies, determined by the relative supplies in relation to demand. 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 responds to interest rate differentials, exchange rate expectations and exchange market conditions, both spot 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 by real developments such as the need for capacity expansion, but the timing of bringing in the funds would depend on interest rate differentials and their movements vis-a-vis the forward premia, current and expected exchange rates and the like. In any economy, irrespective of the wedges between segments of the financial market spectrum created by exchange controls and other 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 beween domestic 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 reduce domestic money balances and seek to acquire foreign money balances. In a freely floating exchange rate regime, the price of the domestic money would fall i.e., domestic interest rates would 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 the demand 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 be exchanged for foreign goods, services, financial assets and money balances until portfolio balance is restored through the monetary authority meeting the resultant increase in demand for foreign money by losing reserves until monetary balance is restored. In the intermediate forms of exchange rate regimes that characterise the real world, a combination of the effects described obtain. Monetary authorities may, in pursuit of a longer term strategy, seek to contest these short run market outcomes. By signaling their stance through various direct policy instruments reflected in changes in the domestic component of base money and in foreign exchange reserves and through indirect instruments such as changes in strategic interest rates, monetary authorities may attempt to induce shifts in the demand for and supply of domestic and foreign money balances, 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 specific features of the Indian economy. It is drawn up under the assumptions that the demand for money is 'fairly stable', the emerging role of interest rates as an argument in the money demand function-'interest rates too seem to exercise some influence on the decisions to hold money'- the importance of the exchange rate objective of monetary policy in the context of the emerging linkages between money, foreign exchange and capital markets and a loose form of purchasing power parity which links domestic prices to foreign prices in a probabilistic form for an economy with a growing degree of openness (supported by the use of the REER as an information variable for exchange rate policy). The construction of the model draws inspiration from 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 importance The 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 effective

exchange 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 to include the interest rate as an argument signifying the opportunity cost of holding money. Output represented by indices of industrial production in the absence of monthly data on GDP is assumed to be exogenous. Equation (2) represents the version of the functional relationship between domestic prices and foreign prices considered in this model: domestic prices are ssumed 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 rate impact on domestic prices. Equation (3) is the uncovered interest rate parity (UCIP) condition which is set out as an underlying assumption relating to the substitutibility between domestic and foreign assets rather than a relationship proposed for empirical testing. It is presented as a part of the model specification to allow the model to be identified. Equation (4) describes the standard money supply formation process under the money multiplier approach, implying that any increase in nominal money stock could be on account of the last period's money stock plus the increase in net domestic assets and net foreign assets of the monetary authority accruing to the current period's money stock through the money multiplier. Under the assumption that the money market clears continuously, the equilibrium condition would be reflected in the identity Ms = Md. Equation (5) represents the reaction function of the authorities. Under a freely floating exchange rate, the value of ut = 0.

The monetary authority does not intervene in the exchange market and hence there is no change in NFA and money supply. When the authorities, on the contrary, peg the exchange rate at a particular level (i.e. ut = ¥), there is unlimited intervention and hence proportionate changes in NFA and money supply. (Here, the general assumption is that the authorities intervene only by changing NFA and not by changing NDA; as Weymark (op.cit) has shown, compensating variations 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 the exchange rate of the rupee). The value of ut in equation (5) thus gives an idea about the degree to which exchange rate is managed. ut can assume negative values when interventions are used aggressively to obtain an exchange rate change which is contrary to or significantly larger than market expectations. Following Weymark, the EMP can be derived as EMPt = DEt + n DNFA where n = - 1/ [ b2+ a3] and IIA as IIAt = n DNFA / EMPt The calculation of EMP and IIA thus hinges critically upon the calculation of the elasticity 'n' which, in turn, depends upon estimates of the parameters b2 and a3 i.e., the coefficient of the exchange 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 exchange rate policy. It does not measure the actual exchange rate change warranted by conditions of demand and supply but instead the degree of external imbalance and the presence/absence of speculative activity. The critical indicator in the EMP is its sign. Negative values indicate downward pressures on the exchange rate while positive values reflect upward pressures which holds 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. Under intermediate regimes IIA assumes values between 0 and 1. When the monetary authority leans with the wind, i.e., amplifies the exchange rate pressures generated by the market, the IIA assumes values greater than 1. On the other hand, when the monetary authority contests the market view, the IIA is less than one.

The Monetary Conditions Index (MCI) which has come to be employed as an operating target or more generally, as an indicator of monetary conditions in countries forced to move away from a monetary aggregates approach by the pace of financial innovations, can easily be seen to be a more readily computable version of the EMP. It is a weighted aggregate of the exchange rate and interest rate channels of monetary policy, providing leading information about the monetary conditions since money stock variations impact upon the exchange rate and interest rate with a much reduced lag than upon prices and output. The manner in which monetary policy should be adjusted to offset the deviation of monetary conditions from the desired levels is addressed through targeting the weighted monetary conditions index within a band, the band limits being enforced by, or by the threat of, monetary policy action. The weights assigned to the exchange rate and interest rate generally depend upon their relative influence on output and prices and are usually derived by estimating a money demand function in which the exchange rate and the interest rate are present as explanatory variables. Adjusting money stock to align the MCI with a desirable level would constitute the appropriate stance of policy.

The EMP would indicate the extent of exchange market pressure on account of monetary disequilibria while MCI would directly show the monetary conditions prevailing at any point of time in relation to some base level monetary condition and thereby help the authorities in deciding the degree and timing of monetary policy changes that may be necessary to keep the EMP within manageable limits. A decline in the MCI indicates tightening of monetary conditions whereas an increase in the index reflects easing.

In this paper a standard MCI has been constructed representing a linear combination of the interest 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 rate and exchange rate as at some point which could be considered as equilibrium (and hence base period E and I). a and b represent the weights which are decided on the basis of the respective influence of interest rate and exchange rate on the goal variable.

Estimation of EMP, IIA and the MCI for India

The data used are as follows: Month-end nominal money stock (M3), monthly indices of wholesale price indices (WPI) as representative of domestic price movements, monthly indices of industrial production (IIP) as the proxy for scale of economic activities in the absence of monthly data on national income, nominal effective exchange rate (NEER) indices to reflect the movement 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 cost of 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 data on intervention purchases and sales, changes in the levels of foreign exchange assets are considered for empirical analysis. In the case of India, however, monthly data on intervention purchases and sales are published regularly by the RBI since June 1995 and for the purpose of estimating and comparing the estimates, both change in reserve levels and net intervention purchases/sales data have been considered.

All the equations for the basic model were estimated in log-linear form. Before estimating the

coefficients of the two elevant equations for EMP and IIA, the stationarity properties of the

variables 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 order

one, [i.e. I(1)], indicating that some linear combination of these variables may represent a long

run equilibrium relationship. (For the DF and ADF test statistics ). In order to establish the long

run 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 sample

period April 1990 to March 1998. The eigen values and trace statistics for both money demand

and 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 LCMR

Purchasing power parity relationship

(2) LWPI = -9.04 + 3.43 LWOPI - 0.51 LNEER

The DF and ADF tests for errors indicate the errors to be

stationary.

DF and ADF tests for errors. Without trend

With trend

 

DF

ADF

DF

ADF

Residuals of

-5.71

-5.33

-5.77

-5.39

Money

Demand

Relationship

Residuals of

-2.15

-3.71

-2.90

-4.03

PPP

relationship

Relevant coefficients from the above relationships are used to estimate the exchange

market pressure and degree of intervention as follows.

EMPt = DNEERt + u x DNFA

Where u = 1/ -(-0.51-0.17) = 1/0.68 = 1.4705882

and

IIAt = u x DNFA / EMPt

.

For the MCI, the weights for exchange rates and interest rates were estimated from the reduced form of Equations (1) and (2) (6) LM3 = 3.80 + 0.74 LWOPI + 1.38 LIIP - 0.05 LCMR - 0.35 LNEER The eigen values and trace statistics suggest the presence of two co integrating vectors. The residuals of the two vectors were subjected to normality tests; in view of the relatively higher coefficient of variation of the residuals of the second vector, the first vector was chosen for generating the MCI and is reported above [Equation (6)]. The coefficients of LNEER and LCMR suggest that the weights could be as follows: a = 0.125, b= 0.875; a + b =1.

References

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.