RBI's Intervention in Foreign Exchange Market: An Econometric Analysis

Author(s): Sumon Kumar Bhaumik and Hiranya Mukhopadhyay

Source: Economic and Political Weekly, Vol. 35, No. 5, Money, Banking and Finance (Jan. 29 -
Feb. 4, 2000), pp. 373-376
Published by: Economic and Political Weekly
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 RBI's Interventionin Foreign
Exchange Market
An Econometric Analysis
In the aftermath of the currency crises around the world, the role of the central banks'
interventions in the foreign exchange market has gained in importance. It is obvious that such
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 intelplay of the macro-
economic variables. The stylised literature has addressed this issue by estimating the so-called
offset coefficients, a method that is ad hoc and that is marked by the conspicuouls absence of
an underlying macro-model. In this paper, we build on the stylised Mundell-Fleming model, and
derive an estitmable reduced form expression that allows us to link exchange rate movements
with the RBl's interventions. The model itself; and the subsequent empirical result 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.
SUNIMON
KUMARBHAUMIK,
HIRANYA
MUKIIOPADIIYAY

I was under pressure, the bank sold dollars
Introduction in the spot and forwardmarkets,and raised
domestic interest rates by increasing the
he past three years have been a cash reserve ratio, bank rate and repo rate.
testing time for the Reserve Bank But, during times of crises, direct interven-
of India (RBI). On the one hand, the tion in the foreign exchange market re-
rupee has been underpressure, sometimes mained the main policy initiative of the
on account of currency crises in other central bank. For example, when the rupee
emerging markets, sometimes on account came under pressure during November
of internationalembargoes, andsometimes 1997, net sale of dollars by the RBI in the
becauseof political instability. At the same spot and forward markets amounted to
time, the Indian industrybelied the expec- USD 1.5 billion, and USD 730 million
tations that were built on the experiences respectively. By contrast, the average net
of the mid- 1990s. Faced with a slow-down sale of dollars in the spot market by the
in industrialgrowth, and downward pres- central bank, during the other 11 months
sureson the rupee's exchange rate, the RBI of 1997-98, was negative USD 497 mil-
was pushed into a balancing act that in- lion. Similarly, during May-June 1998, in
volved maintainingthe stabilityof the rupee the aftermath of Pokhran II, net sales of
on the one hand, and fostering industrial the RBI in the spot market stood at USD
growth on the other.1 1.75 billion.3
However,despite the pressureon the RBI Indeed, this line of action, namely, in-
to foster economic growth, largely be- tervention in the foreign exchange market,
cause of the inability of fiscal policy in was not unique to situations where the
meeting this objective, the central bank's rupee was under pressure to depreciate. In
primaryconcernremainedtheexternalvalue the earlier periods, when the rupee was
of the rupee.2 The concerns were amply under pressure to appreciate, the RBI had
justified. As mentioned earlier, the emerg- bought dollars in the spot and forward
ing economies were in the midst of an ever- markets to prevent a sharp appreciationof
expanding currency contagion. To make the rupee that might have hurt prospects
mattersworse, inflow of hardcurrencyinto of the Indian exporters. However, the
India had been adversely affected by objective and efficacy of official inter-
political instability, global sanctions fol- ventions in the foreign exchange market
lowing the explosion of nuclear devices, has always been a controversial issue in
and the shrinking growth rate of the the literature, especially in the context of
country's exports. post-intervention sterilisation [Mussa
The RBI intervenedinto the marketboth 1980; Kenen 1994; Calvo et al 1994;
directlyandindirectly.Wheneverthe rupee Frankel 1994]. It is easy to identify the
genesis of the debate. Suppose that a
(non-US) central bank purchases dollars
in order to prevent a sharp appreciation
of the domestic currency. The resultant
increase in the volume of high powered
money increases the money supply. This
itself will initiate a second round of
events that will affect the nominal ex-
change rate. But even if the central bank
sterilises the entire addition to the money
stock by way of open market operations,
the increase in the supply of bonds may
still affect capital flows, and hence the
nominal exchange rate, by affecting the
interest rate.4 In other words, the (initial)
impact on the nominal exchange rate by
the central bank's intervention may be
partially (or fully) offset.5
Given the nature of the controversy,
economists disagree about the net effect
of a sterilised intervention, and have at-
tempted to quantify the magnitude of the
so-called offset coefficient for various
countries. In the stylised literature, the
offset coefficient is given by the coeffi-
cient of net domestic assets of a central
bank in a reduced form regressionequation
that has the net foreign assets with the
central bank as the dependent variable.
Interestingly, the reduced form specific-
ation continues to be ad hoc, and has not
been derived from a larger model that
highlights all the macro-economic link-
ages within an economy.
The objectives of this paper are twofold.
First, we would like to derive a reduced
form specification that will allow us to link

Economic and Political Weekly January 29, 2000 373

a central bank's direct interventions in the
foreign exchange market with changes in
the country's exchange rate. Second, we
would test this relationship with the Indian
data to see whether indeed the magnitude
of an offset is significant. Specifically, in
Section II of the paper we derive the
reduced form specification using a modi-
fied Mundell-Fleming model as its basis.
The analysis in this section formally
capturesthe fact that the effect of a central
bank's direct intervention in the foreign
exchange market is ambiguous. Section
IIIdraws upon the aforementioned model,
and provides the intuition as to why the
ambiguity exists. Finally, in Section IV,
we estimate the coefficients of the re-
duced formspecification using Indiandata,
and Section V concludes.
II
Model
The model owes its origin to the so-
called Keynes-Mundell-Fleming (KMF)
model. Specifically, it is an adaptation of
the KMF model with flexible exchange
rates and imperfect asset substitutability.
The most important point of departure
from the classical KMF model is that we
assume that capital account inflows into
developingcountries(LDCs) arenot driven
by interest rate differentials.6 Indeed, the
inflow of non-FDI (foreign direct invest-
ment) capital, often driven by a desire
to diversify the portfolios of the global
fund managers, is dependent largely on
the performanceof the LDC, as measured
by GDP growth rate,7 and the expecta-
tions about the exchange rate movements.
The model is characterisedby the stylised
equilibrium conditions of the commodity
market (IS), money market (LM) and
externalsector (BOP). They areas follows:
IS : Y = C(Y) + I(r,Y) + G
+ X(e) - exM(Y,e) ...(1)
LM : MS - kY + Ir (2)
BOP: X(e) - exM(e,Y) + exFF(e,Y)
+ exAFOREX = 0 ...(3)
H-ere,Y is the GDP of the economy, C is
the consuniption demand, I is the invest-
ment demand, G is government expendi-
ture, X and M are exports and imports
respectively, r is the real interest rate, e is
the exchange rateof the domestic currency
(expressed as units of domestic currency
per dollar), Ms is the money supply, k and
1 are the sensitivities of money demand
to changes in Y and r respectively, FF is
the inflow of foreign currency for port-
folio and FDI-related investment, and
AFOREX is the change in the value of the
foreign currency assets with the central
374
bank. All values are expressed in the
domestic currency.
Why, however, are values of some of the
variables prefixed with e? Assuming that
the domestic price is unity, the value of
exports, expressed in terms of foreign
currency,is given by (1/e)xX(e), andhence
it can be easily seen that the value of
exports is X(e) in terms of the domestic
currency. The value of imports, when
expressed in terms of foreign currency, is
M(Y,e), and thereforein terms of domestic
currency the value of imports is given by
exM(e,Y). The inclusion of e in equa-
tion (3) can be similarly explained.
The endogenous variables of the model
are Y, r and e. Note that the extent of any
change in the value of foreign exchange
reserves with the central bank is perfectly
correlated with the amount of dollars that
the bank buys and sells in the foreign
exchange market.8 Hence, equation (3)
can be rewritten as
BOP: X(e) - exM(e.Y) + exFF(e,Y)
+ exDPUR = 0 ...(3a)
when DPUR is the amount of net purchase
of dollars by the central bank from the
foreign exchange market.
Let us assume linear functional forms
for the consumption, investment, export
and import functions. They are, therefore,
given by the following equations:
Consumption: C = o0 + ocY,
O > 0, c1 E (0,1)
Investment : I = fo + P3r + P2Y,
p1 < 0, P2 > 0
Export : X = ye, Y> 0
Import : M = 50 + 1Y +56e,
8 > 0, <0
Hence, we can rewrite equation (1) as
Y = A + Ar + A2e
...(4)
when A0= (a0 + p0 + 60 + G)/
(1 - U1 - 02 + 61)
Al= fPi/(1 - Ca - P2 + 61)
and A2= (y - 62)/(1 - (l - P2 + 61)
Substituting, equation (2) into equation
(4), we get
Y = Ao + Al{(MS -k)/l} + A2e
such that
AY =
A,'AMS + A2Ae ...(5)
We know that if the central bank pur-
chases dollars, it adds to the volume of
high powered money in the economy, and
there is consequently an increase in the
money supply in the economy. However,
the centralbankmay also choose to sterilise
the purchaseof dollarsthroughopen market
operations. Hence, ceteris paribus, a
change in money supply can be expressed
in the following way:
AMs = vAH - OMO
Economic and Political Weekly
i e, AMS = vxexDPUR - OMO ...(6)
when v is the so-called money multiplier,
H is the stock of high powered money, and
OMO is the net amount sterilised by the
central bank through open market opera-
tions. Substituting equation (6) into equa-
tion (5), we get
AY = Al'(vxexDPUR - OMO)
+ A2Ae ...(7)
As with the IS and LM curves, the
equilibriumconditionfor the externalsector
can also be linearised by assuming appro-
priate linear form for the FF function.
Suppose that the FF function is given by
the following equation:
Foreign inflows:
FF = AXe + X2Y, X < 0 < 2 ...(8)
In other words, if the economy experiences
GDP growth, it will attract both portfolio
investment and direct investment. At the
same time, if the exchange rate of the
economy depreciates, thereby giving rise
to expectations that it might depreciate
further and reduce the returns to the for-
eign investor in terms of the foreign cur-
rency, there will be a decline in foreign
inflows. Then the BOP equation given by
(3) can be rewritten as follows:
e(Xl - 82) = - (DPUR + Y)
+ (61 - X2)Y
i e, e = B1(DPUR + y) + B2Y
or, Ae = B ADPUR + B2AY ...(9)
when Bl equals 1/(62 - X1) and B2 equals
(Xk - 81)/(62 - X1). It is obvious that the
signs of both B1 and B2 are ambiguous.
Substituting for AY obtained from equa-
tion (9) into equation (7), we get the fol-
lowing:
(1/B2)Ae - (B /B2)ADPUR =
A 'v e DPUR - Ai'OMO + A2Ae
i e, (1/B2)Ae- (B /B2)(DPUR- DPUR ) =
A 'v e DPUR - A1'OMO + A2Ae
or {(l/B2) - A2)Ae = {(B1/B2) +
Al've} DPUR - (B1/B2) DPUR_1
- A'OMO ...(10)
Let us assume that, ceteris paribus,
the central bank's decision to sterilise
is dependent only on its net purchases
in the foreign exchange market, such
that we have
OMO = 11DPUR, rl> 0 ...(11)
Substituting equation (11) into equa-
tion (10), we get
{(1/B2)- A2}Ae = {(BI/B2)
+ A1'(ve-rl)} DPUR
-
(B1/B2) DPUR_1 ...(10a)
i e, Ae = W1DPUR- t2DPUR_l ...(10b)
January 29, 2000
 ve - il
AiB2 -+ Bl
when = --- + B
B [1 -AB]
2 22
III
Intuition
Let us take one more look at equation
(l1b). The impact of previous interven-
tions by the central bank in the foreign
exchange market is captured by the co-
efficient W2.Inotherwords, the coefficient
u1 captures the contemporaneous impact
of the bank's intervention in the market.
Now, if the central bank buys dollars, its
contemporaneousimpact on the domestic
currencyshould, ceteris paribus,lead to its
depreciation,andhence Ae (andV l) should
be positive.12 But the nature of equation
(12) suggests that this might not necessar-
ily be the case. Under what conditions,
therefore, will xl1 be positive?
Inorderto simplify matters,and the RHS
of equation (12), we assume ue equals rl,
i e, following purchase of dollars by the
central bank from the foreign exchange
market, the entire addition to the money
supply by way of addition to high powered
money (and the money multiplier) is
sterilised by the bank. As such, we are
ruling out the possible (direct) impact of
changes in interest rate and investment on
the exchange rate. In other words, we are
eliminating the impact of the possible
changes in GDP, and hence trade deficit
and foreign capital flows on the exchange
rate. The simplified version of equation
(12) is given by
lI
Vi =B, B
B2[1 - A2B2]
It is obvious that the sign of gv is
ambiguous, and that this sign depends on
the relative values of the underlying pa-
rameters.Moreover, the conditions under
which the RHS of equation(12a) is positive
can be obtained with a number of com-
binations of the underlying parameters.
Hence, it is ultimately an empirical issue,
and therefore we shall abstract from the
algebra of the model herefrom.
Let us then concentrate further on the
dynamicsunderlyingthe system described
by the model. Once the central bank
purchases dollars from the foreign ex-
change market, the exchange rate depre-
ciates. This is the most immediate impact
of DPUR on e. As e depreciates, ceteris
paribus,tradebalanceimproves, and hence
thereis an increasein the effective demand
facing theeconomy. 13Consequently, there
is an upwardpressure on the GDP. If, as
Economic and Political Weekly
assumed above, the money supply is held
constant with the help of complete sterili-
sation, the rate of interest rises to reduce
(12) the demand for money. Therefore, the rise
in GDP is partially crowded out in the
classic Keynesian manner. Moreover, a
rise in income leads to higher imports, and
the initial improvement in trade balance
is dampened. At the same time, the inflow
of dollars from foreign investors too tends
to rise, dampening the initial downward
pressure on account of the depreciation of
the exchange rate.
What, however, is the dynamics under-
lying the all important foreign exchange
market? The balance of payments is im-
pacted by three forces: there is an increase
in DPUR, an overall improvement in trade
balance, andan overal decline in the inflow
of capital from foreign investors.14 In a
stable model, which was impacted by an
exogenous shock (i e, purchase of dollars
by the central bank),!5 the exchange rate
will have to rise in order to restore equi-
librium. As in any comparative static
exercise, once equilibrium is restored at
the new and higher exchange rate, there
is no further reason for the central bank
to intervene in the market.
But it is an empirical fact that a central
bank, namely, the RBI, intervenescontinu-
ally in the foreign exchange marketfollow-
ing an exogenous shock, in the same direc-
tion and over a reasonably long period of
time. This can, in principle, happen if the
underlying system is not stable. Let us
considera hypotheticalexample.If,forsome
reason, the RBI has to sell dollars in order
to prevent a depreciation, the rupee will
appreciatemarginally,as comparedwith the
exchange ratejust priorto the intervention.
...(12a) Thereafter,as we have seen above, the trade
balance will deteriorateoverall, while the
capital inflows from the foreign investors
will increaseoverall.However, if the system
is unstable, it is possible thatnot only is the
rate of appreciation of the exchange rate
arrested,buteven reversed.In such anevent,
the RBI will once again have to sell dollars
in the market.
What relevance does this have for our
empirical exercise? If the model is stable,
the sign of i1 should be positive, and vice
versa. A priori, it is difficult to say whether
a system is stable or not. Given the com-
plexity of the expressions, the stability of
even a very simplified model can be quite
difficult to obtain and interpret.Given the
fact that historically the RBI has inter-
vened in the similar direction and over a
sustained period following exogenous
shocks, we are tempted to hypothesise that
the Indianmacro-systemmightbe unstable,
as defined within the paradigm of com-
January 29, 2000
parative static exercises. Hence, in the
Indian context, the value of W1may either
be positive or negative. This will be veri-
fied in the next section.
IV
EmpiricalEstimation
The flows in the model described and
analysed in the previous sections are
denominated in terms of the domestic
currency. Now, the principal objective of
this section is to test empirically the sign
of Wl. Hence, we must use the rupee value
of RBI's interventions in the foreign ex-
change market as our RHS variable(s).
However, that would give rise to a simul-
taneity problem: when the RBI intervenes
in the foreign exchange market, it will
change the exchange rate and this, in turn,
will change the rupee value of the inter-
vention. Clearly, this problem can be
averted if we use the dollar value of RBI's
intervention in the foreign exchange
market. Is this 'deviation' permissible?'6
It is obvious that if the model were ex-
pressed in terms of a foreign currency,
namely, dollar,a differentexpression for Wl
would have emerged. However, a change
in the algebraic expression would not have
affected the qualitative argumentespoused
in the earliersections. Specifically, the sign
of Wl would still remainambiguous. Given
that the focus of the exercise would have
remained unaltered, we refrained from
making changes that would have resulted
in anunnecessarydeparturefromthestylised
Mundell-Fleming model.
We have used monthly data on net
purchase of foreign exchange by the RBI
(DPUR), expressed in dollars, and monthly
exchange rates of the US Dollar (e), ex-
pressed as rupees per dollar. Our data set
consists of 36 observations from April
1996 to March 1999. The parameter l1is
estimated from equation (10b), namely.
Ae = JlDPUR - J2DPUR ,
A Dickey-Fuller test was used to verify the
order of integration of DPUR and Ae. The
residuals were found to be stationary,
therefore,we did not tryaugmentedDickey-
Fuller. The results are summarisedin table.
Table : The Results of StationarityTest
A (Ae) ADPUR
Constant 0.16(1.69) 251.34(1.72)
DPUR(-1) -0.64(-3.84)
Ae(-1) -0.76(-4.49)
LMtest forserial
correlation(F test) 0.9 0.44
Note: t- values are in parentheses.
MacKinnoncriticalvalues are -3.63(1 per
cent) and -2.95 (5 per cent).
375
 The test statistics in table suggest that
both Ae and DPUR are stationary. There-
fore, we have regressed Ae on DPUR and
DPUR (-1). The regression results are as
follows:
Ae = 0.40 - 0.28 DPUR - 0.20 DPUR(-1)
(5.21) (-3.13) (-2.16) ...(13)
R2 = 0.4, DW = 1.98
In other words, in response to an appre-
ciation of the rupee vis-a-vis other curren-
cies, if there is an increase in the net
purchase of dollars by the RBI, Ae will
decrease, indicating that the rupee will
appreciatefurther.In otherwords, the effect
of the RBI's direct intervention in the
foreignexchange marketis more thanoffset
by the impact of the intervention on the
macro-economic variables which, in turn,
influence capital flows and nominal ex-
change rates.
This result is preserved even after we
control for the data for December 1997,
clearly an outlier, using a dummy variable
(D). The regression estimates for the
controlled equation are given by:
Ae = 0.32 - 0.27 DPUR - 0.08 DPUR(-1)
(4.63) (-3.64) (-0.92)
+ 1.44 D ...(14)
(3.77)
R' = 0.59, DW = 2.06
Indeed,afterhavingexamined parameter
stability using cumulative sum of recur-
sive residuals (CUSUM) and cumulative
sum of the square of recursive residuals
(CUSUMSQ), we did not find any evi-
dence of parameter instability.
V in the spot marketwith net purchasesof USD
ConcludingViews
To recapitulate, one of the purposes of
this paper was to verify whether the effect
of the contemporaneous intervention -
sterilised or non-sterilised - of the RBI in
the foreign exchange market is effective.
First, using a modified KMF model, we
have demonstrated that, owing to the
presenceof the complex causal links within
the macro-economy, the nature of the
impact of the central bank's intervention
is unclear even when the action in the
foreign exchange market is backed up by
full sterilisation. Thereafter, we tested our
conjectureusing Indiandataandthe empiri-
cal results corroborated our conjecture.
In this paper, despite the shortcomings
that are usually associated with reduced
forms, we have been able to bring to light
the equivocal natureof the impact ofRBI's
interventions in the foreign exchange
market. Further, our reduced form struc-
tureis derivedfroma stylised macro-model,
and is therefore a significant improvement
376
over the models that have been used re-
currently in the literature on offset coef-
ficients in the context of central bank's
(sterilisedandnon-sterilised)interventions.
To be sure, our model does not bring out
the interactions between the macro-vari-
ables fully. In order to capture such inter-
actions in their entirety, one would have
to build a complex multi-equation macro-
econometric model. This is a long-term
endeavour that lies outside the scope of
this paper. M1
Notes
[The authorswould like to thankRaghabendraJha
and Krishnendu Ghoshdastidar for helpful
comments. The usual disclaimers apply.]
1 Fora detaileddiscussionof theRBI's objectives
andpolicy options,see Mukhopadhyay(1999).
2 This is evident from the fact that, despite the
slowdown in the industrial sector, the RBI
increasedthe key interestrates fairly steeply
whenever the exchange rate of the rupee was
threatened by the possibility of sharp
depreciation.
3 Thiswas latersupplementedby thehugecapital
inflow on accountof theResurgentIndiaBonds
floated abroad by the State Bank of India.
4 This result, one that is not germane to the
stylised IS-LManalysis,follows directlyfrom
the asset market approachto exchange rate
theory [Kenen 1994].
5 A strong prima facie case in favour of such
an offset mechanism can be made with the
help of the Indiandata.Forexample,the rupee
was underpressureto appreciatetowardsthe
end of 1996-97. As a consequence, the RBI
intervened in the foreign exchange market,
and its net purchase of dollars in the spot
market,duringApril 1997, stood at USD 641
million. However, the appreciationcontinued
unabated,andthe centralbankhadto intervene
4.7 billion during the May-August period.
6 Globalportfoliocapitaltypicallydoes not flow
into the fixed income securities issued
domestically by the LDCs, because of the
credit,liquidityandinformationalrisksassoci-
ated with these securities. Even government
securitiesissued in theirdomestic marketsare
largely avoided by the global funds. These
fundstypicallyinvest in equitieslisted in these
countrieswhichofferprospectsof highenough
returnsto justify the associated risks.
7 Notethatthefundmanagersareusuallyinterested
in the earningspotentialof listed companies,
which is a manifestationof the profitabilityof
these companies as well as a determinantof
their price-earningsratio.We assume that the
GDP growth rate is a good proxy for the
(expected) earningsof the companies.
8 We are, of course, assuming that the dollar is
the only internationalcurrency,and hence we
are abstractingfrom the problems that are
associated with changes in cross-currency
exchange rates.
9 Thereareotherinstrumentsof sterilisationlike
changes in the cash reserveration(CRR). But
since these are ad hoc measures,centralbanks
are often inclined not to use them too often
andinsteadrelyon marketbasedmeasureslike
open marketoperations.This trend has been
observedin Indiawherethe RBI has distanced
itself from frequentchanges in the CRR and
Economic and Political Weekly
bank rate, and has focused on management
of money supply growth with the use of
repurchaseagreements(repos)andopenmarket
trade in other government securities.
10 There has been a debate about the stabilityof
the money multiplier [Vasudevan 1975;
Mohanty and Mitral999]. However, in the
contextof thismodifiedKMFmodel,it suffices
to assume that u is constant, without being
in conflict with the stylised literature.
11 As we shall see later, much of the analysis
revolves aroundthe possible sign of y,. But
the role of \i, is not as important.Hence, we
have not providedthe full expression for the
latter.However,it is availablefromtheauthors
upon request.
12 Note once again that e is measuredas units
of domestic currency per dollar.
13 This will happen if the so-called Marshall-
Lernercondition is satisfied. We assume that
this will happenin the economy describedby
the model.
14 Note that following the increase in DPUR,
thereis an improvementin tradebalance.This
improvement,in turn, leads to an increase in
the GDP, and thereby increases the imports
duringthe second roundof impact.Hence, the
improvementin the tradebalance is arrested.
Stability conditions of comparative statics
exercises demandthat while such a crowding
out can take place, there cannot be a reversal
of the trend, following an exogenous shock,
in a stable model. Similarly,FF initially falls
and rises thereafter,but since the initial trend
in it was a decline, overall FF has to decline.
15 In reality, the central bank's interventionis
typically triggeredby some other shock that
is exogenous to the model.An exampleof such
a shock is the nuclearexplosions in Pokhran
during 1998.
16 Whydidwe nottacklethesimultaneityproblem
econometrically?That would requirethe use
ofa simultaneousequationmodelwhichwould
have a separate specification for DPUR.
However,since thestructureforDPURimplicit
in the model is includedin equation(lOb), we
would have required a second structureto
define one otherbehaviouralmodelfor DPUR.
Butthatwouldhave led to a problemof closure,
which is an unnecessary complication.
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