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Why the Reserve Bank of India (RBI) has not tried to prevent the recen...

  Jul 15, 2017

Why the Reserve Bank of India (RBI) has not tried to prevent the recent rise of the rupee even though it now seems overvalued in real terms?

 
Policy conundrum
There is an important policy conundrum here. The Reserve Bank of India (RBI) has not tried to prevent the recent rise of the rupee even though it now seems overvalued in real terms. The real effective exchange rate against a basket of 36 other currencies was 118.38 in February—one of the highest levels in many years. Even though Indian exports have recovered in the past few months, it is sobering to remember that currency overvaluation has most often led to higher current account imbalances in the medium term.

Why RBI has not intervened?
It is thus likely that the Indian central bank has stayed away from foreign exchange intervention because it does not want to further exacerbate the excess liquidity problem, because it will have to release rupees into the market whenever it buys dollars. Sterilization firepower is limited right now, which is precisely why it had to issue market stabilization bonds in the first place.

Market Stabilization scheme (MSS) is a monetary policy intervention by the RBI to withdraw excess liquidity (or money supply) by selling government securities in the economy. The MSS was introduced in April 2004. Main thing about MSS is that it is used to withdraw excess liquidity or money from the system by selling government bonds.

The RBI will also have to take into account the fact that loose money market conditions could eventually feed into inflation. Getting the balance right will thus be important.

The question is whether this is a temporary issue that will go away once people begin to withdraw money from their banks or when bank lending picks up. But there can be no doubt that the excess liquidity sloshing in the system right now could be one important reason why the RBI has not been intervening more aggressively in the foreign exchange market to keep the rupee down.