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 Perils of an ad hoc forex policy
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Perils of an ad hoc forex policy
May, 16th 2013

In a speech that he gave last month at the International Monetary Fund, the Reserve Bank of India (RBI) Governor, Duvvuri Subbarao, posed several questions about countries’ policies on foreign exchange market intervention and their holding of reserves.

The Governor did not answer those questions himself, instead suggesting that many of the issues they raised were not amenable to easy open-and-shut answers or solutions.

That may well be so. But one would still have expected the Governor to at least identify some criteria that could help find answers. For instance, cannot the RBI identify a larger economic objective — say, an inflation target or some other quantitative variable such as unemployment or real GDP — that would guide its forex market operations, as many other central banks have done?

Take the Swiss National Bank (SNB), whose recent forex market interventions the Governor seemed to be alluding to in his speech. The SNB has resolved to prevent the Euro-to-Swiss Franc exchange rate falling below 1.20. That stance on intervention has, in turn, been driven by the SNB’s objective of preventing de-growth and deflation in its home country.

Similarly, if the Reserve Bank of Australia were to prospectively consider forex market intervention to prevent the Australian dollar from rising beyond a particular level — say USD 1.02 or 1.03 — that will be clearly part of a domestic monetary policy easing strategy.


Governor Subbarao, by contrast, did not identify any such economic goal-posts driving the RBI’s forex market intervention or even operations in other markets — say, the money markets — to influence the level of the rupee’s exchange rate.

So, what we will continue to have is a forex market policy on the go. Policy-makers will continue to react in an ad hoc and unstructured manner to market developments. In such an environment, market intervention and the holding of forex reserves become ends in themselves.

The RBI Governor seemed to be saying as much, when he indicated that market intervention to defend the local currency during a phase of depreciation, even with reasonable official forex reserves holdings, may not be a workable proposition at all.

When it came to preventing local currency appreciation, the Governor was frank in admitting that there was no limit to such intervention, as countries could print their own currency at will.

That India, indeed, did over the last decade, accumulating some $300 billion of reserves in the process, besides also triggering outsized asset price and overall inflation pressures.


India Inc can well testify to the effects of that arbitrary approach of the RBI. Indeed, one hopes our corporates — at least now, after the significant disorderliness they have weathered in the forex markets in the past couple of years — would have learnt their lessons and accordingly instituted structured financial risk management practices.

We have, indeed, seen how hundreds of companies that took on forex liabilities assuming an exchange rate not more than Rs 45-to-the-dollar, were compelled, literally overnight, to reckon with a new base some 25 per cent lower. It has since required repeated amendments to the official accounting standards to disguise those massive forex losses on companies’ balance-sheets.

The recommendation on disciplined risk management would be even more relevant for India’s vast unlisted corporate sector, comprising thousands of small firms with significant forex exposures, also suffering from notable information and knowledge gaps.

For long, Indian companies seemed to have relied on the RBI’s repeated promises of ensuring orderliness, stable conditions and controlled volatility in the forex markets.

The central bank had, then, been typically prefacing its messages about forex reserves as these being held “as an insurance against disorderly market conditions”, “to reduce volatility”, “to meet liquidity needs for essential imports”, “to ward off speculative attacks”, and so on.

Having heard those repeated messages over the years, it is not surprising that many in the corporate sector took on large forex exposures, while literally out-sourcing risk management to the RBI.


The risks in such out-sourcing, to a central bank which did not have a structured policy framework in this regard, were made very clear even in 2007. Unfortunately, our corporates did not learn their lessons then.

The RBI, during that period, withdrew from large-scale forex market intervention all of a sudden, resulting in a steep appreciation of the rupee.

The prospect of more such appreciation, then, became one of the critical drivers of complex, large-scale derivative transactions in India’s forex markets. These were products ostensibly designed to protect companies from any further domestic currency appreciation.

Unfortunately, once the rupee reversed direction in due course, the entire complex of those derivatives transactions generated huge losses for their corporate buyers. It led to court cases that are still being fought, with not much hope for the companies concerned.

The RBI, in fact, penalised the banks involved by levying fines of something like Rs 15-20 lakh, whereas losses for the firms that bought the derivative contracts ran into hundreds of crores of rupees. Some small and mid-sized companies even had their net worth wiped out by the losses.

The RBI’s forex market intervention practices, and their impact on the rupee’s exchange rate movements and the corporate sector’s financial fortunes, have therefore had a checkered history.

What is striking, even despite this, is the fact that the RBI is still not anchoring its forex market policy to some larger economic objective or target.

In the light of such a stance, one cannot really disagree with the Financial Sector Legislative Reforms Commission report’s call for setting the RBI clearly defined and measurable economic objectives, and holding it accountable for that.

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