Engineering a substantial reduction in the volatility of the exchange rate has been a critical component of the Reserve Bank of India’s (RBI) post-Covid currency policy. This has resulted in the International Monetary Fund (IMF) reclassifying India’s official exchange rate regime as a “stabilised arrangement” as opposed to the earlier classification of a “floating system”. In an economy with a relatively open capital account, the central bank suddenly and sharply lowering the currency volatility is deeply problematic for two main reasons: (i) it can trigger ‘moral hazard’ among foreign currency borrowers in India’s private sector¹; and (ii) ironically enough, it can further aggravate the currency fluctuations. 

RBI’s currency management

From 2000 to 2022, the average annual volatility of the rupee-dollar (henceforth INR-USD) exchange rate was around 5%. In contrast, in 2023 and 2024, the average annualised volatility of the INR-USD fell drastically to 1.8% (Figure 1). This was the lowest volatility in more than two decades, even lower than the 2000-2004 period when the INR was effectively pegged to the USD. 

Figure 1.  Volatility of the rupee-dollar rate

It is worth pointing out here that if exchange rate stability comes about as a natural outcome of market forces, then it is welcome. For example, the euro-dollar exchange rate is one of the most stable in the world, not because their central banks regularly intervene in the market – they do not – but because a vast number of players are freely able to take money in and out of these financial markets, creating huge but roughly balanced cross-border movements of capital which in turn keep the exchange rate stable. 

However, this is not the mechanism through which the recent stability of the INR-USD exchange rate came about. Instead, it has been an outcome of the RBI’s active interventions in the foreign exchange (FX) market. The substantial increase in the RBI’s currency spot market interventions since late 2022 is shown in Figure 2. 

Figure 2. RBI’s net interventions in the currency spot market

Note: This figure shows the net intervention by the RBI in the currency spot market, with positive values indicating a net purchase and negative values indicating a net sale of US dollars. This excludes interventions in the forward exchange market.

Source: RBI data.

Consider the underlying FX market developments over the past two years. Between end-September 2022 and end-September 2024 there were large swings in foreign capital flows, triggered by global uncertainties such as Russia’s invasion of Ukraine and aggressive monetary tightening by the US Federal Reserve to fight inflation. Yet the INR-USD exchange rate moved within a tightly bound range of 81.5 to 83.8. 

This was primarily the result of the central bank’s interventions on both sides of the FX market, on some days buying dollars to prevent the rupee from appreciating and on other days selling dollars to prevent the rupee from depreciating. In November 2024, the RBI did a net sale of US$20.23 billion in the spot market. This was the highest monthly amount of FX intervention since 2000, higher even than during the turbulent years of the Global Financial Crisis. 

The RBI intervenes not only in the currency spot market but also in the currency forward market. However it is harder to pin down the extent of its interventions in the latter because the RBI does not release data on the forward contracts or how much of it is rolled over or settled every month. In a curious turn of events, the RBI also began intervening in the offshore NDF (non-deliverable forward) market in 2024.² By November 2024, the RBI had run up a huge short position in USD in the NDF market, which amounted to nearly US$65 billion. 

It is worth noting in this context that the NDF market has developed in the first place, in response to the periodic and frequent imposition of capital account restrictions by the RBI, as a result of which international participants engaged in cross-border transactions are unable to easily access the onshore currency forward market. Hence, they go to the NDF market to either hedge their rupee exposures or to speculate on the currency movements. It is interesting therefore that the RBI itself decided to intervene in this offshore market in a bid to control the exchange rate movements. 

Effectively, through multiple kinds of interventions, the RBI has been pegging the rupee to the dollar, thereby ushering in a sudden shift in the exchange rate regime from 2022 onwards. Yet it is not clear till date why the Central Bank decided to adopt this approach. As a result of the RBI’s active currency management, the INR-USD volatility in the last two years has been extraordinarily low, not only compared to India’s own past but also to its emerging economy peers. Figure 3 shows the currencies (vis-à-vis the USD) of a few major emerging economies, indexed to 100 in January 2021. The INR-USD has clearly been the most stable pair since late 2022. 

Figure 3. Emerging market currencies, indexed to 100 as on January 2021

 

Post-November 2024, there seems to have been a change in the RBI’s currency policy. While we do not know the extent of its continued interventions in the FX market given that the data on interventions are released with a two-month lag, we can observe that the rupee has been depreciating against the dollar, with the INR-USD exchange rate falling from 84 to 87 between November 2024 and February 2025 (data till 17 February). Admittedly, the depreciation is modest and it is even smaller when measured against an overall basket of India’s trading partners (the nominal effective exchange rate). This is because the US dollar has been strengthening against most other currencies following the election of President Donald Trump in November 2024. Still, it is greater than the movements allowed during the previous two years.  

In other words, over the last two years, the RBI’s currency policy seems to have gone through two phases. First, an aggressive attempt to minimise volatility and peg the rupee to the dollar, followed by a move towards a more market-determined exchange rate. Problems arise in both phases, especially when one follows the other. 

Repercussions of RBI’s currency experiments

There are two main ways in which the RBI’s strategy to minimise currency volatility can cause distortions in the economy. First, when the volatility of the currency is low due to RBI’s interventions in the FX market, firms in the private sector start taking on currency risk. They assume that the RBI would be able to prevent the rupee from depreciating and would succeed in delivering a low-volatility currency for a long period of time, and hence feel encouraged to take on greater dollar exposures on their balance sheets. 

Moreover, when the central bank provides such an insurance against currency fluctuations, firms are unlikely to hedge their dollar exposures. This is because hedging is costly, whereas firms are getting insulated from currency volatilities for free (at least for the time being) as a result of the RBI’s actions. However, if a large number of firms have currency risk on their balance sheets, this can create a problem of systemic risk in the economy. This is because when the exchange rate eventually depreciates, the rupee burden of the private sector’s dollar debts will increase, perhaps beyond some firms’ capacity to pay. 

A reasonable proxy of the market’s expectations about future exchange rates is the forward premium. Historically the forward premium has fluctuated in a 3-5% range. But, we see in Figure 4 that from 2023 onwards, when the RBI lowered the INR-USD volatility, the forward premium went down significantly to 1-2%. This implies that the market was under the impression that the RBI would keep the rupee pegged for a long time. This kind of expectation could have caused an increase in unhedged dollar borrowing by the firms. 

Indeed, the Financial Stability Report published by the RBI in December 2024 highlighted that unhedged external commercial borrowings (ECBs) of firms stood at US$65.49 billion, nearly 34.4% of the total debt raised under this avenue. The Report further mentioned that the rise in foreign currency borrowings by non-banking financial companies (NBFCs) could pose currency risks to the extent they are unhedged. This is worrisome given that the rupee has been depreciating, particularly from December 2024 onwards, thereby exposing these firms to balance sheet vulnerabilities. 

Figure 4. Forward premium and currency volatility

Note: Figures shows the movement of forward premium (FP) of various maturities along with the annualised volatility of the INR-USD exchange rate.

Source: RBI data. 

Secondly, the RBI can ensure that currency volatility will be low for an extended period of time, but no central bank can achieve this forever, especially when foreign capital can move relatively freely in and out of the domestic financial markets. Sooner or later the exchange rate is bound to become overvalued, in which case pressure on the rupee will grow, potentially triggering a speculative attack on the currency. At that point, the RBI could keep depleting FX reserves to defend the currency. But the size of the FX market is so large today that it would require very large interventions by the RBI to keep supporting the rupee, especially when the US dollar is rapidly and persistently strengthening. And the stock of reserves is finite. Once the market observes that the RBI is trying to defend the rupee, they would expect it to end when the RBI runs out of reserves, and as a consequence everyone would want to buy dollars, thereby further weakening the rupee sharply. In the end, the RBI cannot really prevent the rupee from depreciating, and the longer the Central Bank tries to defend the rate, the greater the risk of a speculative currency crisis.

In other words, the RBI’s aggressive attempts to keep currency volatility low may have aggravated the currency depreciation.

What should be done instead?

The rupee has depreciated in the last couple of months. In the coming days it is likely that the pressure on the rupee will remain high, especially due to spillover of policy uncertainties from the US under the new Trump administration. In this context the crucial question for India is: should the rupee be allowed to find its own level or should the RBI continue to intervene to prevent the rupee from depreciating and continue to maintain a low currency volatility?

Even under normal circumstances, defending a currency is difficult and we are living in extraordinarily uncertain times. In this kind of a volatile global environment, the RBI trying to fight against the vast FX market to defend the rupee is a particularly bad idea, for reasons described above.

Instead, allowing the rupee to move in both directions can lead to sensible behaviour among the private market participants. Higher volatility will prevent firms from taking on unhedged dollar borrowings. As firms learn to live with a more market determined exchange rate, they will also adapt and devise ways to become more resilient to sharp currency fluctuations. Likewise, when the rupee is allowed to fluctuate, foreign investors will no longer speculate that it can only move in one direction and hence will give up betting on the rupee.

The views expressed in this post are solely those of the author, and do not necessarily reflect those of the I4I Editorial Board.

Notes:

1. Moral hazard refers to a situation where an economic agent (individual or institution) has an incentive to take on excessive risk because of the knowledge that someone else will bear the burden of that action.
2. An NDF is similar to a regular forward FX exchange contract, with the main difference that an NDF does not involve a physical settlement of the contract and exchange of currencies. The underlying premise is that the NDF contracts are traded on currencies that are not deliverable offshore. The INR NDF market is a USD settled market on the USD-INR rate. The NDF contracts in INR are bilaterally settled and are traded in over the counter (OTC) market at various offshore locations such as Singapore, Hong Kong, London, Dubai, and New York.