However, this action, while help the RBI to achieve its objective of fixed exchange rate along with open capital account, will change the amount of liquidity in the domestic market, making it impossible for the RBI to have an independent monetary policy. The size of RBI’s balance sheet would go down in this case, effectively leading to tighter monetary policy. In short, this would be equivalent to a hike in interest rates to encourage foreign investors to invest in the Indian economy, irrespective of what the domestic fundamentals suggest.
Alternatively, the RBI could choose to sterilize those FX operations by buying government securities. The sucking of INR liquidity due to FX operations, thus, would be offset by injecting INR liquidity through G-sec purchases, keeping the size of its balance sheet unchanged. Higher demand for G-secs, however, would lead to lower interest rates, effectively implying easy monetary policy.
Sterilised or not, therefore, if RBI chooses to intervene in the FX market, it will surely hurt its ability to continue with an independent monetary policy. This is the cost of RBI’s intervention in the FX market – losing control over its monetary policy.
In contrast, if the RBI adopts a hands-off approach, foreign capital flows will lead to commensurate changes in the exchange rate to bring back the equilibrium. Large foreign capital outflows will weaken INR and lead to better competitiveness. Eventually, it would improve growth prospects, which will encourage foreign investors. The adjustment process in this approach, thus, materialises through the FX market, as RBI practices an independent monetary policy, along with open capital account.
Like most of the times, however, the starting point matters. With India’s inflation at around 6 per cent, further monetary easing is totally off the table for the RBI. Of the three options discussed above, thus, the sterilised intervention (leading to lower interest rates) and hands-off approach (weaker INR could lead to further inflation) at this stage is not recommended.
What is left is the unsterilised FX intervention by the RBI, which implies that the monetary policy tightening will be faster than otherwise. Although this may be the most preferred form of intervention, it also comes with a limitation. Unlike most of the western world, it is widely acknowledged now that growth recovery in India is much weaker, which justifies only a gradual monetary policy normalisation. The unsterilised FX intervention, however, could hasten the monetary tightening.
Therefore, even though India holds the fourth highest FXR in the world, the use of these reserves to defend the domestic currency must be exercised with caution. The most ideal policy is to stay off the markets as long and as much as possible. Let the markets be free. Nevertheless, too much volatility and sharp INR depreciation obviously lead to some jitters, especially because the inflation rate is already on the higher side, which justifies RBI’s intervention.
The RBI’s decision, thus, to not enter in FX markets in late 2021 or January-February 2022 and intervene only in the first half of March 2022, when INR weakened quickly, was a prudent choice.
(The author is Chief Economist, Motilal Oswal Financial Services. Views are his own.)
Source Name:-Economic Times