CHAPTER4

EXCHANGE RATE MANAGEMENT BY THE RBI: SOME ISSUES

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SECTION: 4.1: INTRODUCTION

Exchange rate policy - and, more specifically, the management of the rupee rate - has

taken the lead in the much publicised "structural adjustment" of the Indian economy.

Starting with the two-step devaluation in July 1991, through the partial float in budget 1992,

and on to the supposed full float in budget 1993, the rupee has undergone a substantive

change in persona. Coupled with this, there have been progressively major changes in the

exchange rate policy of the RBI that have had profound implications in influencing the

direction of the rupee dollar rate.

This chapter will provide an overview of major facets of the exchange rate policy of the RBI.

Theoretically speaking, purely floating and fixed exchange rates are only two of the possible

exchange rate regimes a country can choose. In reality there are many layers between

these· two extremes. Section 1 will give a prelude to the economic crisis in 1991, which

ultimately gave way to steep exchange rate devalu·ation in 1991. We will also give a brief

overview of the alternative exchange rate regimes and point out where does India stand in

this regard.

There is an extensive literature on pros and contras of exchange rate based stabilization

policies in developing countries. One eleh1ent of such exchange rate based stabilization

policy in developing countries is to target a particular level of nominal exchange rate

consistent with a given purchasing power parity value. In section 2 we will provide a brief

overview of exchange rate targeting of the RBI, which has been a major policy debate in

India.

At the forefront of the exchange rate policy of the RBI has been the nature of intervention in

the foreign exchange market, both spot and forward. The nature of intervention by the RBI

in the spot and forward foreign exchange market has been always with a definite purpose

(either implicit or explicit) and sometimes on a continuous basis for several days. However,

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the RBI publishes only monthly intervention data and as like most central banks of the world

keeps its daily intervention a closely guarded secret, as and when it does. In section 3, we

document the nature of the foreign exchange intervention by the RBI.

The response of the RBI in countering undue volatility in the foreign exchange market has

also been a major topic of debate. In section 4, we will provide a tabular calendar of the

measures announced by the RBI in curbing volatility in the foreign exchange markets, the

purpose and the effects thereof.

A discussion on the foreign exchange market activities in India is incomplete without a

survey on global foreign exchange and derivatives market. In section 5, we concentrate on

the dynamics of global and domestic foreign exchange activity. The subsequent realisation

on the thinness of the Indian markets is emphasised.

SECTION: 4.1: ALTERNATIVE EXCHANGE RATE REGIMES

4.1 a: The histo,.Y of exchange rate policy of the RBI till managed float

The exchange rate policy of the RBI in 1980's was limited to pegging the rupee/sterling rate

in the morning and responding to the volatility in the market by changing its reference dollar

rates each time the market threatened to break out of its controlled range. The

rupee/sterling rate was also changed sometimes by the RBI in case of undue movements in

the rupee vis-a-vis sterling. This was done ostensibly to prevent commercial banks from

buying sterling overseas and dumping the pounds on RBI (at their morning fixed rate,

providing an attractive arbitrage opportunity)1.

The devaluation of the rupee in 1991 signified a sharp drop in its value (in terms of a 14.1

per cent over end-December 1990 level). The rupee's fall was hardly surprising, given the

tremendous strains that the economy has had to bear in 1990's with the external account

1 April 15, 1988 and June 17, 1988 provides a typical example. The RBI changed the sterling parity in the afternoon taking the market by surprise.

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coming close to breaking point. A host of factors like domestic political crises and the oil

price rise contributed to the chaotic scene. A modest $1.8 bn from IMF in January 1991

gave some temporary relief, but by early March the situation went out of control, when the

last quasi-government fell. The then caretaker government was only able to present a vote

on account instead of the 1991-92 budget. India's credit rating was downgraded twice (the

last time to "speculative grade") and with instalment payments on some of the loans coming

due, the economy nearly collapsed.

The situation was however salvaged temporarily by RBI by acting through SBI. Nearly $ 4

bn of short-term acceptance in the local foreign exchange market was rolled over. In other

words, when a payment came due, SBI bought spot dollars on behalf of the RBI and sold

forward; when that sale came due, once again they bought spot and sold forward; and so

on - effectively buying a little time. The huge volumes of the rollovers put a terrifying

pressure on the local market, which at that time was able to handle no more than $ 1.2

billion a day (of which not more than $500 million is in the forwards). By early March, the

forward market collapsed. The RBI lowered down imports - tightening the margin

requirements (to as high as 200% in some case) and required RBI clearance before virtually

any commercial import remittance could be made.

Meanwhile, a new government was sworn in and the rupee was immediately devalued (in

two quick steps) by a total of 22 per cent. Parallel with this, dramatic changes in trade policy

-the negative list for imports was pruned sharply and a new instrument (the Eximscrip) was

created to provide exporters with some additional returns; thus began the process of

liberalization.

This was clearly the first step towards the supposed market determination of the Rupee.

Next in budget 1992 the rupee was made "partly convertible" - or, more correctly, partly

floated I liberalised exchange rate regime (LERMS). 40% of export receipts were to be

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surrendered to RBI at a predefined ("official") rate; to be used for "essential" imports (like

petroleum, fertilzers, edible oils, etc.). The balance couid be sold in the "free market" to be

used by importers to purchase their requirements. The official [RBI buying] rate was virtually

at the same level it had been since the devaluation in July 1991; the free market rate was at

first extremely volatile but finally settled down.

In fact, the "free" rupee may have become even stronger except for heavy market

purchases of dollars made by RBI through most of April-November 1992. This surprising

strength of the rupee was caused by a variety of factors. First of all, imports were

considerably constrained by the imposition of penal margin requirements through most of _

1991; as a result of this several importers had found alternative local supplies. Further

imports now had to be paid for (largely) devalued rupee rate at the free market, this made

heretofore OGL imports much more expensive than before.

Secondly. the hawala rate fell as official gold imports were allowed and a greater

percentage of workers' remittances started coming in through official channels.

Finally, under LERMS, the companies were allowed to cancel and rebook foreign exchange

contracts virtually at will. This provided tremendous cash flow benefit to companies who had

booked forward contracts before the budget, particularly in the case of long-term covers of

foreign currency loans that had been booked years earlier. Several companies took

advantage of the new rules to cancel their covers encashing huge floats and generating

large supply of dollars in the interbank market.

At the start of December 1992, ostensibly in acknowledgement of the dollar's sharp gains

overseas (which had rendered exports in non-dollar's currencies much less profitable), RBI

signalled a change in policy by stepping-down (devaluing) its official rate. The market knee­

jerked to the sudden move and the rupee slipped immediately. A political crisis at home that

time only compounded matters and there was a steady decline in dollar inflows, and by

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February 1993 the rupee was falling fast. However the forward premia did not shoot up as

they would have if the market was demand driven (and, in fact, as they had before budget

1992, when a major change in the exchange rate was anticipated). And, sure enough, came

the budget- and the anticipated supposed full float of the rupee took place2.

4.1b: The exchange rate system in India

Even though the exchange rate system in India is supposed to be a full float, the RBI

intervenes in the market at regular intervals to direct the movement in rupee values (and

hence we call it a managed float). The intervention by the RBI in the market could be

passive, whereby the RBI engages in off market deals, and active whereby the RBI actively

purchases $ or sells $. The intervention could be also a verbal talk or press statements in

times of exchange rate crises, or in the extreme case when the market goes haywire a

package of monetary and other measures to pull up the rupee. We will explore all this policy

issues in details in section 4.4.

The exchange rate system in India is therefore anything but full float. We call this exchange

rate system in India a "managed float". The table below documents the alternative

exchange rate regimes. The table describes briefly the main features of each regime.

summarises their alleged merits and shortcomings and the historical experiences. In the

table, as we move from top to bottom, the degree of flexibility that they impart to. the

economy is arranged in descending order.

2 The discussion in this section is mostly from press archives, and RBI Reports.

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TABLE 4 1 Alternative exchange rate regrmes Regime Main Features

1. Free Float Value of foreign exchange freely determined. Actual and expected changes in demand/supply of assets reflected in exchange rate changes

2. Managed Float

3. Floating within a Band (Target

Zone)

4. Sliding Band

A 'managed float' could be conceived as a float with wide bands with the (undisclosed) position of the bands providing the criterion for intervention. Sporadic central bank intervention in the market with the objectives varying. Active intervention (sterilised and non­sterilised) results in changes in reserves Indirect (monetary management) does not The nominal exchange rate is allowed to fluctuate (somewhat freely) within a band. The centre of the band is fixed either in terms of one currency or of a basket of currencies. The width varies.

No commitment by the authority to maintain the central parity indefinitely The system is an adaptation of the band regime to the case of high-

Main Benefits Changes in nominal exchange rate shoulder bulk of adjustment in foreign and domestic shocks. High international reserves not necessary.

Same as in free float, but that higher international reserves are required. Dampens excessive fluctuations of exchange rates. ·

Flexibility with credibility. Key parameters (bands, mid-point) guide public expectations. Changes in the nominal exchange rate within the band help absorb shocks

Allows countries with an ongoing rate of inflation higher than world to adopt a band without having to experience a

Main Shortcomings Volatility of exchange rates may distort resource allocation. Monetary policy needs to be framed in terms of nominal anchors different from exchange rates. Inflation bias may be large.

Comments Virtually no country has a pure float The USA, Germany, Switzerland (and Japan, according to some) comes close.

Lack of transparency of Many advanced central bank behaviour may economies have introduce uncertainty. adopted this regime -Effects of intervention are Canada, Australia, typically short-lived and may (Japan, according to be stabilising others) and Mexico

If the band is narrow, the system can be prone to speculative attacks. Selecting the band is difficult. Allowing for the .possibility of realignment of the bands and central parity weaken the credibility.

The timing and size of the central parity unknown, introduces considerable uncertainty, resulting in

following the 1994-95 crisis. India typically falls into this category.

Exchange rate mechanism of the European Monetary System (ERM). The ERM crises of 1992-93 exposed the vulnerability of the system to speculative pressure and even collapse when currencies are misaligned and the apex bank are hesitant to defend. Israel had a system similar to this from early 1989 to December 1991.

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Regime 5. Crawling Band

6. Crawling Peg

7. Fixed-but­adjustable

exchange rate

inflation economies.

Main Features A band system where the central parity crawls over time. The rate of crawl is backward looking crawl (based on past inflation differentials) and forward looking crawl (based on expected or target rate of inflation).

The nominal exchange rate is adjusted periodically to a set of indicators (usually lagged inflation differentials) and is not allowed to fluctuate beyond a narrow range. One variant of the system consists of adjusting the nominal rate by a pre-announced rate set deliberately below ongoing inflation (variant known as 'tablita effect)

Bretton Woods System. The nominal exchange rate system is fixed, but the central bank is not obliged to maintain the parity indefinitely. No constraints on monetary and fiscal policy and adjustments of the parity (devaluations) are a powerful policy instrument

severe real appreciation.

Main Benefits High inflation countries can adopt a band system without having to undertake (large) stepwise adjustments of the central parity.

interest rate volatility. Difficult to choose the appropriate width for the band.

Main Shortcomings A backward looking can introduce inflationary inertia, whereas a forward looking can produce overvaluation and give rise to speculative pressures.

Comments israel adopted this system in December 1991. Chile had a widening band from 1986 to mid-1998. Italy between 1979 and 1991.

Allows high inflation countries A pure backward-looking to avoid severe real exchange crawling peg introduces rate overvaluation. inflationary inertia and may

This was popular in the 1960s and. 1970s in Chile, Colombia and Brazil. In January 1998, the foreign exchange market in India was agog with rumours that the RBI was veering towards a crawling peg, whereby it would only contain volatility and not direct the movement of rupee.

Provides macroeconomic discipline by maintaining tradable goods prices in line with foreign prices. The built-in "escape clause" allowing the authorities to devalue in case of need provides the system with some flexibility.

eventually cause monetary policy to lose its role as a nominal anchor. Equilibrium changes in the real exchange rate are difficult to accommodate Will not last if the fiscal and income policies are consistent

Realignments under this The most popular system has been large and regime. Most developing disruptive (introducing countries held on to uncertainty and inflationary (variants of) after the pressures) rather than formal collapse of orderly Bretton Woods. Many

developing countries continue to subscribe to this system de facto (Mexico, 1983-1993, Thailand 1993), if not de jure

'----------'---------- ··----------~---· ·----·---- -·---- --- -·---- -----------------------'-----------___!

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Regime 8. Currency

Board

9. Full 'Dollarization'

Main Features Main Benefits Strict fixed exchange rate, with The system maximises institutional (legal and even credibility. constitutional) constraints on monetary policy. The monetary authority can only issue domestic money when it is fully backed by inflows on foreign exchange.

The country gives up completely its monetary autonomy by adopting another country's currency

Credibility is maximised.

Source: Edwards and Savastano, NBER: 1999, but for India (author's observations)

Main Shortcomings Long on credibility but short on flexibility Large external shocks cannot be accommodated through exchange rates but have to be fully absorbed by changes in unemployment and economic activity. Central Bank loses its role as a lender of last resort. Long on credibility, but short on flexibility Central Bank loses its role as lender of last resort. It is usually resisted on political and nationalistic grounds.

Comments When faced with major external shock countries have abandoned this regime. Currently, Hong Kong have currency boards. Argentina and Bulgaria have quasi­currency board arrangements.

Few episodes of full do/larization. Worked well in Panama. In Liberia, when faced with an ·emergency, politicians decided to change the rules of the game and issued a national currency.

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Two points are in order. First, the exchange rate system in India is quite flexible as the table

shows (the managed float is second only to free float in terms of degree of flexibility).

Second, since the RBI is not completely transparent regarding the intervention patterns

(because of compulsions) it introduces a system of uncertainty in the system as witnessed

during January 1998 when the market was agog with rumours that the RBI was veering

towards a 'crawling peg' whereby the RBI would merely intervene to contain volatility but not

to direct movement of the rupee. Finally, since a managed float is typified by undisclosed

position of the bands providing the basis of intervention, the Indian foreign exchange market

is convinced that the RBI targets a specific nominal exchange rate in line with the real

effective exchange rate. This target keeps on changing to keep pace with the real effective

exchange rate. We take up this issue of exchange rate targeting by the RBI in the following

section.

SECTION: 4.2: EXCHANGE RATE TARGETING BY THE RBI

4.2a: Exchange Rate Targeting by the RBI: the Tarapore recommendations

The issue of exchange rate targeting is always a sensitive issue and more so after the

South-East Asian crisis in 1997 and the Russian as well as the Latin American crises in

1998. The issue of targeting a nominal exchange rate based on a real effective exchange

rate gained prominence in 1997 after the Tarapore Committee Report on Capital Account

Convertibility (May 30, 1997) recommended that the RBI should have a "Monitoring

Exchange Rate Band" of +5 I - 5 per cent around the neutral Real Effective Exchange Rate

(REER). A Monitoring Band, built around a neutral REER (explained below) could be

expected to provide an opportunity to the market participants for anchoring their

expectations.

The Committee also suggested that the RBI should ordinarily intervene as and when the

REER is outside the band to bring the real value of the rupee closer to its neutral level. The

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Report also recognised that there was a case for the RBI to intervene even when the REER

was within this 5 per cent band if it felt that there was unwarranted speculation or excessive

volatility of the rupee.

Finally, the Committee also emphasised that there must be transparency in exchange rate

policy in as much as the announcement of the neutral REER, the declaration of the REER

monitoring band, making public any changes in neutral REER and publication of REER on a

weekly basis.

4.2b: The logic of exchange-rate targeting: the REER

As can be appreciated, determining the "natural" or "desired" level of the exchange rate is

one of the most difficult jobs of the Central Bank of any nation. A widely used concept to

calibrate the exchange rate, is the "Purchasing Power Parity" (PPP). This means that a pre-

determined basket of commodities should cost the same in all countries, when evaluated by

a common yardstick, say the dollar or the SDR.

A simple and adequate measure of PPP as mentioned above is an index called The Real

Effective Exchange Rate (REER). This is a weighted combination of the exchange rate of

the Rupee against a selected set of (important) currencies. The importance of the

currencies is usually determined by the share of India's trade (or exports) that is

denominated in that currency. The weighting of the various currency exchange rates

(against the Rupee) is what provides the "Effective" in the REER3.

The "Real" part is due to a process whereby the exchange rate is deflated by the relative

inflation differential of the two countries for which the exchange rate is being included. For

3 REER data is available from RBI in two formats: on a 5-country-basis and the 36-country basis. In both cases, the inflation deflator used is the new series of the WPI (base year: 1993-94) The 5-country REER incorporates the nominal exchange -rates of India's major trading partners adjusted for inflation on a trade-weighted basis. These countries are USA, UK, Germany, Japan and France. The 36 country REER is computed with bilateral

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instance, if the annual inflation rate of the USA is 3 per cent, while that of India is 6 per cent,

the same basket of commodities, denominated in say, dollars, would be 3 per cent costlier

(6%- 3%) in India at the end of the year. The rupee would have to depreciate by 3 per cent

in order to equalise the cost of the basket in the two countries. This assumes that there are

no other influences in the determination of the rupee.

4.2c: The RBI viewpoint: Statements made by Governor and Deputy Governor

In recent times (after the foreign exchange market disturbances in May and July 2000) the

RBI has come out with explicit press statements reiterating that the apex bank does not

target a nominal exchange rate. To quote from RBI statement on May 25, 2000 (when the

market was plagued by turmoil): "RBI would reiterate once again that it does not, repeat

does not, target a particular value of the rupee in relation to the US dollar. The often cited

numbers, such as "Rs 42", "Rs 43". or "Rs 44" simply have no significance for the

management of the exchange rate by the RBI. Nor does RBI recognise any level su'ch as

"lowest ever reached in the past" or "lowest last year" or any such dividing line".

Again on July 21, 2000 the RBI emphasised that "it does not "target" a particular level of the

exchange rate and there is no specific level it is prepared to defend through unlimited sales

of foreign currency and/or through introduction of strong monetary and other measures.

Furthermore, the statement added that past international experience has made it clear that

the defence of a "fixed" previously set target is not feasible as brought out during East Asian

crisis in 1997 and in Latin America in 1998 (as well as in India during November 1997) The

announcement of a fixed target leads to one way speculation in the currency and can result

in surge in the demand for foreign currency.

weights (both exports and trade-based for our major trading partners, with 1985= 100 as the base.

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This position of the RBI has also been repeated in the October 1998 credit policy. Again to

quote from this credit policy: "The RBI does not consider REER to be an effective tool for

management of short-term movements in the exchange rate. REER movements are subject

to various influences including capital flows, and the estimation of REER raises several

methodological issues. While the data on REER have some information content, the RBI

does not use short-term movements in REER as indicator of appropriateness or otherwise

of exchange rate movements".

The successive statements would give an impression that the RBI is not obsessed with

targeting a nominal exchange rate in line with a REER. But a closer look at the statements

by the RBI officials indicates that the RBI has followed exchange rate targeting.

Alternatively, there is a strong correlation between t~e disturbances in the foreign exchange

market and the supposed overvaluation of the rupee in terms of the REER.

Perhaps. the most influential statement on the overvaluation of the rupee against the dollar

using the REER yardstick was made by the Deputy Governor in August 1997. The crux of

the statement was: "The slowdown in export growth during 1996-97 could be attributed to

the decline in world trade coupled with sluggishness in manufacturing goods prices in global

market, variation in cross-currency exchange rates and deceleration in domestic industrial

activities. However, we should accept that, beyond a point, real appreciation of a currency

could hurt exports. Over August 1993 and in August 1995 the REER appreciation was 7.8

per cent. In August 1995, the volatility in the exchange rate of the rupee started and the real

appreciation was corrected by January 1996. The REER was stable for most of 1996.

However, with sharp appreciation of the dollar vis-a-vis other major currencies in the last

quarter of 1996, the rupee also appreciated in real terms. Over January 1996, the

appreciation in April 1997 was 10.3 per cent. As per the REER, the rupee certainly appears

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to be overvalued, which has been exacerbated with the sharp appreciation of dollar against

major international currencies."

4.2d: Simple tests to ascertain the validity of exchange rate targeting

The clamour to devalue the Rupee, or at least to allow it to depreciate, to its "natural" level

actually gained momentum from the end of August 1997, coinciding with this statement of

the Deputy Governor of the RBI that the Rupee needed to depreciate about 10 per cent to

reach a "desired' level.

To test for the validity of the "exchange-rate targeting" by the RBI we carried out two simple

exercises, the first one calculated a neutral REER4 from the 36-country REER, and the

deviation from such. The second one calculated the deviations of the nominal exchange

rate from a PPP value using the 5-country REER. In both the cases, we found a strong

correlation between the overvaluation of the REER and disturbances in the foreign

exchange market and subsequent RBI policy actions to nudge it towards the REER neutral

level.

For the first exercise, the most crucial pillar was choosing the neutral REER. Since the RBI

has not specified the neutral REER, it was derived from RBI deputy governor statement in

August 1997. This seemed to suggest that the REER neutral was August 1993. The

rationale for choosing this period most likely rests on the fact that it was a few months after

the LERMS was scrapped and a unified exchange rate system came into being and so the

rupee was "fairly valued".

The most striking result (see table 4.2 and exhibit 4.3 in annexure) is that if one plots the

extent of over I undervaluation of the 36 country REER from the neutral REER, it is clearly

observed that a swing outside the monitoring bands (the +5 or the - 5 per cent as

4 We define a neutral REER as the rate at which the rupee is exactly valued, (neither overvalued or undervalued)

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advocated by Tarapore) has always prompted a correction in the nominal level of the rupee

against the dollar within 4 to 6 months, induced by RBI overt or covert intervention in the

foreign exchange market.

In August 1995, for example, the REER was overvalued by nearly 8 per cent from the

REER neutral level (the REER was overvalued by more than 5 per cent since May 1995).

Subsequently, the RBI made a conscious policy decision of routing foreign currency

government debt through the interbank market. As a result, the rupee started to depreciate

and was undervalued by 5 per cent at the end of February 1996.

In August 1997 (again, the REER was overvalued by more than 5 per cent since January

1997) the REER was overvalued by as much as 11.7 per cent. This time, it was a statement

by the then Pri~e Minister that the Rupee must be allowed to move in an ''exchange band"

that roiled the foreign exchange market, already on edge with the RBI Deputy governor's

comment earlier that the rupee was overvalued and must be allowed to settle 10 per cent

lower. The market was thrown into turmoil and by January 1998, when the RBI came out

with a rescue package, the REER was still overvalued, by 9.6 per cent. The market was

again thrown into a tailspin in August 1998 (this time it was the longest period of 19 months

from January 1997 that the REER was overvalued by more than 5 per cent), and by

January 1999 the rupee was very close to REER neutral (overvalued by only 0.34 per cent).

Finally, the trigger for the foreign exchange market disturbance during May 2000 was again

the overvaluation, by as much as 10.2 per cent (the REER was overvalued by more than 5

per cent since March 2000) The overvaluation of the rupee beyond the 5 per cent

monitoring band therefore bears a strong correlation with the foreign exchange market

disturbances. Whenever the gap between the REER and REER neutral breaches the 5 per

cent monitoring band, the rupee is under pressure and actually depreciates to a level

consistent with REER neutral. Interestingly, sometimes the REER even after correction may

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still be overvalued, as was the case in January 1998. This could have provided the

provocation for another bout of volatility in the foreign exchange market in May 1998 and

August 1998 (the nuclear blasts in May 1998 only added to the jittery sentiments).

What could be the possible reason for the foreign exchange market to come under pressure

whenever the REER is overvalued? The most likely reason for this could be the stimulation

of perverse expectations that the rupee will be soon devalued through some informal

mechanisms/ news (a case in point was the Korean Won in 1997). This was indeed

substantiated during August 1995 when the RBI made a formal announcement that the debt

repayments were to be routed through the market, in August 1997, the statement by Deputy

Governor of RBI and the then Prime Minister that the rupee was overvalued by 10% and

may be allowed to float in a band, in November 1997 by the then Union Commerce Minister

that the government would not interfere with value of the rupee and again in June 1998 by

the Finance Minister that the RBI would not interfere with the value of the rupee provided

the initial trigger point to the fall in rupee value. We will return to this news element in Indian

foreign exchange market in greater detail in the following chapter. But what is important is

the perverse expectation of the market participants that the rupee is to devalued whenever

it is grossly overvalued is substantiated by the news element in the foreign exchange

markets.

In the second case, we carried out another exercise (see table 4.4 in the annexure) by

taking the more narrower definition of REER, the 5-country one. We carried out a simple

exercise by regressing the nominal exchange rate on the absolute purchasing power parity

value (we have discussed this purchasing power parity in chapter 3). The absolute

purchasing power parity value was calculated by taking the ratio of India's WPI to the

weighted CPI of India's major trading partners. The weights were derived from the share of

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each country's average total trade to India's average total trade5 The nominal exchange

rate that is consistent with a purchasing power parity (PPP) value was then arrived at.

The results show that whenever the gap between the actual and PPP value was widening,

the foreign exchange market was plunged into turmoil, and the rupee settled at an

undervalued level (but for January 1998). Take for example, the May 1995 level when the

rupee was overvalued by 15 paise. This went up to 52 paise by end July 1995. As

mentioned earlier, the RBI sought to rectify this anomaly by routing debt repayments

through the market. After a strong bout of disturbance in the foreign exchange market, the

rupee finally settled at a depreciated level in February 1996.

This exercise threw up one more interesting result. Whenever the disturbance ended, the

rupee settled at a far more depreciated level than was actually warranted by the PPP

value6. As a corollary, calm prevailed in the foreign exchange market till the gap again

widened (for example, the gap that was 17 paise in May 1997 widened to 38 paise in July

1997 before the August 1997 crisis), and the process continued. ~,-,_ . --- -- -

Before we move onto patterns of RBI intervefr{JuTiA,;;'"ft~e-iuTer!:Jr1"'exc~ange::.marKet~some

points are in order. First, the basic purpose of the REER is to establish a long-term

benchmark for the rupee, in terms of one component of the balance of payments, the trade

balance. There is a basic fallacy in the reasoning that the rupee/dollar exchange rate

should move in tandem: the dollar being a component of the REER basket, the movement

of the dollar will be attenuated in the movement of the REER by the movement of the other

component currencies. Any move to change the rupee/dollar move in tandem with the

5 For a fuller discussion, see the RBI monthly bulletin, July 1998, pp-s654.

6 This result is also supported by a study by Patel and Srivastava. Using monthly data from 1980 till 1995, it was observed that the nominal exchange rate was consistently undervalued. In other words, real exchange rate targeting has entailed policies designed to achieve a more depreciated level of real exchange rate.

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REER will only change the REER further. Second, in the modern financial scenario, such a

singular consideration on REER targeting will not be sufficient. Foreign fund flows,

particularly Fll (we will discuss this later in this chapter) driven by the demand and supply of

foreign currencies, increasingly determine the short- and medium-term value of the rupee.

The long-term value of the rupee is determined on perceptions of balance of payment

sustainability (and consequently external debt obligations) only one part of which is the

balance of trade (exports minus imports).

SECTION: 4.3: RBI INTERVENTION IN THE FOREIGN EXCHANGE MARKET: A

DOCUMENTATION

The interrelated objectives of monetary management, debt management, credit

management, and forex market regulations (besides having an actiye say in industrial and

commercial policy) makes intervention by the RBI in one market, specifically the forex

market a high-wire balancing exercise. A change in policy in one sector invariably spill over

into others, having totally unintended consequences, which need to be minimised.

The thrust of the RBI's forex market view (Deputy Governor's statement in August 1997) is

to ensure that economic fundamentals are reflected in the external value of the rupee.

Subject to this predominant objective, the conduct of exchange rate policy is guided by

three major purposes.

• To reduce excess volatility in exchange rates, while ensuring that the market correction

of overvalued or undervalued exchange rate is orderly and calibrated (preventing undue

appreciation in the context of large inflows and providing supply of dollars in the market

to prevent sharp depreciation).

• To help maintain an adequate level of foreign exchange reserves.

• To help eliminate market constraints with a view to the development of a healthy foreign

exchange market.

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The volatility of exchange rates in turn has been sought to be reduced by

• Make arbitrage I speculative activity more expensive for banks and other market

players

• Enable an increased supply of foreign currencies, either by enhanced repatriation from

foreign accounts or reducing the outflow of funds from the domestic markets

• The RBI had also to balance these against the genuine needs of exporters in using

their foreign currency earnings to facilitate their business needs, while making sure that

exporters are not harmed by the rise in credit costs.

In this section, we will highlight this thrust of RBI intervention strategy, by focusing

particularly on the volatile periods in forex markets and the run-up to that I possible reasons

(apart from the news element). We will also provide a overview of the RBI intervention in the

forward forex market.

4.3a: The reasons for the turbulence in the foreign exchang·e markets

The trigger for the turbulence in the foreign exchange market apart from the domestic news

element is often a prolonged period of disappointing export performances (table 4.5). This

period can be either conceived of in terms of cumulative export growth rates declining over

a period of time or a continued period of declining monthly export growth rates. Take for

example, the August 1997 disturbance in the forex market. The fiscal export growth rate

during 1996-97 had touched a measly 4.01 per cent from the huge 21.38 per cent in the

previous fiscal. This trend continued into the 1997-98 also, with the export growth rates in

the first four months hardly inspiring. In fact, the double digit export growth rate during July

1997 and the 7 per cent + during August 1997 was a statistical aberration as it was on top

of a lower base in the like months the previous year (export growth rates during July and

August 1996 was 2.6 and 3.6 per cent respectively, a huge drop from the average 16 per

cent monthly export growth rate during the five month period ended June 1996). The

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ultimate provocation was the statements made by the Deputy Governor and the Prime

Minister later in the month throwing the market into turmoil.

The run up to the January 1998 and August 1998 exchange market crises was not much

different. The monthly export growth rates from November 1997 onwards till August 1998

were negative for all but two of the months (even for these two months, the growth rate was

less than 5 per cent). The August 1998 crisis was accentuated with the release of the June

1998 trade data, the second straight month of negative double-digit export growth rate. The

14 per cent+ fall in exports in this month galvanised the government into action in the way

of generous export-boosting measures in the first week of August. The final trigger for the

crash in rupee value was the announcement by Russia in the same month that it would

allow the Rouble to move in a lower (and broader) band against the dollar and restructure

its existing debt, and the subsequent statement by Finance Minister that the domestic

markets were likely to be affected by international developments only aided in the fall in the

rupee value. The crisis was also abetted by fears of the devaluation of the Chinese Yuan

and this was given a further edge by its expectation of impending political instability with the

notification of the Cauvery water agreement at that time. Having identified that disappointing

export performance provides the initial impetus to the disturbance, the question is how it is

transmitted? Is it through a speculation of an impending rupee depreciation by the market

players or otherwise? If we take the August 1997, January 1998, August 1998 crisis, the

answer is affirmative. Let us now take up the cases one by one.

Take for example the August 1997 crisis. With a string of disappointing months of export

growth rates and the subsequent statements made by the then Prime Minister and the

Deputy Governor espousing the cause that the rupee was overvalued, the market players

construed it as a signal of a weaker rupee and were quickly on to the speculating game.

This is also substantiated by the table below. The Fll inflows in the first five months of the

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fiscal 1997 were healthy at $1135 mn and the excess demand in the merchant (trade,

corporales, invisibles) segment were negative till July 1997 and turned only marginally

positive in August 1997. Similar was the case in the interbank segment (RBI and scheduled

commercial banks) with excess demand negative for the first three months and turning

positive in July. Surely, excess demand was not the initial cause.

The January 1998 was a fallout of the August 1997 crisis, but this time it was the turn of the

Fils to turn net sellers, which turned the heat on the market. The depreciation of the rupee

during August and September 1997, and even though the rupee strengthened in October

1997, the Fils pulled out a cumulative amount of$ 366.9 mn during the three month period

ended January 1998.

Why do the Fils pull out in the event of a rupee depreciation? Since a typical Fll invests in

domestic currency but brings in the portfolio investment in foreign currency, a weakening of

the domestic currency will only· imply that the portfolio investor will be able to take out a

lower amount of foreign currency compared to the original investment. On the other hand. if

the portfolio investor makes the investment after the domestic currency has settled at a

depreciated value, the returns will be much higher. We have already modelled this

behaviour in chapter 3. Whatever be the reason, the Fll outflow only precipitated the

second round of exchange market crisis in January 1998.

The August 1998 was only waiting to happen. The markets were already jittery with the

imposition of sanctions in May 1998 following the nuclear blasts. Fils were net sellers to the

tune of $ 323.2 mn in the first three months of fiscal 1998. The excess demand in the

merchant and inter bank segment which had touched a peak in June 1998 ($ 4.4 bn and

$3.1 bn) declined in July ($ 2.5 bn and $ 1.2 bn) but shot up again in August when the

market was plagued by turmoil. Here again, excess demand was not the initial cause. The

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crisis was also abetted by the bout of financial turmoil across the globe in the form of rouble

trouble, fears of Chinese devaluation and domestic political instability, as explained above.

If Fll outflow is taken as the leading indicator of the troubles ahead in the foreign exchange

market, then the May 2000 also fall into the set pattern. Fll inflows were as much as$ 858.6

mn from December 1999 till May 2000 (but declined in June and turned negative following

the onset of the forex market disturbance, for reasons cited above). Even then excess

demand conditions persisted in the forex market in May 2000 ($2. 7 bn and $2.4 bn in the

merchant and inter bank segment respectively).

The May 2000 crisis was not driven for the first time by the domestic news element in the

foreign exchange market. The trigger point. for this disturbance was the rise in US Federal

Fund Target Rate in May 2000 (the sixth time since June 1999) and the European Central

Bank refinance rates in April 2000 (the third time since November 1999): This point has

been also highlighted in the RBI Annual Report, 2000, a clear enunciation of the fact that

Indian markets are getting interlinked with the international markets, and hence international

news has had a role to influence the domestic market.

How do we explain speculation from the table 4.6 on excess demand? Consider the

merchant segment comprising of exporters, importers and corporales. In an environment of

rupee depreciation, the exporters typically adopt a wait-and watch attitude with regard to

bringing in export proceeds from abroad (a lower currenc:y value will translate into higher

export earnings). For the same reason, the GDR and ECB proceeds of the corporales may

also be delayed. This pushes down the supply of dollars. The corporales and importers on

the other hand, typically scramble for forward cover of their existing dollar liabilities, and

may also try to repay their commitments ahead of schedule. This pushes up the demand for

dollars. Consequently, the gap between demand and supply of dollars increases.

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In the table, the supply of dollars from exporters (and also corporales) had always shown a

clear tendency to decline in times of rupee depreciation. The supply of dollars declined by $

637 mn in between August and November1997. In the like period, the demand for dollars

jumped by close to $2.5 bn. Similar situation was witnessed during June and August 1998.

The demand for dollars increased by a huge $ 1.7 bn in June 1998 over the previous

month, following the nuclear blasts and subsequent sanctions in May 1998. The supply of

dollars increased by only $364 mn in the same period. However, unlike November 1997 and

January 1998, the May 1998 crisis was short-lived as most of the corporales had already

covered their positions, as the rupee had on a progressively declining trajectory since

February 1998.

Clearly, speculation by market players only hastened the fall in rupee value. This situation

has also been aggravated at times by extraneous factors, like the petro product price hike in

August 1997 that had the corporales scrambling for forward cover of their dollar liabilities on

the expectation that the hike would enable the funds-rich oil companies to enter the

domestic forex markets to buy dollars for future oil imports, and pay off some its earlier and

costlier dollar borrowings.

Another way to look at the speculation is the demand for dollars in the forward and spot

market (table 4.7). The forward demand for dollars is magnified during times of forex market

crises in both the merchant and inter bank segment. In the merchant segment, the demand

is because of rush to cover unhedged positions (in September 1997, the excess demand for

forward dollars crossed a staggering$ 2 bn from a negative$ 61 mn in July 1997). In the

inter bank segment the mad rush is because banks typically go long on forward dollars with

the idea of making profits (from $ 137 mn in June to nearly $ 2 bn in September 1997). The

percentage of forward demand as given in the table below gives a fair idea of the

speculation in the markets, whenever the rupee is under pressure.

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A point to be noted is that the demand for dollars in the forward market always acts as a

leading indicator, and the spot market only follow suit. As an example, the excess forward

demand in the merchant segment was $ 485 mn in August 1997, whereas the spot demand

was negative. The demand for forward dollars touched a peak in November and declined

thereafter. The demand for spot dollars also tapered of earlier than the forward segment.

Finally, the forward premia in the Indian foreign exchange market are largely determined by

the demand and supply of forward dollars and do not necessarily reflect interest rate

differentials. However, in recent times (particularly, from March 2000 onwards) with the

growing interlinkage between the domestic and international money markets, there has

been a close correspondence between forward premia and interest rate differential.- This

also explains the forex crises in May and July 2000, when the domestic news element was

absent.

4.3b: The RBI intervention in the foreign exchange market: a documentation

A foreign exchange market intervention is defined as a sale or a purchase of foreign

currencies undertaken by the central bank to change the exchange rate of their own

currency vis-a-vis the foreign currency. In India, since the intervention currency is dollar. the

foreign currency is the dollar itself. With the introduction of the managed float of the rupee

from March 1993 onwards, there has been a subtle shift in policy focus of the RBI from time

to time, depending on the priorities. This section explicitly formalises this shift in policy

regimes of the apex bank. Alternatively, a brief taxonomy of this section is given in table 4.8

in the annexure.

In India, the following distinct phases of exchange rate movements are clearly discernible

with the advent of the managed float in March 1993.

7 RBI Annual Report, 2000 highlights the growing integration by plotting the interest rate differential, proxied by the difference between the overnight domestic money market and

197

March 1993 till August 1995, when the forex market was characterised by remarkable

stability of the nominal exchange rate,

September 1995 till February 1996, when acute exchange market pressure was staved

off through RBI exchange and money market operations,

March 1996 till July 1997, a period of tranquillity in the forex market,

August 1997 till January 1998, again a period of heightened volatility in forex market

overcome through a slew of exchange and money market measures,

February 1998 till April 1998, that marked the return of calm,

May 1998 till June 1998, when the forex market was characterised by considerable

uncertainties in India as well as abroad,

August 1998, again a month of uneasiness in forex market overcome through a

package of measures

September 1998 till April 2000, a quit period in the forex market but with minor hiccups

in May and June 1999

May 2000 till July 2000, the return of volatility in the market.

Section 4.3c: March 1993 till July 1997

With the introduction of the managed float of the rupee from March 1993 onwards. the forex

market was witness to a prolonged period of sustained capital inflows. This prompted the

RBI to aggressively intervene in the market to mop up the dollars to keep the rupee from

appreciating. The RBI bought dollars 12.58 bn in fiscal 1993 and another dollars 10.3 bn tn

fiscal 1994. This pushed up the foreign exchange reserves of the RBI by dollars 8.7 bn and

dollars 4.6 bn in the same period. Not surprisingly, the rupee was remarkably stable from

July 1993 onwards and stayed put at 31.37 against the dollar for a record period of 18

months till February 1995. The rupee depreciated in March 1995, only to appreciate in

the 3-month US dollar LIBOR.

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subsequent months and was once again nearly close (31.38 against the dollar) to the July

1993 level in July 1995. In fact, the RBI sold only dollars 1.36 bn in fiscal 1993 and a

measly dollars 1 mn in fiscal 1994, reflecting the remarkable stability of the rupee.

The quiescent period in the forex market got over from September 1995 onwards with the

RBI making public its intention to rout the huge debt service repayments through the market

(close to dollars 12 bn). The market was thrown into a tailspin, and the RBI after a gap of 11

months (22 months if we exclude the token sale of dollars 1 mn made in October 1994) sold

dollars (both spot and forward) in the market. The total sale of dollars were as much as

dollars 3 . 75 bn on a gross basis from October 1995 onwards till February 1996, and on a

net basis it was dollars 1.68 bn in the same period.

Even as the RBI sold gross dollars 785 mn of dollars during October 1995, it was unable to

halt the -slide in the rupee value. Consequently, the RBI changed tactics and instead of only

selling dollars it announced a comprehensive package of currency-supportive measures in

the same month. These were designed to bolster the supply of dollars, stop speculation at

the same time and thereby helping in the exercise of exchange rate management. This

shift in strategy was advantageous on two counts: first, it was to avoid run-down in foreign

exchange reserves and second with the prospects of a two-way movement in Rs dollar rate

becoming real, speculation was to become difficult. These measures stabilised the spot

foreign exchange market, but in the process the pressure shifted to the money market with

call rates touching astronomical levels (crossed 100 per cent). This resulted in the forward

premia going through the roof (the forward premia on dollar touched 15.6 per cent in

November 1995 rising from 9.3 per cent in October, then declined marginally during

December and January 1996 only to climb up to 23.4 per cent in March).

To halt the increase in forward premia, the RBI was also actively intervening in the forward

market by selling outright forward dollars, from October onwards. The forward sale of the

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RBI that was zero in September touched a high of dollars 1.78 bn in January 1996 (this

explains the decline in forward premia in the same month).

But the most interesting aspect of the RBI intervention was the beginning of swap

transactions during this period. As the forward premia climbed up steeply, the RBI was

engaged in buy sell swaps. Under a buy sell swap, RBI buys dollars from a commercial

bank, augments it's rupee resources and then sells it back at a future date at a pre­

negotiated price. The purchase of spot dollars will get reflected in the net spot purchases

total of a particular month (the RBI does not give the break-up for spot, outright forward and

swap separately) as well as the total purchases. The forward sales will boost the

outstanding forward sale figure and the total sale of dollars. This buy sell swap has the

unique advantage i~ that it serves the twin objective of cooling the call rates and the forward

premia at the same time.

How is the buy sell swap explained in the table? As the table 4.9 shows. the total gross

purchase of dollars during January 1996 was as much as dollars 1.36 bn, as agamst a

paltry dollars 272 mn in December 1996. The outstanding forward sales rose to dollars 2.2

bn in January 1996 from dollars 456 mn in the earlier month. Since the RBI would nor have

been purchasing dollars (as we have seen earlier, the apex bank purchases dollars in times

of rupee appreciation and sells dollars in times of rupee depreciation, that is leaning against

the wind) in a period of rupee depreciation, much of this purchase was because of swap

transactions entered into during the month.

Why did the forward premia rise in tandem with an increase in call rates? The increase in

call rates in the first place was because of liquidity tightening measures introduced by the

RBI to stop arbitrage between the money and the foreign exchange market. As call rates

rose, banks dependent on FCNR (B) deposits sold dollars cash and purchased these

dollars forward, pushing up the forward premia in the process6.

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Nevertheless, the increase in forward premia forced the RBI to announce a second round of

currency supportive measures in February 1996 by making import and export credit

prohibitive8. The market finally stabilised, with Fll inflows that had declined dollars 44 mn in

November touched dollars 427 mn in February 1996, largely to reap advantage of the

depreciated domestic currency (FII flows actually was on the rise from November onwards

itself and touched dollars 279 mn in January 1996). The rupee appreciated to 34.39 in

March 1996 against the dollar from a level of 36.63 in the earlier month. The RBI again

turned a net purchaser in the market by mopping up dollars1.1 bn of foreign currency.

What was the priority of the apex bank during this period? As seen from above, the RBI

initially was taking the direct route of intervening in the forex market by selling dollars. But

by selling dollars, the RBI took out rupee resources from the system, apart from the direct

drawdown of foreign exchange reserves. This did put a strain on the money market with call

raies crossing 100 per cent in November 1995. But more importantly, the RBI announced

the currency-supportive measures after a clear gap of two months (the first signs of

disturbance was noticed on September 4, 1995 and we take this as starting point) and the

first set of measures were announced on October 31, 1995 only after the bank had sold a

huge dollars 785 mn in October.

Clearly at this time, the apex bank was not worried about the money market implications of

intervening in the foreign exchange market, and prolonged the intervention in the forex

market. The priority of the RBI was thus to maintain forex market stability at any cost during

this period.

The market stabilised from March 1996 onwards and the RBI had to intervene aggressively

to hold the rupee back from appreciation. For the 18 month period ended August 1997

8 Importers typically rush for forward contracts, whereas the exporters postpone receipts from abroad hoping for rupee depreciation.

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(from March 1996 onwards) the RBI mopped up dollars 19.15 bn of dollars on a gross basis

and dollars 14.18 on a net basis.

Section 4.3d: August 1997 till June 1998

The crisis in August 1997 followed a prolonged interlude in the foreign exchange market,

and with the onset of the crisis towards the end of this month, the RBI again turned a net

seller in the market after a hiatus of 18 months and sold dollars 9.1 bn on a gross basis

during September 1997 till February 1998 (when the rupee finally stabilised) and dollars 3

bn on a net basis. The trigger point for the crisis was a statement by the then Prime

Minister that the rupee should be allowed to move in a band.

Was there a pattern of intervention by the RBI during this period? If we compare the

response of the RBI this time with earlier September 1995 crisis, there is a difference. At

that time, the RBI announced a package of currency-supportive measures after a clear gap

of nearly two months. In August 1997 the RBI initially was an aggressive seller in the forex

market, in both the spot and forward. But in contrast to the previous crisis, the RBI this

time was quick to announce a set of currency-supportive measures after a gap of twenty

days on September 12, 1997 (We take August 21, 1997 as the starting date, a day after

the Prime Minister's comment) from the starting date.

Coming back to the intervention by the RBI, it is estimated9 that of the total sale of dollars

1410 mn during the whole of September 1997, nearly dollars 1325 mn were in the first 11

days preceding September 12, 1997 (the day of the announcement of the currency-

supportive measures). In fact, even of the dollars 1325 mn, dollars 675 mn were only in the

4 days preceding September 12, 1997.

9Constructed from press reports. In fact, there was only one more instance of RBI selling dollars (dollars 1 OOmn) after September 12, 1997. If we add this figure to the dollars 1325 mn, the total estimate is dollars 1425mn, pretty close to the actuals dollars 1410 mn.

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What can we infer from above? By selling dollars, the RBI directly takes rupee resources

out of the system. This puts a strain on the money market, as was witnessed during

November 1995. With this at the back of the RBI mind, the apex bank was quick to

announce the package of measures to support the rupee. Consequently, the priority of the

apex bank was now to maintain money market stability and money supply considerations

was also given due weightage. This did have the effect of not putting an undue strain on

the money market immediately.

Even as the priority of the bank revealed a shift from forex to money market, the August

1997 crisis marked the beginning of innovative measures to ward of the speculation. This

feature was never there earlier. The measures were typically indirect measures of

intervention in the foreign exchange market further strengthening the shift. in the line of

thinking of the bank (as mentioned above, indirect measures like currency-supportive and

others avoid the simultaneous withdrawal of forex reserves and money market liquidity). As

an example, the RBI reportedly sold dollars only to select banks, excluding the foreign

banks. The intention was purportedly to prevent the latter from profiting from the arbitrage

opportunities between the RBI rates and the market ones.

Even as the rupee stabilised following the measures, the RBI again purchased dollars to

stop the rupee from appreciating in the second half of September 1997. The extent of the

intervention was not large, but the signal was unmistakable. The low transaction volumes·

in turn ensured that even such nominal purchases affected the rates.

The period of volatility returned to the forex market in November 1997 again. The

depreciation of the exchange rate was testament, if such were needed once more, to the

power of the spoken word. An Union Minister statement that the government was not to

interfere with the rupee provided the momentum to the initial fall. The RBI was quick to

intervene in the market by selling dollars and this time announced the first measure after a

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gap of 14 days on November 26, 1997 (we take November 12, 1997 as the starting point,

when the Union Minister made the statement). A clear sign was therefore emerging that

the RBI cannot sustain the direct intervention for long (from two months in the first place to

twenty days to fourteen days), and the measures were to be put in place quickly. That the

money market was on the priority of the bank was again substantiated, as witnessed

during the September 12, 1997 crisis. The RBI this time also tried its hand in innovations I

indirect intervention methods and was successful. For example, after intervening

aggressively in the couple of days after the crisis broke out, the RBI was conspicuous by

its absence from the market. The non-intervention appeared part of the strategy to keep

speculators off balance, since many banks had taken positions in the markets, buying

dollars short, in the expectation that RBI intervention would strengthen the rupee. As a

result, the rupee depreciated and the failure of the central bank to come into the market at

this level forced the speculating banks to buy dollars to cover their positions, thereby

pulling up the rupee in the process.

The crisis however did not end here. Even as the measures to augment the supply of

dollars came into being, the forward premia, specifically in the near term went up steeply

reflecting the perception that liquidity in the system was tight. Surprisingly, the call rates did

not rise this time as much was anticipated. The RBI responded by intervening massively in

the forward market through buy sell swaps. This partially cooled the forward premia.

The crisis in the forex market was further aggravated in January 1998. The market

sentiments were already jittery and the momentum to the disturbance came directly from

the market players having built up long dollar positions in anticipation of a further

depreciation of the rupee. But this time, the RBI attempt to quench volatility through an

informal mechanism actually boomeranged. For example, the RBI instruction to the banks

not to carry their positions forward, squaring them by the end of the day directly affected

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the markets by making them thin and extremely volatile. Banks were afraid of lending to

corporales without holding dollars for fear of not being able to cover their open positions at

the end of the day. Finally, the news that Moody's Investors Service had put India's

sovereign rating under review further spooked the markets, leading to a panic covering of

payables in the forwards. Dollar premia shot up across the board, and market collapsed.

Sustained corporate demand for forward dollars, without recourse to banks being able to

buy spot, also pushed up premia.

The RBI this time clamped down immediately on the markets on January 16, 1998 (we

take January 7, 1998 as the starting point when the rupee touched a new low of 39. 72, a

loss of 25 paise over the previous close) with a slew of measures, within a span of 9 days.

For the first time, the bank rate I the referen~e rate was jacked up giving an indication, that

even if it meant that the lower interest rate structure was to go (that the apex bank had

been assiduously espousing in the monetary policies), so be it. The money market reacted

immediately with the call rates shooting up beyond the 100 per cent. The net result was

the immediate strengthening of the spot dollar and the forward premia rose in tandem with

call rates, taking advantage of the speculation opportunities.

But this time, the priority of the bank signalled a definite change. The money market

stability that was uppermost on the RBI mind during September 1997 and November 1997

crisis (recall that the gap between the starting point of the rupee disturbance and the

announcement of measures were reduced from 2 months in August 1995 to 20 days in

September 1997, and further to 14 days in November 1997) took back seat, as the bank

rate was jacked up. The role of the RBI was presumably complicated by political

compulsions of defending the rupee with general elections round the corner at that time.

Whatever may be the reason, the stability in the forex market I defending the rupee against

speculative attacks took precedence over the money market considerations.

205

But, again and this time on a much larger scale the RBI resorted to buy sell swaps. The

use of this swap actually started from September 1997 onwards, and this reached a

feverish pitch in January 1998. As discussed earlier, a buy sell swap is akin to a repo

transaction in money and securities market.

From table 4.9 the RBI actually bought dollars 432 mn of dollars in September 1997. This

went up progressively to dollars 812 mn in December and touched a peak at dollars 2532

mn in January. Concomitantly, the outstanding forward liabilities also increased from a

paltry dollars 40 mn to as much as dollars 3190 mn in January 1998. It was not that the

RBI was only engaged in buy sell swaps, but also outright swaps, as mentioned above.

The gross purchase of dollars was only dollars 432 mn in September 1997. whereas the

gross sales was as much as dollars 1410 mn in the same month. The outstanding forward

liabilities, on the other hand climbed to dollars 944 mn in the same month, from a

negligible dollars 40 mn in the month before. Clearly, a part of the purchase was swapped

against the sale of forward dollars, but the much larger figure at dollars 1410 mn and also

the sudden jump in outstanding forward liabilities indicates that there was outright forward

sales also.

Meanwhile, with call rates touching stratospheric levels, relief came from the RBI itself. The

RBI decided to roll over existing buy sell swaps coming up for maturity during end-January.

These had been entered sometime in September-October and if these had come up for

maturity in January there would have been an outflow of rupee resources from the banking

system while augmenting the stock of dollars. By rolling over contracts coming over for

maturities, RBI ensured that the strained position in the money market was not

aggravated.

In another significant move during this month, the RBI decided to enter into fresh buy sell

swap (January-July, January-August) transactions on a cash basis rather than on a spot

206

basis. When a transaction is on a cash basis, the settlement is on the same day while if

the transaction is on a spot basis the settlement date is two trading days hence. This

implied that on the day the central bank executed a buy sell swap with a bank, the rupee

resources of the banking system was bolstered. This had the effect of cooling the call rates

immediately, and the forward dollars also declined in tandem with the call rates.

Even as the forward premia eased, the RBI decided to take no chances and made a smart

move from its normal buy sell swap intervention pattern in the forex markets. The RBI

conducted sell/buy swaps in the forward market (selling spot dollars and buying them

forward) to check a possible depreciating trend in the rupee. This reversal of swap

transaction in February 1998 by the RBI was cleverly done to neutralise the increasing

amount of liquidity coming into the system and it was feared that currency speculators

were getting active again. The tactic obviously worked, since trading was very dull in the

spot markets with traders desisting from taking positions given the uncertainty about the

RBI's intervention intentions.

There is one more advantage with sell buy swaps also. A sell buy swap results in the

forward premia rising and this could be the best way to fight speculation. The deliberate

increase in forward premia could lead to a quick back off of speculative pressure. as the

exchange rate expectations are belied. This strategy is nothing but leaning with the wind in

the forward market, as against leaning against the wind in the spot market.

How is the sell buy swap explained in table 4.9? This would be reflected in an increase in

sale of dollars and a simultaneous increase in outstanding forward purchases. As the

figures for February 1998 shows, the gross sale of dollars was dollars 2.37 bn and forward

purchases were dollars 817 mn. Since the RBI would not have been selling dollars in times

of currency appreciation (the rupee appreciated in February 1998 over January 1998

levels), this was purely on account of sell buy swaps. Moreover the sell buy swaps worked,

207

as it immediately pushed up the forward premia in February 1998, only to decline in the

subsequent months, till the nuclear blasts and the sanctions pushed the market back into

disturbances in May 1998.

The crisis in the forex market during May and June 1998 was short-lived, possibly because

the corporates had hedged their exposures after the January 1998 crisis and given that the

rupee was on a gradual declining path after February 1998, the corporates were extra

cautious. Moreover, the announcement by Moody's Investor Services of the downgrade of

India's sovereign credit rating in June 1998 was discounted by the market as the institution

had already announced a possible downgrade in January 1998 itself.

Section 4.3e: August 1998 till July 2000

Come August 1998 and the market was again plagued by turmoil. This time, it was bouts

of financial turmoil that dominoed across the globe (the devaluation of the Russian rouble.

fea~s of the devaluation of the Chinese Yuan) putting the forex market in a quandary. The

jittery sentiments was also abetted and exacerbated by domestic political compulsions and

also a statement by the then Finance Minister that domestic markets were likely to be

affected by international developments. The reaction of the RBI was swift and after

intervening for only two days since the crisis broke out (we take August 17,1998 as the

starting point, the day Russia announced the devaluation of the rouble), a package of

measures were announced on August 20 1998, that sought to put in place a higher

interest rate regime to nip in the bud any arbitrage game. The priority of the bank thus

continued to be forex market, as like the January 1998 crisis.

One of the most important aspects of the August 1998 crisis making it stand out as

compared to the other crises was that it was extremely short-lived. This was because the

money market was largely unaffected, even though the CRR was hiked. The primary

reason was that the sell buy swaps entered by RBI with commercial banks during February

208

1998 matured in August, thus augmenting the rupee resources of the system. This more

than neutralised the buy sell swaps, a portion of that also matured in this month, taking out

rupee resources of the system. Otherwise, the forward purchase in August 1998 could not

have been positive at dollars 508 mn (the buy portion of sell buy swap more than

neutralising the sell portion of buy sell swap). There was also the accidental coincidence of

a hefty redemption inflow at this time, the success of the State Bank of India's RIB issue 10

thereby mitigating the possible strains on the money market.

Another important feature of the RBI intervention which shortened the forex crisis during

August 1998 was the immediate sell buy swaps executed by the RBI in the last week of

August (we take August 21, 1998 as the starting date of sell buy swaps from press reports.

a day after the RBI announced currency supportive measures) to quickly discourage

speculation and put an end to the increase in call rates as witnessed during January 1998.

In January 1998, the RBI had resorted to sell buy swaps from February 3, 1998 ten days

after the last buy sell swap transaction on January 23, 1998. As mentioned above. the

advantages of a sell buy swap is that it pushes up the forward premia. thereby intentionally

penalising the speculators who were inclined to arbitrage between the money and forex

market with liquidity. Going by press reports at this time, the RBI reportedly reduced its

forward liabilities by dollars 515 mn in the last ten days of August following the RIB

inflows. This was done by entering into sell buy swaps with SBI maturing in September.

With the total outstanding forward liabilities rising by dollars 648 mn in September 1998 of

which dollars 515 mn was because of sell buyswaps in August 1998, the rest, dollars 133

mn could be attributed to previous sell buy swaps outweighing buy sell swaps.

10 On August 18, 2000 there was a liquidity inflow of Rs 20 bn following the redemption of the 13.65% 1998 paper. In the following week, there was the news of the huge success of the SBI Resurgent Bond Issue at dollars4.16 bn. This RIB inflow was nearly 2.5 times more than

209

There was a minor crisis in the foreign exchange market during June 1999 following

tension along the border. The RBI turned a net seller in the market after a gap of nearly

five months. The disturbance was short-lived even though the RBI continued to be a net

seller in the market till October 1999 after which it turned a net purchaser. The RBI

reportedly purchased dollars 12.77 bn on a gross basis and dollars 3.90 bn on a net basis

from November 1999 onwards till April 2000.

The May 2000 crisis in the foreign exchange market was for the first time not triggered by

domestic news. The possible reason, was perhaps the announcement of a rate hike by the

Federal Reserve Bank of New York in the same month that followed a string of rate hikes.

The crisis in May 2000 witnessed the complete withdrawal of the RBI from intervening in

the market to prop up the dollars. Instead, the apex bank after a gap of a fortnight smce

the beginning of the turmoil in the forex market announced a package of measures ( we

take May 12, 2000 as the starting point) to arrest the slide on May 26, 2000. The package

unlike the August 1998 did not prescribe a rise in the bank rate, the signalling rate.

However, for the first time the RBI made a explicit press statement discounting that the

bank was not targeting a specific exchange rate. The market refused to behave, and with

the Fll inflows declining sharply in May to dollars 43 mn, from a huge dollars 552 mn in

April, the demand for dollars far outstripped the supply of dollars in both the merchant

(excess demand at dollars 2764 mn) and the inter-bank segment (excess demand at

dollars 2465 mn) in May. The Fll's turned net sellers in June 2000 and the second fortnight

of July saw the shades of May 2000 revisited again in the forex market. This time, the RBI

could not resist the interest rate hike and the bank rate was jacked up by 1 per cent along

with a 0.5 per cent increase in CRR. The money market, was immediately thrown into

the dollars 1.6 bn lOB collections, that was launched following the 1991 balance of payment crisis.

210

turmoil. But curiously enough, the rupee did not stabilise, and it was only after the apex

bank announced a major tinkering with the EEFC, that the market returned to a semblance

of order.

If one aspect of the RBI operation needs to be emphasised during this period, it was again

the buy sell swaps executed by the RBI. Net dollar purchases (in the spot and forward

market) rose from dollars 1872.5 mn in April 2000 to dollars 3180 mn in May and since

then has declined to dollars 2426 mn in July 2000. The total outstanding forward sales also

rose steeply from dollars 670 mn to dollars 1903 mn in the same period. And since the RBI

could not have been purchasing dollars during a period when the rupee was depreciating

such purchases could have only a part of the swap operation.

The RBI also conducted outright forward sales, in an effort to cool the forward premia

Outstanding forward sales increased from dollars 670 mn to dollars 1380 mn in May 2000.

Gross sale of dollars rose to as much dollars 4080 mn in May 2000 from dollars 1904 mn.

A part of gross purchases were swapped against the dollars, but the much larger sale

figure points out to outright forward sales also.

The pattern of RBI intervention during May 2000 brought out one more aspect, that of the

RBI desire to maintain a stable interest rate regime (recall that the RBI did not raise the

interest rate and continued to sold dollars in the forward market till the end of July 2000).

This signalled a clear change in the priority of the apex bank from forex market to debt

market. This might have been the reason for the RBI to simultaneously resort to buy sell

swaps and at the same time selling spot dollars through the SBI. While the first one

ensured that commercial banks were flush with liquidity, the second one avoided a direct

withdrawal of liquidity with the SBI given the onus of selling dollars. This entire purpose of

prioritising the debt management policy over the exchange rate management through a

211

stable interest rate regime was to make the huge government borrowing programme

successful.

Even as the priority of the apex bank showed a definite change from forex market stability

to debt market, the issue of an explicit press statement for the first time revealed the RBI

desire to influence market expectations by giving an appropriate signal. Setting clear

signals about the exchange rate or for that matter monetary policy it is believed is likely to

be more effective in influencing the expectations of market participants (already discussed

in chapter 2).

As repeated, selling dollars directly sucks out liquidity from the system. This in turn would

lead to more devolvement on the RBI (if the interest rates are not hiked commensurately)

and perhaps a higher IT)Onetised deficit (as has been the case in the current fiscal). The

spectre of devolvement on the RBI is very real, given that the RBI avoiding the private

placement route11 given the market antipathy12 to it. The higher level of monetised deficit

in turn will push up the growth rate in reserve money.

As the table 4.10 shows, the RBI manages the borrowing programme without a

concomitant hike in interest rate regime, through private placements. However this

purpose will be defeated if there is a sudden decline in rupee value. Also, an increase in

monetised deficit resulting from private placements could result in a hike in the interest

11 Private placements refer to the placement of government of India dated securities with the RBI on a private basis, without going to the market. The devolvement of the RBI thereby goes up· exactly by the same amount, initially, only to offset by higher open market operations (OMO) by the apex bank in the secondary market. Hence higher is the private placement, the higher should be OMO to reduce the net monetised deficit on the RBI I deficit on the RBI after the initial devolvement on the RBI has been neutralised by OMO. The advantage by the private placement that it does not affect the yield curve. But at the same time, excessive private placements may not be conducive in an environment of liquidity tightening and also the yield curve may not reflect the market perception of the interest rate.

12 The primary dealers appointed by the RBI to broaden the debt market are not interested in private placements, as it does not help them to attain the prescribed operational ratios by the RBI, as they don't get favoured access.

212

rate, thus defeating the very RBI desire of a stable interest rate regime. Moreover since the

gross borrowings can be conceived as the sum of absorption by the market and the

monetised deficit (not absorbed by the market and hence absorbed by the RBI after

simultaneous OMO), liquidity tightening will lead to a decline in market capacity· to

absorption.

Clearly, the priorities of the apex bank keep on changing from time to time. In the first

phase during August 1995 crisis, the RBI was taking the direct route by intervening in the

foreign exchange market. The indirect measures like currency-supportive package was

only announced only after a gap of two months from the beginning of the crisis. At this

time, the RBI was clearly not worried about the money market implications (liquidity

squeeze because of purchase of dollars) of intervening in the foreign exchange market,

and prolonged the intervention in the forex market. During the August 1997 crisis, the RBI

after intervening in the forex market for around twenty days announced currency

supportive measures. Unlike the earlier crisis, this time the gap between was shortened

from two months to twenty days, indicating the anxiety of the RBI of liquidity squeeze in

lieu of selling dollars, apart from a direct drawdown of forex reserves. Alternatively this

signalled the beginning of the end of direct measures like intervention in the forex market,

and instead onto indirect measures. The measures however did not recommend a hike in

interest rate. During the November 1997 crisis the gap was further reduced from twenty

days to fourteen days. During the January 1998 crisis, the RBI reduced the gap between

the direct and indirect measures to seven days from fourteen days. Interestingly, the

currency supportive measures however included a hike in bank rate, indicating explicitly

that the RBI was now prepared for a higher interest rate regime I to defend the domestic

currency (the earlier packages carries an implicit message of a higher interest rate regime

by pushing up the CRR obligations). Alternatively, money market priorities took a back

213

seat. The August 1998 crisis however, witnessed the gap between the direct and indirect

measures (these included among others a hike in the bank rate) vanish altogether,

indicating that the RBI like the January 1998 crisis was ready to defend the domestic

currency, even at the cost of a higher interest rate regime. That the interest rate did not go

up was for another reason, as explained earlier.

The May 2000 crisis in the forex market underscored the dilemma of the RBI in

undertaking measures to ward of speculative pressures in forex market, as the debt

management policies were to be given a precedence.

To sum up, the initial priority of the RBI was to maintain forex market stability (August

1995) followed by the concern to maintain money market stability (August 1997 and

November 1997). The January 1998 and the August 1998 saw the overwhelming

prerogative of the RBI in terms of forex market stability, whereas the latest crisis in May

2000 revealed that the overriding concern was debt management policy.

The implications for the changing priority of the apex bank from time to time clearly reflect

the absence of a transparent exchange rate policy. To repeat again, as early as in May

1997, the T arapore Committee Report on Capital Account Convertibility had recommended

that the RBI should have a "Monitoring Exchange Rate Band" of +5 I - 5 per cent around

the neutral Real Effective Exchange Rate (REER) as part of a transparent exchange rate

poiicy. The Committee also suggested that the RBI should ordinarily intervene as and

when the REER is outside the band, (and for that matter even within the band) to bring the

real value of the rupee closer to its neutral level. The Committee emphasised that there

must be transparency in exchange rate policy in as much as the announcement of the

neutral REER, the declaration of the REER monitoring band, making public any changes in

neutral REER and publication of REER on a weekly basis. Close on the heels of the

214

Report, the RBI Deputy Governor in August 1997 announced that "henceforth the Reserve

Bank will make available the weekly data relating to its intervention in the forex market".

The RBI has since then deemed it unfeasible to target exchange rate based on REER

neutral. But as we have seen, there is indeed some definitive nominal exchange-rate

targeting by the RBI based on the purchasing power parity (PPP) value. The targeting is

further reinforced in our belief when it has been found that there is a strong correlation

between overvaluation of the rupee and simultaneous disturbances in the forex market,

that brings back the rupee to the PPP value. Moreover, the RBI still now does not make

available the neutral REER value, nor does it make it available on a weekly basis. The

REER statistics is made available only with a clear lag of 2 months. In a similar vein, the

intervention data by the RBI that was supposed to be made available on a wee~ly basis, it

still published on a monthly basis, and with a two month lag.

This absence of transparency in RBI exchange management policy contributes to the

piece-meal strategies to curb volatility in the market. The policies in turn are driven by

priorities of the bank that keep on changing from time to time. The priorities in turn are

determined by both non-economic and economic factors. For example, the priority of the

bank was forex market stability during January 1998, presumably because of elections, a

non-economic factor. In contrast, the priority of the apex bank was debt market during July

2000, a result of huge borrowings programme of the government, clearly an economic

factor.

There is one more aspect to the non transparency in exchange rate policy of the RBI.

Because of this, the forex market is driven more often by speculation. As a result, the

trigger point of disturbance in the forex market, is the by product of the domestic news

element.

215

4.4: The measures taken by RBI to reduce volatility in forex markets

This section provides a brief overview of the measures taken by the apex bank to tide over

volatility in the forex markets. The August 1995 forex market crisis witnessed the RBI in

trying to correct the asymmetry between the inflow and outflow of dollars clamp down on

the market with a set of packages that made the export and import credit costly. The

measures in the first place was therefore a clear acknowledgement by the bank that

speculation was the driving force behind the disturbances in the forex market. These

included a import surcharge and a hike in interest rate on export credit so as to get

exporters to bring their dollar proceeds back quickly, restrain bunching of imports and

hence lift the supply of dollars in the market. Coupled with this, the bank also revised the

interest rate on non resident deposits in order to give the banks more operational flexibility

in mobilising these deposits. The entire package, was therefore directed at reducing the

demand supply mismatch of dollars by increasing the supply of dollars through exporters

and deposit mobilisation and simultaneously restrain the demand by reigning in import

demand.

But most importantly, the import surcharge was levied on all items, including essential

price inelastic items like crude, petroleum products, fertilisers and edible oils but export­

related items. This surcharge and of the same magnitude was imposed only once in the

1990's, and that too during May 1991 to ward of the BOP crisis. By imposing a surcharge

on all items, the apex bank send out a clear signal to the market that stabilising the forex

market was the overriding concern, even at the cost of sacrificing the domestic objective of

price stability and long-term investment.

The set of measures that finally brought peace to the market was the move by the RBI to

monitor cancellation of forward contracts and a further increase in import surcharge from

15 to 25 per cent. Interestingly, this import surcharge was withdrawn only in the last week

216

of July 1996, nearly 9 months after the RBI had imposed this measure. Interestingly, this

imposition of import surcharge did not affect the import or export growth rates adversely in

the interlude period (that is during October 1995 and July 1996).

The August 1997 crisis witnessed the RBI taking recourse to a modified version of the

measures that it had taken recourse to in August 1995. Instead of making export credit

dearer, the apex bank this time reduced the interest rate on export credit . This was done

to provide incentives to exporters to accelerate the realisation of export proceeds. This

particular move by the apex bank could be attributed to the fact that export growth during

April-August 1997 (see the table on export growth rates, earlier in this chapter) was

disappointing and hence the bank did not take any chance to penalise the exporters. The

bank also, at the same time did not impos~ the import surcharge on importers, possibly

because of the same reason.

But this move did not work. As the table 4.11 shows, this reduction in interest rate was

reversed in the last week of November and again in the last week of December as the

forex market continued to be in doldrums. In a similar vein, the bank imposed a import

surcharge at the rate of 15 per cent on imports in the last fortnight of December but bulk­

related and export-related imports. It is thus clear that during a period of forex market

disturbance, it is clear to adopt a policy of carrot and stick I penalising the speculators,

rather than trying to provide incentives as this could be conceived by the players to be

signs of half-baked efforts of buying truce with the market.

There was one more difference with the measures this time. The essential imports were

spared the burden of import surcharge as opposed to the August crisis. Clearly, the bank

was equally worried about the fall-out of this measures on the domestic objectives of price

stability and the money-market stability. The bank however was unable to delink the

money market from the forex market and was forced to signal a higher interest rate regime.

217

The signal towards a higher interest rate regime was made implicit in the last week of

November when the RBI announced the fixed-repo13 system for the facility of the market

players. This was reinforced during January 1998 when the RBI at one go explicitly

signalled a higher interest regime by increasing the bank rate (implicitly, also the cut in

refinance rate and the CRR increase carried a message of a higher interest rate regime).

This comprehensive set of measures signalled a clear shift in the RBI's role from that of a

central bank with multiple economic and financial targets to presumably Hong Kong style

Currency Board for the time being, with the primary, if not sole objective of defending the

currency against speculative attacks !(also substantiated by the fact that quantum of

penalties imposed on speculators were more as compared to the August 1995 crisis: for

example, the import surcharge was raised was at 30% as against 25% last time). The

prerogative of bank was thus to maintain stability in the forex market at any cost.

The consequences of the measures were immediately felt with scheduled commercial

banks increasing the lending rates. the second round of increase after the crisis broke out

in August 1997. Deposit rates also moved up in tandem, with liquidity at a premium.

Interestingly, the 9 per cent fixed repo rate offered by the RBI during this time was more

academic in nature with the central bank not receiving any bids. Simultaneously, the

increase in cut-off yields at the treasury-bill auction was measly given that comparable

yields in the secondary market were twice the rates.

13 A fixed repo system is a facility whereby the market players places a collateral of government securities with the RBI for a specified period and in return gets an assured sum of money. This deal is reversed after the specified period by the bank. The advantage of this deal that the market players gets a fair deal from the bank itself and don't have to go to the inter-bank market for borrowing money. Subsequently, the rates in the inter-bank market, the call rate also goes up along with this. The entire purpose, is therefore to move over to a higher interest rate regime to defeat the objective of speculation with surplus funds.

:218

The August 1998 crisis, witnessed the RBI waste no time in clamping down on the markets

with a set of measures, that included a hike in the repo rate and a increase in CRR

liabilities in the first place. The measures not as punitive as they were in January with the

RBI refraining from taking measures of making export and import credit dearer. Instead,

the exporters were advised not to delay the repatriation of export receivables beyond the

due date of 180 days. The exporters were also given the facility to make business related

payments in India and abroad from the Export Earner's Foreign Currency Account (EEFC

account), but with a caveat that wilful delay in repatriation would result in this facility being

withdrawn. Part of this reason could be traced to the reason that just a fortnight earlier, the

bank had announced a series of generous export-boosting measures and did not want to

disturb ~hat. By announcing the interest rate hikes, the RBI again indicated that forex

stability was its priority.

The last major crisis was in May 2000. The approach this time by the RBI was an

imposition of import surcharge to the extent of 50%, as against 30% in January 1998 and

15% during October 1995 and a surcharge of 25% on overdue export bills, as against 20%

in December 1997. Clearly, the RBI tried to overcome the crisis by trying to penalise any

possible speculation, but at the same time maintaining a delicate balance between the

money and the forex market by not resorting to a higher interest rate regime. The

objective, as we have emphasised earlier that the RBI concern was now debt management

policy - ensuring the completion of the government borrowing programme at the lowest

possible cost.

There was one more novelty by the RBI to ward of the disturbance this time: an exclusive

press statement. This was intended by the RBI as an explicit signalling device of

influencing market expectations, to make market participants respond to policy measures,

and at the same time discourage speculation. This use of monetary policy measures as a

219

signalling device is relatively new in Indian context and emphasises the RBI believe that

intervention (direct or indirect) can only affect exchange rate through signalling channel,

and not through portfolio balance channel (more so, as in Indian context the capital

account is not open).

The market, however, did not stabilise and it was only after the RBI resorted to the classic

textbook prescription of pushing up interest rates (bank rate hiked) to ward of speculation

that the market responded favourably. Simultaneously, the RBI effected a reduction in

general refinance rate and also issued another press statement. The apex bank also

slashed the limit of forex earnings that the exporter could keep in EEFC account (the first

time, it took such measure) that brought in a large inflow of dollars.

The statement by the RBI during July 2000 deserves a special mention. For the first time.

the bank acknowledged that Indian markets were getting integrated with international

ones, arid thus the movement in the value of the rupee should not be seen in isolation, but

together with the movement in other currencies against the dollar. This is perhaps an

indication by the RBI that disturbances in the forex markets in the future if it happens will

have to be tackled but differently (as done in July through a tinkering with the EEFC

account).

SECTION:4.5: THE DYNAMICS OF GLOBAL FOREX ACTIVITY

In this concluding section, we concentrate on the dynamics of global foreign exchange

market activity with special reference to India. A large part of the discussion in this section

is from the BIS Annual Report, 1999.

In terms of notional principal amounts, global turnover in traditional foreign exchange

market segments (spot transactions, outright forwards and foreign exchange swaps)

reached an estimated daily average of $1.5 trillion in April 1998. This represented growth

220

of 26% in the three-year period since April 1995, an apparent sharp slowdown from the

45% rate of expansion of the 1992-95 triennium. However, adjusted for differences in the

dollar value of non-dollar transactions, growth accelerated between the two periods, from

29% to 46%.

Forward instruments (outright forwards and forex swaps) consolidated their dominant

position, with a market share of 60% (up from 56% in April 1995). At the same time, the

market continued to be dominated by inter-dealer business (63%) and cross-border

transactions (54%).

After allowing for the double-counting resulting from local and cross-border inter-dealer

transactions and for estimated gaps in reporting, the average daily turnover in "traditional"

global foreign exchange instruments (spot transactions, outright forwards and foreign

exchange swaps) can be estimated at US$ 1,490 billion in April 1998, compared with USS

1,190 billion in April 1995. Although the rate of growth in other Over-The-Counter (OTC)

foreign exchange derivative instruments (currency swaps and options) was considerably

higher than in traditional ones, they remained, at US$ 97 billion, a small fraction of overall

trading. As the table 4.14 shows, the turnover in the Indian market was a measly 0.12 per

cent of the total world turnover in April 1998. This substantiates the relative thinness of the

Indian market.

In the traditional segment of the foreign exchange market, percentage changes in turnover

in the two latest three-year periods ( 1992-95 and 1995-98) show a considerable

deceleration in the rate of expansion in current dollar terms (from 45% to 26%). Between

April 1995 and April 1998, however, the dollar rebounded strongly (in particular, it

appreciated by more than 50% vis-a-vis the yen, which correspondingly reduced the dollar

value of yen transactions). Adjusted for differences in the dollar value of non-dollar

transactions, growth accelerated from 29% to 46%.

221

Forward instruments (exhibit 4.12) consolidated their leading position, pushing the share of

spot turnover down further (to 40%, from 44% in 1995). Within the former group, foreign

exchange swaps continued to overshadow outright forwards by a large margin.

In current dollar terms, the breakdown by currency reveals (exhibit 4.13) another increase

in the role of the dollar on one side of transactions (from 83% in April 1995 to 87%).

However, at constant exchange rates, the share of the dollar actually declined (to 76%).

There was, in particular, a strong pick-up in yen business (from 24% to an exchange-rate­

adjusted share of 29%) and in a large number of small currencies. This finding is

consistent with anecdotal evidence of a wide range of investment strategies involving the

yen. There was, in contrast, a reduction in currency plays between core continental

European currencies (with a sharp fall in Deutsche mark/French franc turnover).

Although data on emerging market currencies (table 4.14) was not collected explicitly for

the survey, turnover in local currency provides a fairly good estimate of market size. The

crisis that developed in the wake of the devaluation of the Thai Baht in July 1997 has

probably hampered turnover in Asian emerging market currencies. Overall, the US dollar

occupies a very strong position in the trading of emerging market currencies.

Compared with 1995, the distribution of counterparties remained largely stable. with a

large share accounted for by trade among reporting dealers (63%). Since the category

"Other financial institutions" covers any financial institution not participating in the survey, a

slight decline in this category can partly be ascribed to more comprehensive coverage. As

in 1995, more than half (59%) of business between reporting dealers is transacted across

borders, while business with non-financial customers is more locally oriented, with about

two-thirds (68%) of deals being struck in the domestic market.

In medium-sized markets there is a tendency for the share of turnover accounted for by

local dealers to be comparatively low. In these markets, greater reliance on major financial

::?.22

centres to intermediate business tends to dampen the share of local transactions. In

contrast, in the very large markets (the United Kingdom, the United States and Japan) the

local market is so large and liquid that many deals are done with local counterparties. In

the smallest markets, marked differences in financial regulations, costs and structures

imply a wide dispersion in the respective weights of cross-border and local business.

There are also disparities between centres with respect to the share of business

conducted with non-financial customers. Non-financial customers account for 20% to 30%

of turnover in the smaller markets, but their share tends to fall rapidly as markets increase

in size. The relatively high share of non-financial customers in the United States and Japan

is consistent with the comparatively high ratio of foreign trade to foreign exchange turnover

in these two countries.

CONCLUSION

In this chapter, we have examined the major facets of the exchange ra~e policy of RBI

through a documentation of intervention in the foreign exchange market, juxtaposed with

the RBI desire to maintain inter-related objectives. A crucial aspect of the exchange rate

policy of the RBI is the changing priorities from time to time which drives it. The priorities

are actually compulsions as it may be purely e~onomic (e.g. debt management, monetary

management) or non-economic (e.g. general elections). This has resulted in the bank

relying more on indirect measures to direct rupee movements rather than using direct

measures like intervening in the foreign exchange market. Also, the distinction between

direct and indirect measures in the event of a domestic currency crisis has been

continuously reduced so that it has vanished altogether. Interestingly, the RBI now relies

more on influencing the expectations of market participants by releasing an appropriate

signal.

ANNEXURE TO CHAPTER 4

Table 4.2: The over under valuatio~ ~!_th~_!'_l:![lee outside_the 5% _!_lli'Qitoring ba!l~ __ - -- -~-

+5percent REER -5per cent Overvaluation Rs/$ Monthly depreciation

Apr-93 60.85 57.95 55 05 -5 03 31 31

Aug-93 64.07 61 02 57.97 0 00 31.37 0.19

Apr-94 68.24 64.99 61.74 6 51 31.37 0 00

May-94 68.54 65.28 62.02 6.98. 31 37 0.00

Jun-94 68.32 65.07 61.82 6.64 31.37 0 00

Jul-94 67.87 64 64 61.41 5.93 31.37 0 00

Aug-94 67.89 64.66 61.43 5.97 31.37 0.00

Sep-94 67.34 64.13 60.92 5 10 31.37 0 00

Nov-94 67.45 64.24 61.03 5 28 31.38 0 03

Dec-94 69.02 65.73 62.44 7.72 31 37 0.00

Jan-95 69 08 65.79 62.50 7 82 31 37 0 00

Feb-95 68.72 6545 62 18 7 26 31 65 0 89

May-95 67 36 64 15 60.94 5 13 31 42 0.16

Jun-95 67.29 64.09 60.89 5 03 31 t10 ~079

224

+5per cent REER -5per cent Overvaluation Rs/$ Monthly depreciation

Jul-95 67.77 64.54 61.31 5.77 31.38 -0.10

Aug-95 69.07 65.78 62.49 7 80 31.58 0.54

Feb-96 60.85 57.95 55 05 -5 03 36.63 6 05

Jan-97 67.37 64.16 60.95 5 15 35.87 0.39

Feb-97 68.97 65.69 62.41 7.65 35.89 0.70

Mar-97 69.16 65.87 62.58 7.95 35.87 0.36

Apr-97 69.70 66 38 63 06 8.78 35 81 -0 08

May-97 69.12 65.83 62.54 7.88 35.81 -0.17

Jun-97 69.31 66.01 62.71 8 18 35.81 -0.22

Jul-97 70.38 67 03 63.68 9.85 35.74 -0.36

Aug-97 71.57 68.16 64 75 11.70 35 92 0.31

Sep-97 71.11 67.72 64.33 10.98 3643 1.73

Oct-97 71.68 68.27 64.86 11 88 36.23 1 17

Nov-97 70 08 66.74 63.40 9 37 37 21 4 11

Dec-97 68 87 65.59 62 31 7.49 39.23 9.21

Jan-98 70.21 66.87 63.53 9.59 39 36 8 05

Feb-98 69 70 66.38 63 06 8 78 38 95 7.51

225

+5per cent REER -5per cent Overvaluation Rs/$ Monthly depreciation

Mar-98 ' 68.79 65.51 62.23 7.36 39.51 6.18

Apr-98 69.50 66.19 62.88 847 39.66 1.10

May-98 68.96 65.68 62.40 7.64 4048 2.84

Jun-98 67.50 64.29 61 08 5.36 42.25 847

Jul-98 67.71 6449 61.27 5.69 42.52 7.62

Aug-98 67.54 64.32 61.10 541 42.77 7.85

Mar-00 68.34 65 09 61 84 6.67 43 59 044

Apr-00 69.63 66 31 62 99 8.67 43.64 0.37

May-00 70.63 67.27 63.91 10.24 43.99 0.99

Jun-00 68.52 65.26 62.00 6.95 44.68 244

Source: As explained in the text and RBI Monthly Bulletin

15.CO --overvaluation 45.CO

12.5) -Rs;$ 40.CO

lO.CO

7.5)

2.5) 20.CO

o.co 15.CO

-2.5) lO.CO

-5.00 ~~----------f---------------~"A-

-7BJ o.m ·~) (·) (·) 'Oj- 'Oj- 'Oj- ~-1 ~-1 ~-1 •i• '"' •.L• r·- r·- r·- .:·:· (•:• (0 ·:r· (T'I ,., -' ,_ •'1• . ,.. •"1• •']• .,. . . ,., ·:r· i']l .;r • .,.. (T'I •'J• ,,., ,,., ,,., •'J• ,,., •'J• I"]• •J• ,,., ,-' ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' ' 'i .. IJ• '·' .. IJ• '·' .. IJ• '·' .. IJ• '·' .. IJ• '·' .. IJ• '·' .. IJ• '·' .. ll. ::0 ·~· ll. ::0 '·' ll. ::0 ·~· ll. ::0

. ._. ll. ... .._. ll. ::0 . ._. ll. ::0

.._ . ll. •l: -l: 0 ·l

. . 0 ·l .

0 -l: . 0\ •l .

0 ·l: ·l 0 •l 0 . . ·l . . ·l ·l . . ·l ·l . ·l.

Source: table 4.2. Note: The nominal exchange rate is on the right-axis and the extent of over (under)valuation from the REER neutral on the left-axis. The two horizontal straight lines are the Tarapore Band.

227

Table 4.4: The deviation of the Rs/$ from the PPP durin periods of foreign exchange market disturbances: A ril 1993 till Jul 1998

May-95

Jun-95

Jul-95

Aug-95

Sep-95

Oct-95

Nov-95

Dec-95

Jan-96

Feb-96

Aug-97

Sep-97

Oct-97

Nov-97

Dec-97

Jan-98

Feb-98

Mar-98

Apr-98

May-98

Jun-98

Jul-98

Actual PPP PPP over Actual

31.42

31.40

31.38

31.58

3318

34.54

34.74

34.96

35.74

36.63

35 92

36.43

36.23

37.21

39 23

39.36

38.95

39.51

39.66

40.48

42.25

42.52

31.56

31 61

31.90

31.45

31.64

33.58

34 94

34.96

35.11

35 78

35.83

36.00

36.62

36.71

37.55

39.61

39 51

39.12

39.47

39.73

40.81

42.71

0.14

0 21

0 52

-0.13

-1.54

-0.96

0.20

0.00

-0 63

-0.85

-0 09

-0.43

0.39

-0.50

-1.68

0.24

0.56

-0.39

-0.19

-0.75

-1.44

0.19

Comments

Overvalued

Overvalued

Overvalued

Undervalued

Undervalued

Undervalued

Overvalued

Neutral

Undervalued

Undervalued

Undervalued

Undervalued

Overvalued

Undervalued

Undervalued

Overvalued

Overvalued

Undervalued

Undervalued

Undervalued

Undervalued

Overvalued -- ---------- _____________________ _____!

Source: CP[ data were obtained from World Bank.

228

Table 4.5: Export rowth rates precedin and durin Periods

April 1993 - March 1994 April 1994 - March 1995 18.70 April1995 -March 1996 21.38

April 1996 - March 1997 4.01 April1997 -10.08 May 1997 643

June 1997 1.14 July 1997 1043

August 1997 7.13 November 1997 -0.15 December 1997 -6.08

January 1998 -5.59 February 1998 -33.60

March 1998 -11 70 April 1997 - March 1998 -2.01

April 1998 4.17 May 1998 -17.17

June 1998 -14.18 July 1998 3.11

August 1998 -2.67 April 2000 30.03 May 2000 30.25

June 2000 27.55 July 2000 16.56

Source: DGCIS

229

Table 4.6 : The demand and supply of$ in the merchant and interbank segment of the forex market (in$ mns)

Merchant Inter Bank

Fll ss of$ by dd of$ by Excess ss of$ by banks dd for$ by Excess inflows exporters and importers and Demand banks Demand

corporates corporates Apr-97 148.5 5613 5273 -340 21537 21786 249

May-97 199.6 6362 5470 -892 19347 18974 -373 Jun-97 362.9 6267 5293 -974 21098 20886 -212 Jul-97 274.2 6780 5986 -794 20719 21133 414

Aug-97 149.8 6352 6452 100 26986 28635 1649 Sep-97 174.6 6236 8733 2497 32212 ·36111 3899 Oct-97 178.9 6023 6603 580 27636 30006 2370 Nov-97 -149 5715 9808 4093 32648 37598 4950 Dec-97 -141.3 6156 9232 3076 34762 37717 2955 Jan-98 -76.6 6005 9125 3120 33410 36909 3499 Feb-98 188.9 5409 6613 1204 28315 29359 1044 Mar-98 114.8 7740 7697 -43 35975 35183 -792 Apr-98 -8.4 6320 7218 898 25488 25757 269

May-98 -124.3 5613 8695 3082 36769 39068 2299 Jun-98 -190.5 5977 10407 4430 46455 49625 3170 Jul-98 22.2 5931 8502 2571 34112 35388 1276

Aug-98 -90.1 5291 8771 3480 33593 36097 2504 Sep-98 45.2 5525 7319 1794 22825 23104 279 May-99 376.7 6888 7337 449 25227 25220 -7 Jun-99 100.5 5627 7596 1969 24452 25563 1111 Apr-00 552.0 7473 8520 1047 20228 22910 2682

May-00 43.0 7606 10370 2764 35216 37681 2465 Jun-00 -235.6 7901 9465 1564 33967 35398 1431

Source: RBI Annual Reports for transactions 1n forex market and SEBI for Fll tnflows. The transaction data IS

available from January 1997 onwards.

230

Note: 1. The sum total of purchase of spot and forward dollars in the merchant segment is the analogue of supply of dollars by exporters and corporales. The sum total of spot and forward sales in the merchant segment is the analogue of demand for dollars by importers and the like. 2. The sum total of purchase of spot and forward dollars in the inter bank segment is the analogue of demand for dollars and vice versa.

Table 4.7: The demand for$ in the spot and forward segment of the merchant and inter-bank market in$ mn

Merchant Inter-Bank

Spot forward demand %of forward Spot forward demand %of forward demand in total dem.and in total

April1997 -187 -153 45.0 189 60 24.1

May ' -191 -701 78.6 -647 274 73.5

June -352 -622 63.9 -369 157 74.1

July -733 -61 7.7 -390 804 . 194.2 August -385 485 485.0 46 1603 97.2

September 483 2014 80.7 1960 1939 49.7

October 14 566 97.6 -112 2482 104.7 November 1553 2540 62.1 2926 2024 40.9

December 1446 1630 53.0 1289 1666 56.4

January1998 1423 1697 54.4 1477 2022 57.8

February 558 646 53.7 659 385 36 9

March -447 404 939.5 -903 111 -14 0

April -127 1025 114.1 261 8 3.0

May 990 2092 67.9 1581 718 31 2

June 1024 3406 76.9 1804 1366 43 1

July 555 2016 78.4 892 384 30 1 August 1255 2225 63 9 1608 896 35 8

September 846 948 52.8 604 -325 -116 5 May1999 -306 755 168.2 -601 594 8485.7

June 683 1286 65.3 566 545 49 1 ------·-·--------- -----~------ --- ---·- -- -- ----·- ---- ----·-· ---- ··-·.

231

Spot forward demand %of forward demand in total

April2000 202 845 80.7

May 855 1909 69.1

June 233 1331 85.1

Source: RBI Annual Reports

Table 4.8: Taxonom of RBI intervention in forex market Date

September 1995

August 1997

November 1997

Trigger Point RBI making public its intention

to rout the huge debt service repayments through the market

(close to dollars 12 bn).

The trigger point for the crisis was a statement by the then

Prime Minister that the rupee should be allowed to move in a

band.

A Union Minister statement that the government was not to

interfere with the rupee provided the momentum to the

initial fall.

'-------------- -- ---

Spot forward demand %of forward demand in total

1390 1292 48.2

1998 467 18.9

649 782 54.6

Priority of the RBI The apex bank was not worried about the

money market implications of intervening in the foreign exchange market, and prolonged the

intervention in the forex market For example, the RBI announced the currency-supportive

measures after a clear gap of two months (from the date when the forex. market was thrown into

a turmoil) The priority of the RBI was to maintain forex market stability during this

period.

The RBI this time was quick to announce a set of currency-supportive measures after a gap of 20 days. Consequently, the priority of the apex

bank was now to maintain money market stability.

The RBI was quick to intervene in the market by selling dollars and this time announced the

first measure after a gap of 14 days. A clear sign was therefore emerging that the RBI

cannot sustain the direct intervention for long (from two months in the first place to twenty

days to fourteen days), and the measures were to be put in place quickly.

Pattern of RBI intervention Direct Intervention: Sale of spot and ,

outright forward dollars Indirect Intervention: Buy Sell Swap

Direct Intervention: Sale of spot and outright forward dollars.

Indirect Intervention: Selling of dollars to select banks and buy-sell swap

Direct Intervention: Sale of spot and outright forward dollars

Indirect Intervention: Non-intervention to keep speculators off-balance, Buy Sell

Swap

232

January 1998 The trigger point for the crisis was the RBI instruction to banks

not to carry their positions forward, and the news that

Moody's Investor Service has put India's sovereign rating under review. International

news is now getting prominence.

August 1998 Bouts of financial turmoil that dominoed across the globe (the

devaluation of the Russian rouble, fears of the devaluation

of the Chinese Yuan), domestic political compulsions and also a

statement by the then Finance Minister that domestic markets

were likely to be affected by international developments

International news takes precedence

May 2000 The possible reason, was perhaps the announcement of a

rate hike by the Federal Reserve Bank of New York in

the same month that followed a string of rate hikes.

The RBI this time clamped down immediately on the markets with a slew of measures, within

a span of 9 days. For the first time, the bank rate I the reference rate implying that even if it

meant that the lower interest rate structure was to go, so be it The priority, forex market

The reaction of the RBI was swift and after intervening for only two days since the crisis

broke out a package of measures were announced, that sought to put in place a higher

interest rate regime The priority, continued to be forex market

The pattern of RBI intervention during May 2000 brought out one more aspect, that of the

RBI desire to maintam a stable interest rate regime This signalled a clear change in the priority of the apex bank from forex to debt

market.

Direct Intervention: Outright purchase and sale of forward dollars.

Indirect Intervention: buy-sell swap, sell­buy swap, rollover of existing buy-sell

swaps and entering into buy-sell swaps on a cash basis.

Direct Intervention Not observable. Indirect Intervention: sell buy swap. ·

Direct Intervention: Outright purchase and sale of forward dollars.

Indirect Intervention: buy-sell swap, press statements.

---··-·--···--·--------------- ..• ··-··- ---------------

Table 4.9: Month I RBI intervention in the forex market in $ mn Purchase Sale Net outstanding Monthly Rs/$ Six-month forward premia

forward liabilities change in forward

liabilities August 1995 00 00 00 31 58 4.7

September 0.0 00 00 00 33 18 5.1

October 6.5 791.5 -20.0 -20.0 34.54 9.3

November 290.0 401 0 -248.0 -228.0 3474 15.6

December 272.0 328 0 -456.0 -208.0 34.96 14.3

January 1996 1368.0 1770 0 -2236.0 -1780.0 3574 13.3

February 140 0 468.0 -2316 0 -80.0 36 63 17.2

March 1135.0 175.0 -2216.0 1000 34.39 234

January 1997 565.0 15 0 -859 0 1357.0 35.87 7.3

February 929.5 00 -1259.0 -400.0 35 89 7.3

March 2329.0 0.0 -345.0 914.0 35.87 6.9

April 641.0 00 25.0 370.0 35.81 5.5

May 1759.0 366.0 112.0 87.0 35.81 4.8

June 1828.0 493.0 158.0 46.0 35.81 4.2

July 1185.0 00 40.0 -118.0 35.74 3.8

August 1363.0 491.0 -40.0 -80.0 35 92 7.2

September 432.0 1410 0 -944.0 -904 0 36.43 5.7

October 552 0 363 0 -663.0 281.0 36.23 5.5

November 724.0 2314 0 -1396.0 -733.0 37.21 69

December 812.0 1219.0 -1956.0 -560.0 39.23 8.6 ---·- -----

234

Purchase Sale Net outstanding Monthly Rs/$ Six-month forward premia forward liabilities change in

forward liabilities

January 1998 2532.0 2110.0 -3190.0 -1234 0 39 36 12.9

February 1041.0 1722.0 -2373.0 817 0 38.95 14.6

March 2194.0 745.0 -1792 0 581.0 39.51 9.6

April 1159.0 958 0 -1427.0 365.0 39 66 6.9

May 800 0 1554 0 -1415.0 12 0 4048 8.2

June 4848 0 6475 0 -1634.0 -219.0 42.25 10.3

July 4457.0 4578 0 -17740 -140 0 42 52 8.2

August 5460 0 4918 0 -1266 0 508 0 42 77 9.2

September 2863.0 2103.0 -1216.0 50.0 4253 8.3

May 1999 2542.5 1568.0 -732.0 484.0 42.78 55

June 1999 2348.0 2504.8 -972.0 -240.0 43.14 5.2

April2000 2272.0 1904.0 -670.0 302.0 43.64 2.8

May 3183.0 4080.2 -1380.0 -710.0 43.99 2.5

June 2780.0 3831.2 -1693.0 -313.0 44.68· 3.2

July 2426.0 2834.8 -1903.0 -210.0 44.78 3.7

Source: RBI monthly bulletins. + implies purchase of$ and - implies sale of$ Note: The RBI gives out only the total intervention figures (the sum total of spot, forward and swap) in the monthly bulletin. It was only once, (RBI Report on Currency and Finance, 1997-98) the break-up of intervention was given out, and that too for a limited period from April 1997 till September 1998.

Table 4.10: Gross borrowings, devolvement and monetised deficit (Rs bn)

Gross Borrowings of the Government Devolvement on RBI

1997-98 596.37 141.17

1998-99 939.5.

455.95 (300.0)

Open Market Operations 7614 296.69 Monetised deficit 129.14 118.0 Absorption by the market 467.23 821.5 Repayments 109.03 148.03

Note: 1. Absorption by the market is gross borrowings of the government net of monetised deficit 2. Figures in parentheses are exclusively private placements.

1999-2000 996.3 325.7

(270.0) 308.61 -55.87

1052.17 163.53

Table 4.11: Calendar of measures announced by the RBI to reduce volatility in the foreign exchange markets.

INTEREST RATES

Measures Announced

• October 31, 1995 Interest rates on NRE deposits of maturity of 6 months to 3 years and above increased from 11 to 12 per cent.

• September 12, 1997 Interest rates on NRE deposits of 6 months and over were freed, as against the earlier norm of one year and above.

• September 12, 1997: Interest rate on post shipment rupee export credit for period upto 90 days was reduced to 'not exceeding 11 per cent' from 12 per cent.

• September 12, 1997: Interest rates on post shipment rupee export credit was reduced from 14 per cent to 'not exceeding 13 per cent.

• September 12, 1997 Interest rates on post shipment rupee export credit beyond 90 days and upto six months was made 13'X, from the

Objective

• To provide greater flexibility to banks in mobilising non-resident deposits

• To provide incentives to exporters to accelerate the realisation of export proceeds.

2000-2001 1151.83 303.26 (180.0) 232.50

67.05 1084.78 274.78

236

-------=-~--:::"! date of advance.

• January 1, 1998: The interest rate on post shipment rupee export credit beyond 90 days and upto six months was reduced to 13 per cent from 15 per cent, thereby restoring the position prevailing as on November 26, 1997. Further, the interest rate was made applicable for a period beyond 90 days and not from the days of advance.

• October 31, 1995: Interest rate on post-shipment foreign currency export credit in lieu of usance bills for period beyond 90 days and upto 180 days from the date of shipment was raised from 7.5 per cent to 9.5 per cent Interest rate on export credit not otherwise specified for post-shipment export credit that was 9.5 per cent was freed

• January 15, 1996: Rate of interest on post shipment foreign currency export credit upto 90 days was raised from 7.5 to 9.5 per cent Banks were given the freedom to fix interest rates for credit over 90 days.

• February 7, 1996 Post-shipment export credit denominated in dollars scrapped.

• February 8, 1996: Interest rate on post-shipment rupee export credit over 90 days and upto 180 days was deregulated.

• November 26, 1997: Interest rate on post-shipment rupee export credit beyond 90 days and upto 180 days was increased from 13 per cent per annum to 15 per cent per annum

• To increase the cost of funds of the exporters forcing them to remit their proceeds from abroad.

237

and made applicable only from the period beyond 90 days and not from the date of advance.

• November 28, 1997: Interest rates on post-shipment rupee export credit made15% from the date of advance and not from period beyond 90 days.

• December 18, 1997 Interest rates on post shipment overdue export bills pegged at a minimum of 20%. Earlier banks were free to charge any rate of interest on overdue export bills.

• December 31, 1997: The 20 per cent surcharge on overdue export bills was made applicable only for the overdue period and not from the date of advance.

• May 26, 2000: Interest rates on post shipment overdue export bills pegged at a minimum of 25% This was made applicable to the existing advances only for the overdue period.

• November 28, 1997: Daily fixed rate (4.5%) repos introduced.

• December 3, 1997: Fixed repo rate increased to 5 per cent

• December 4, 1997: Fixed repo rate increased to 6.5 per cent

• December 11, 1997: Fixed repo rate increased to 7 per cent

• January 16, 1998: Reverse repo facility made available to primary dealers in government securities on discretionary basis

• January, 17, 1998 Fixed repo rate increased from 7 to 9 per cent.

• · The fixed repo rate to act as a floor below which call rates will not fall.

CRR CHANGES ON NR DEPOSITS

CRR CHANGES

• August 20, 1998: Fixed repo rate increased from 5 to 8 per cent.

• January 17, 1998: Bank rate Increased from 9 to 11 per cent.

• July 21, 2000: Bank rate increased from 7 to 8 percent.

• October 31, 1995: The increase in liabilities under NRE and Non­Resident (Non-Repatriable) Rupee (NRNR) accounts over the level outstanding as on October 27, 1995 exempted from maintaining CRR.

• November 29, 1995: The increase in liabilities under the FCNR(B) scheme over the outstanding level as on November 24, 1995 exempted from CRR.

• December 6, 1995 Average CRR on outstanding FCNR(B) deposits was reduced from 14.5 to 7.5 per cent.

• January 5, 1996: Average CRR on outstanding NRE liabilities as on October 27, 1995 was reduced to 10 per cent and all liabilities under NRNR and FCNR(B) exempted from CRR.

• December 2, 1997: Incremental CRR ori NRI deposits abolished.

• To put an upward pressure on the call rates and the entire term-structure of interest rates, as the refinancing rates and non-resident external rupee dep()sit rates are all linked to the bank rate. The resultant increase will push up lending rates as banks will be eager to maintain their spreads.

• Banks given the flexibility to mobilise non-resident deposits and to market them more competitively.

• November 28, 1997: CRR cuts, • To suck out liquidity from the system. beyond the 0.5% already instituted, postponed till January 1998.

• December 6, 1997: CRR cut of 0.5% revoked, CRR taken back to 10%.

239

FORWARD MARKETS

• January 17, 1998: CRR increased from 10 to 10.5 percent.

• August 20, 1998: CRR increased from 1 0 to 11 per cent.

• July 21, 2000: CRR rate hiked from 8 to 8.5% in a staggered phase.

• February 7, 1996: RBI to monitor cancellation of forward contracts for amounts of US $ 100, 000 and above.

• September 12, 1997: Proceeds of GDR and ECB flows allowed to be sold forward.

• November 29, 1997: RBI to monitor cancellation of forward contracts for amounts of US $ 500, 000 and above.

• December 1, 1997: RBI prohibits re­booking of cancelled forwards for corporales and importers without underlying exposure. December 2, 1997: Booking of forward contracts allowed only on documented evidence. January 6, 1998: RBI instructs banks to square off their positions by the end of the day and not carry on their positions forward till the next day.

• January16, 1998: Across-the-board square/near square positions stipulation goes, to be decided for individual banks if the situation so warranted. August 20, 1998: The RBI decides to withdraw the facility of rebooking cancelled contracts for trade related transactions covering imports. The RBI withdrew with immediate effect the facility provided to corporales to cover their forward commitments by first locking into a forward rate and then covering the spot.

• To put brakes on the rise in forward premia.

240

IMPORT SURCHARGE

October 31, 1995: Surcharge of 15% on bank credit for imports, across all items (including bulk imports like fertilisers, edible oils, crude oil, petroleum products and other essential items) but export-related items.

• February 7, 1996: Import surcharge hiked from 15% to 25%.

• December 17, 1997: Surcharge of 15% on bank credit for imports, barring bulk imports and export-related imports.

January 16, 1998: Surcharge on bank credit for imports raised from 15% to 30% but for bulk imports and export­related imports.

May 26, 2000: Surcharge on bank credit for imports at 50% barring essential items.

• To discourage importers to rush to the forward market to cover their imports.

241

OTHERS • January 16, 1996: Banks were made eligible for refinance under the ·export credit scheme against bills upto 90 days only.

• February 7, 1996: RBI to monitor intra-day trading transactions of authorised dealers.

• December 19, 1997: Banks' investments in Nostro accounts abroad brought under the 15% overall limit of investments of their respective Tier I capital in overseas money markets.

• January 16, 1998: Request of individual banks in regard to limits on nostro account-balances to be considered.

• January 17, 1998 Reduction in refinance limit from 100 to 50 per cent of the increase in outstanding export credit over the level of such credit as on February 16, 1996. Reduction in general refinance limit from 1 to 0.25 per cent of fortnightly average outstanding aggregate deposits.

• August 20, 1998: The RBI decides to permit exporters to use the EEFC balances for all business-related payments in India and abroad.

• August 20, 1998 The RBI advised the authorised dealers to report (at close of business every day) their open position as also their peak intra-day position.

• August 20, 1998:The RBI decided to gradually extend the facility of

• To discourage banks from taking recourse to refinancing.

242

PRESS STATEMENTS BY RBI

forward cover to the existing investments of Fils to the extent of 15% of their investments as on June 11, 1998.

• July 21, 2000: A reduction in general refinance limit to the extent of 50 per cent.

• July 21, 2000: The limit for holding dollar earnings in EEFC account slashed from the existing 50% to 25%. For export oriented units this was cut to 35% from the existing 70%.

• May 25, 2000 The RBI issues a press statement clarifying that the apex bank does not "target" a specific exchange rate. Alternatively, there is no specific level, which the apex bank is prepared to defend through unlimited sales of foreign currency and/or introduction of strong monetary and other measures.

• August 3, 2000: The RBI issues a press release clarifying that the dollar has strengthened against major international currencies, including rupee. The RBI reiterated again that it does target a specific exchange rate and also emphasised it will meet partially or fully dollar demand from bulk importers such as oil PSUs and serv1c1ng of foreign currency government debt through the inter­bank market.

• The press release was aimed at curbing excessive speculation in the foreign exchange market regarding exchange rate targeting.

243

Outright transactions

o Less than or equal to 7 days

IB Over 7 days and 51 upto a year

0 Over a year

Swap transactions

0 Less than or equal to 7 days Swap transactions

1111 Over 7 days and upto a year

o Over a year

Note: The outer ring represents global aggregates, and the inner ring the Indian lorex market forward transactions

Exhibit 4.13: Currenc composition of forex market transactions Dail India World

19 14

1316

0 US dollar

liD 11/ark

o Japanese Yen

o Found sterling

• French Franc

86426 .

o US dollar

o Found sterling

37598 18140

111 D 11/ark o Japanese Yen

• French Franc

L..:::=========================-=---=--=-=-:=! ... _ .. _________________ ··---··-·· ---- ··-·---~----------·-

244

Table 4.14: Details of net forex market turnover in Apri11998 (Daily average,$ millions) Reporting dealers Other FinanCial institutions Non-financial Total

customers Local Cross-border Local Cross-border Local Cross-

border India Spot 239 570 105 68 171 2 1156 Outright forwards 113 45 8 0 196 1 382 Forward swaps 374 331 113 16 25 0 903 Total 727 946 226 84 392 3 2441 World Spot 153432 388518 58219 62490 73371 35599 771996 Outright forwards 22088 53979 23093 11331 34616 11541 156660 Forward swaps 192878 637681 48862 75214 62298 35819 1052962 Total 368398 1080178 130174 149035 170285 82959 1981619

Source: 815 and RBI

245