Overview of RBI's Currency Intervention and Monetary Policy
The Reserve Bank of India (RBI) states that it does not target specific levels for the USD/INR exchange rate and intervenes in currency markets solely to manage volatility. However, the scale of such interventions often impacts not only volatility but also the overall trajectory of the exchange rate.
Guiding Principles for RBI's Intervention
RBI intervenes in bond markets and manages banking liquidity to ensure effective monetary-policy transmission, although the implications for the external sector are not explicitly considered. A more transparent and objective approach to intervention, considering the trilemma, could enhance policy effectiveness.
The Scale of FX Intervention
- Over the past decade, RBI's average annual currency intervention has been about $60 billion, equivalent to 2% of GDP.
- In FY21 and FY22, amidst balance of payments surpluses, the RBI net purchased $157 billion, establishing a floor for the exchange rate.
- In FY25, the RBI sold $118 billion to restrict the USD/INR increase from 83.50 to 85.50, and further sold $37 billion from April 2025 to February 2026 as the rate rose to 91.
- Amidst the Iran war outbreak in March 2026, another $37 billion was sold, stabilizing the USD/INR at around 93.50 by month-end.
India's Trilemma in Monetary Policy
India’s interest-rate policy involves more than just the MPC setting the repo rate. Interventions in bond markets and liquidity management are crucial for monetary transmission.
- In FY26, net government debt rose by ₹17.8 trillion, with the RBI accountable for 40% through increased holdings.
- This intervention kept rupee-denominated interest rates lower than needed, influencing discretionary savings and causing equity market overvaluation.
- The low-interest differential led to compressed USD/INR forward premia, affecting net foreign investments.
The Need for a Formal Framework
Inflation-targeting central banks consider global monetary conditions, interest-rate differentials, and exchange rates. While not aiming at exchange rate targets, these factors recognize constraints and transmission channels.
- The RBI needs to consider the impacts of large interventions on interest-rate differentials, capital flows, and exchange rates.
- A framework could outline when large-scale intervention is warranted, ensuring financial stability without opacity.
Addressing the Trilemma
The RBI has attempted to ease the trilemma by attracting foreign funds via FX-swap windows, yet the core issue persists.
- Proposals include lower taxation on fixed-income returns to draw discretionary savings into deposits and debt markets.
- This approach supports interest rates based on willing savers, ensuring sustained domestic equity valuations and attracting foreign investments.
Recognizing the interconnection between interest rates, capital flows, and exchange rates is essential. The impossible trinity remains relevant, and acknowledgment of the trilemma can promote coherence, transparency, and policy discipline.
