• Direct Intervention: In case of any currency movement, a country’s central bank can directly intervene to either push the currency up, as India has been doing, or to keep it artificially low, as the Chinese central bank does. To push up a currency, a central bank can sell dollars, which is the global reserve currency, or the currency against which all others are measured. When it needs to keep its currency lower, it can buy dollars, as the Chinese do, to the point where they are the largest holders of dollar-backed US Treasury paper.
• Indirect Intervention: A central bank can also intervene indirectly by regulatory action, as the RBI has done in the past few weeks. The banking regulator has relaxed caps on the interest rates for foreign currency non-resident deposits (FCNR) in the hope that this will attract depositors to put more dollars into such accounts. It has also allowed banks to self-regulate export credit limits. On May 10, it asked exporters to cut by half their dollar holdings in exchange earners foreign currency (EEFC) accounts in an attempt to release more dollars into the system.
• Why Intervene: The RBI has been intervening in the currency markets because a weaker currency pushes up the country’s import bill – you pay more rupees for the same amount of dollars – and contributes to the current account deficit. It is also indicative of a country’s economic health and a weaker currency is a signal to investors that the economy is not being well-managed. India has a huge import bill largely because it buys almost 80 per cent of its oil from abroad, and a weak rupee can wreak havoc with the government’s finances. On Wednesday, RBI deputy governor KC Chakrabarty said that the market would decide the value of the rupee and that the central bank would only intervene to halt volatile currency movements caused by speculative trades.
• Dollar sales: The Reserve Bank of India has been intervening in the forex market since December 2011, when the rupee hit a record low, to stabilize the currency. Over the past couple of weeks, it has stepped up its dollar sales to stem the rupee’s slide. On Monday, the RBI injected $500 million into the currency markets, but that has been offset by high, bunched-up import demand.
• Intervention Impact: The reason that the rupee has continued to fall is because the RBI is caught in a cycle where it has to battle inflation, liquidity crunch and a falling rupee at the same time. Unfortunately, any action it takes to tackle one could be negated by the others. Inflation is already at a high level of 7.23 per cent, higher than expected. To tackle inflation, the RBI must keep rates high and liquidity tight, but that can stifle economic growth and push the currency down. If it sells dollars to support the currency, that too sucks liquidity out, choking growth. Slower growth makes India an unattractive destination for foreign investors, which in turn leads to drying up of dollar flow. But if it releases too much liquidity into the system, inflation could go into double digits and push the value of the rupee down, completing the vicious cycle. Clearly, the RBI at this time has very limited options.
• Fiscal Deficit: This is the 800-pound financial gorilla in the room. India’s fiscal deficit for 2012-13 is projected at 5.1 per cent of GDP. A large part of this is driven by India’s trade deficit, or when imports are higher than exports. A high trade deficit contributes to the fiscal deficit, which the government needs to cover. A weak currency will only drive the import bill higher, expanding the fiscal deficit. In such a case, the government will need to borrow more from the RBI, leaving less money for growth
