The rupee closed at 44.51 against the dollar on Wednesday, close to its highest value in more than two years. There are indications that the Reserve Bank of India will intervene to stop the currency from appreciating further. ET looks into the whole issue.
Why do central banks intervene in the currency market?The short-term price of a currency vis-à-vis another depends largely on its supply and demand. Though these are driven by fundamentals, mostly the country’s net foreign exchange position, the exchange rate can deviate sharply in the short term from the perception of a ‘fair value’. This is somewhat the situation in India at present with inflows of over $10 billion in the last couple of months pushing the rupee higher. The volatility caused by inflows and the loss of export competitiveness could force RBI to intervene to check further appreciation.
How do central banks intervene?
Intervention in foreign exchange market means increasing/ decreasing the demand or supply of a foreign currency (say, dollar) through large purchases or sales in the forex market. The increased demand drives up the price of dollar and the value of the local currency drops. On the other hand, the central bank will sell dollars if it feels the local currency is undervalued.
What are the consequences of an intervention?
Whenever there is an intervention by the central bank, the volume of the local currency in the economy changes. If the central bank sells dollars, it drains rupees from the system. By purchasing dollars, it increases the supply of rupees. This changes the monetary base of the economy. There is also a need to neutralise the impact of interventions as changes in money supply could be disruptive. In case of high inflation, for instance, intervention aimed at depressing the value of the local currency can add to the problem.
What is sterilised intervention?
Sterilized intervention means mopping up extra liquidity in the market by issuing bonds. The central bank issues bonds to mop up extra liquidity in the system. But a large-scale sterilization could push interest rates up, as a glut of bond would push their prices down. In other words, in a situation of excessive supply of bonds the interest rates would have to be high to entice investors.
