The RBI’s Currency Management

Source-This post on The RBI’s Currency Management has been created based on the article “Why RBI’s attempts to control the Rupee can have adverse consequences” published in “The Indian Express” on 24 August 2024.

UPSC Syllabus-GS Paper-3- Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Context– The Indian rupee operates under a managed floating exchange rate system, where the central bank steps in to buy or sell dollars to stabilize the rupee’s value. Recently, the RBI appeared to be using its regulatory authority to exert more control over the rupee’s exchange rate.

Currency fluctuations are a natural part of the market. However, using regulations to manage these fluctuations creates uncertainty and increases costs for businesses in regulated sectors.

What are the Three Regulatory Measures and Their Implications?

1) Prohibiting Speculative Trades on Exchanges-In 2008, the RBI allowed currency derivatives trading with rules on design and limits. By 2016, traders could trade up to $100 million without proving underlying exposure. However, a new rule requiring proof of exposure led to an 80% drop in trading volumes, potentially decreasing liquidity in the onshore market and increasing costs as trading could move to offshore markets.

2) Regulating Offshore Trading Platforms-The RBI’s proposal seeks to oversee the offshore market by requiring ETPs (electronic trading platforms) to register and giving it powers to refuse registration, demand information, and set terms. This approach is criticized as overreach because it attempts to regulate offshore platforms used by Indian residents.

3) RBI’s Instructions to Banks- The RBI recently asked banks not to increase trade that weakened the rupee as it neared 84. It also required banks to settle UAE transactions in rupees rather than dollars to stabilize the rupee and cut dollar reliance. These measures may impact market behavior and raise costs.

Read More- Inflation Targeting in India

Conclusion- The RBI should avoid broadly expanding its regulatory powers to manage rupee volatility. Regulations, unlike market operations, set the rules of the game and can have long-lasting, negative impacts on business incentives and costs.

Question for practice

What are the Three Regulatory Measures and Their Implications?