An Analysis of Forex Market Intervention: Evidence from India

Article excerpt

Reserve bank of India occasionally intervenes in the foreign exchange market to curtail the exchange rate volatility. The nature of intervention by the RBI in the spot and forward segment of the forex market has always been with a purpose (either implicit or explicit) and sometimes on a continuous basis for several days. This paper empirically examines the profitability and stabilizing effect of the intervention operations of the Reserve bank of India. Murray approach (1990) and GARCH model has been adopted to study the same. It also presents evidence on the extent to which intervention operations are sterilized. The main conclusion is that the central bank has incurred substantial losses on account of negative Net Interest Income and sterilization is almost complete.

JEL Classification: C2, E5, F3

Keywords: Intervention, Sterilization, GARCH, Exchange rate volatility

INTRODUCTION

The failure of the gold standard and the subsequent introduction of the Bretton Woods exchange rate system post World War II marks the evolution of central bank intervention in the foreign exchange market in a formal sense. The response of the economics profession towards central bank intervention appears to have shifted several times in the second half of the twentieth century. At the time of collapse of the Bretton Woods system in the early 1970s, the profession appeared strongly to favor a pure float, involving zero intervention. The 1970s experience with the floating exchange rate system among the developed countries, and the ensuing volatility of their exchange rates gradually led to a shift in this consensus so that, by the late 1970s, both economists and policy makers frequently criticized the US authorities for not intervening enough in support of the dollar.

In the early 1980s, with the substantial increase in capital flows among the developed economies, the economists came to believe that in face of these massive capital movements; intervention can be effective only over a very short run. This view was further acknowledged in the Jurgensen Report on the intervention operations of the US Federal Reserve which was commissioned by the 1982 G7 Economic Summit of Heads of Government at Versailles. This report did not provide very explicit conclusions. The official press release of the finance ministers and central bank governors of the G7, however, stated that the main results of their report could be summarized as follows:

* Sterilized intervention affects long run exchange rates much less than non-sterilized intervention

* Sterilized intervention can influence exchange rates only in the short run

* Coordinated intervention can be much more effective relative to intervention by the central bank of a single country.

The introduction of the direct quotation system in 1993 and the termination of RBI announcing it's buying and selling rates in 1995 were important miles stones in moving towards a market determined exchange rate. The dilemma posed to the policy makers was to manage volatility without deviating from the path of market driven system. RBI's response to volatile exchange rate movements has been a combination of monetary policy and administrative measures together with intervention. A significant change in approach was made in 1998 following the sharp volatility experienced in international markets. The provisions, which allowed incentives for speculation to end-users and intermediaries, were identified and withdrawn. The focus of operation shifted directly from intervening in the market to identifying those demands that could rectify the imbalance viz. oils payments and bunched demands were smoothened by RBI. The RBI does not target any exchange rate or resist fundamentals. Thus leads and lags have become the major focus of exchange rate management. The RBI's operations have all along aimed at evening out the imbalances and smoothening the process of two-way changes. …