The widespread misconception that the Reserve Bank of India’s (RBI) “intervention” (selling dollars), in India’s inter-bank “foreign exchange” (forex) market, by itself, depletes India’s dollar reserves, needs to be cleared. Not one dollar of reserve is, or can be, depleted by RBI’s intervention alone. RBI’s exchange control regulations disable every “player” of the forex market (RBI itself can be a player by intervening) and all banks licensed by RBI to remit forex out of India in a vacuum.

Forex outgo takes place only for import (goods or services) transactions, or for transactions approved under the Foreign Exchange Management Act, 1999 (FEMA), administered by the RBI. But why does RBI intervene at all? Under Section 40 of the RBI Act, 1934, which continues to operate till date, the RBI is required to sell and buy forex to/from banks (authorised persons) at a specific rate to be decided by the Central Government having regard to India’s obligations to the International Monetary Fund (IMF)! This rate is the prime determinant of the rupee’s external value.

Once RBI fixes the benchmark, the inter-bank forex market moves and operates within a range. RBI does not fix the benchmark on a daily basis, but when it intervenes, the benchmark is fixed. Now turn to the mechanism of intervention. Assume today the rupee is trading at about Rs.94.70/dollar. Assume forex reserves today are 670 billion dollars. Assume also that the RBI intends today to strengthen the rupee a little, say, to around Rs.93.50/dollar. Then, in order to achieve this objective, the RBI may supply (sell) dollars to a bank........

© The Statesman