This paper describes recent developments in India’s foreign exchange markets, where participants operated in an environment of increased volatility for most of the past year. The paper reviews the role of market reforms and policy measures in containing exchange rate volatility, and in this context discusses the Reserve Bank’s intervention in spot and forward markets. The paper outlines a broad agenda for further reform, focusing on measures that would increase the integration of the foreign exchange market with domestic money markets.


This paper describes recent developments in India’s foreign exchange markets, where participants operated in an environment of increased volatility for most of the past year. The paper reviews the role of market reforms and policy measures in containing exchange rate volatility, and in this context discusses the Reserve Bank’s intervention in spot and forward markets. The paper outlines a broad agenda for further reform, focusing on measures that would increase the integration of the foreign exchange market with domestic money markets.

II. Foreign Exchange Markets: Developments and Issues1

1. The rupee has depreciated by almost 20 percent against the dollar since August 1997 (Chart II.1) and, partly in reaction to the Asian crisis, the Indian foreign exchange market has become significantly more volatile in recent months (Table II.1). Despite the turmoil in Asian markets, the depreciation has largely taken place in an orderly fashion, notwithstanding a period of increased market uncertainty in late 1997 that was accompanied by sharp increases in forward premia and overnight interest rates. As these events have occurred amid ongoing structural change in India’s foreign exchange market, the focus of this chapter is on how market reforms and exchange rate movements have affected each other, and on the lessons that can be drawn for further market development.

Chart II.1.
Chart II.1.

Rupee/Dollar Exchange Rate

Citation: IMF Staff Country Reports 1998, 112; 10.5089/9781451818536.002.A002

Table II.1.

Rupee/Dollar Exchange Rate Volatility

(Standard deviation of daily changes in RBI reference rate; in percent)

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2. The chapter is organized as follows: section A provides a brief overview of the market environment (see also the Annex for technical details) and section B describes the two major phases of the recent rupee depreciation. Section C discusses some general lessons for containing exchange rate volatility, while section D discusses the role of forward intervention in greater detail. The concluding section lists options for further market reform.

A. The Market Environment

3. For most of the recent past, foreign exchange dealers in India were largely constrained to trade-related activities and not allowed to engage in forward or swap transactions. However, as capital account restrictions have been gradually relaxed over the last few years, the scope for trading in forward markets was also increased. For example, banks were given permission to provide forward cover for foreign loans, and restrictions on forward cover for trade-related transactions were eased. Moreover, currency exposure limits (so called “gap limits”) were enlarged on a bank-by-bank basis, and forward cover was introduced for FII investment in debt instruments and certain NRI deposits.2 Perhaps the most significant move took place in the October 1997 credit policy statement, when banks were allowed to invest or borrow up to the equivalent of 15 percent of their core capital abroad. In response to the reforms, market turnover in foreign exchange markets has substantially increased, particularly in the forward and swap markets.3

4. Nevertheless, exchange rate movements remain substantially driven by leads and lags in trade-related transactions. Normal turnover on the spot foreign exchange market typically amounts to US$l–2 billion per day (Chart II.2), but speculative pressures can lead to US$5 billion being added to either demand or supply within a few days (as exporters and importers are able to advance or delay foreign exchange transactions typically by about 1 month). As importers have often chosen not to hedge their foreign exchange exposure in times of stable exchange rates, exchange rate adjustments in the past have frequently been accompanied by bandwagon effects that led to overshooting.


India: Daily Foreign Exchange Market Turnover (April 1997–July 1998) 1/

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 1998, 112; 10.5089/9781451818536.002.A002

1/ Thick lines indicate 10-day moving average. Data for April 1998 through July 1998 are incomplete.

5. Despite the reforms and increase in turnover, the foreign exchange market has remained thin, in the sense that transactions by large market players can significantly exceed normal market turnover and cause noticeable shifts in the exchange rate:

  • The State Bank of India (SBI) is by far the largest participant in the foreign exchange market as it conducts foreign exchange transactions for large public sector enterprises.4 Although the SBI, according to market participants, is using its market power in a responsible way, it would be in a position to move the market in a particular direction if it chose to do so.

  • Market developments can also be disrupted by single large transactions, e.g., payments for oil imports by the Indian Oil Corporation. Transactions of that size are on occasion made directly through the RBI (i.e., not through the regular foreign exchange market) in order not to increase market volatility.

B. Recent Developments in Foreign Exchange Markets

6. The rupee depreciation over the past months can be separated into two distinct phases. The initial phase, from August 1997 to mid-January 1998, was characterized by relatively strong market uncertainty that culminated in three episodes of exchange rate adjustments amid bandwagons effects and overshooting. In the second phase, after the RBI had calmed expectations with a strong package in mid-January, the rupee has embarked on a smoother adjustment path. Although the rupee declined again after international sanctions were imposed on India for conducting nuclear tests in May, there was considerably less RBI involvement in exchange markets. The two phases are described in the following.

The initial depreciation

7. August/September 1997. Prior to August 1997, the rupee had been stable around Rs 36 vis-à-vis the dollar for more than a year, reflecting strong capital inflows that led to an accumulation of foreign exchange reserves by the RBI. However, with rising exchange rate pressures in several Asian countries (Thailand, Malaysia, Indonesia, the Philippines, and Singapore), continued slow growth in exports, and increasing concerns about the rupee’s overvaluation, a slide in the rupee exchange rate in mid-August triggered panic reactions by importers and speculative dollar buying.5

8. Notwithstanding the relatively small decline in the exchange rate, data on foreign exchange turnover reveal a significant shift in market positions (Chart II.3). Similar to earlier depreciation episodes (e.g., in 1995/96), market activity shifted from spot to forward markets as merchants scrambled for forward cover, buying some US$2 billion in forward markets between mid-August and mid-September.6 However, excess demand for spot currency remained relatively low, and market expectations of the amount of depreciation necessary to restore competitiveness appeared limited. Therefore, with FII inflows remaining relatively strong, and helped by some RBI intervention, market confidence was quickly restored. The overall depreciation amounted to some 2½ percent against the dollar but the rupee recovered some of this loss to close around Rs 36.40 by the end of September. In fact, the RBI purchased dollars in late September to prevent further appreciation.


India: Foreign Exchange Market Activity (April 1997–July 1998)

(In millions of U.S. dollars; cumulative since April 1, 1997) 1/

Citation: IMF Staff Country Reports 1998, 112; 10.5089/9781451818536.002.A002

1/ Data for April 1998 through July 1998 are incomplete.

9. November 1997. As conditions in Southeast Asia deteriorated during November 1997, and the currency crisis spread to Korea, depressed market sentiment towards emerging markets led to the cancellation of planned GDR issues by Indian companies, and foreign portfolio investors also began to withdraw funds (although the net outflow during November was only US$110 million). These developments coincided with heightened domestic political uncertainty preceding the fall of the United Front government later in the month. Currency depreciations of other Asian countries deepened concerns about a possible overvaluation of the rupee, and the exchange rate began to decline amid another strong shift in market sentiments. Forward premia came under renewed pressure from importers, but there was a also substantial demand for spot dollars as expectations of a stronger fall in the rupee gained hold (see Chart II.3). Eventually, the rupee depreciated sharply (by 8 percent) during November, particularly in the last week as the fall of the government was imminent.

10. The exchange rate firmed around Rs 39.20 per dollar after the RBI announced two packages of measures on November 28 and December 2, including increases in the CRR (reversing the most recent Credit Policy Statement), the repo rate (together with the introduction of fixed rate repo auctions), and the interest rate on import and post-shipment export credit to discourage arbitraging by merchants (Table II.2). Moreover, forward market activities were curbed by the reintroduction of an earlier regulation requiring banks to ensure that forward contracts were backed by documentary evidence of a customer’s future exposure.

Table II.2.

Recent RBI Policy Measures

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11. December 1997/January 1998. During the remainder of December, the RBI took additional administrative steps to reduce the scope for commercial bank activity in exchange markets. To curb what was perceived to be speculative pressure from banks, the RBI tightened overnight exposure limits and, eventually, prohibited taking any overnight currency position at all on January 6. However, with currency traders barred from taking open rupee positions, the lack of dollar supply in the market contributed to a slow but continuous slide in the exchange rate. At the same time, the Asian crisis intensified and expectations of a more significant rupee depreciation grew stronger, leading to an increase in forward premia by 400–500 basis points in early January despite RBI intervention.

12. To arrest a further decline in sentiments and pressure on the rupee, the RBI on January 16 forcefully tightened domestic monetary conditions, announcing increases in the CRR, bank rate, and fixed rate repos, as well as further administrative measures to discourage trade-related speculation (see Table II.2). Call money rates briefly shot up to 50–100 percent (Chart II.4), and as arbitrage opportunities against the rupee diminished with the rise in domestic interest rates, the RBI largely abandoned the requirement for banks to square overnight positions, and overnight exposure limits were again widened on a bank-by-bank basis. The measures were designed to take markets by surprise, restore market confidence and reverse the expectations of a further decline. These objectives were achieved, and the exchange rate stabilized between Rs 38.50 and Rs 39 per dollar despite a significant re-injection of liquidity around the end of January.



Citation: IMF Staff Country Reports 1998, 112; 10.5089/9781451818536.002.A002

Sources: Data provided by the Indian authorities; IMF, Information Notice System; and WEFA.1/ Annualized rates.2/ Call money rates for January 22, 23 and 26, 1998 were 60 percent, 60 percent and 70 percent, respectively.

Developments in the first half of 1998

13. As conditions in exchange markets calmed in January, domestic liquidity conditions also began to improve. Although the increases in interest rates and the CRR were not immediately reversed, funds that had been taken out of the market by the RBI on January 16 were essentially re-injected by the end of the month, including through a substantial rollover of maturing swap liabilities by the Reserve Bank. Call money rates thus declined to below 10 percent by mid-February, and forward premia also came down significantly.

14. The rupee remained stable through May as market turnover returned to more normal levels, with the formation of a new government and the relative calm in Asian markets contributing to lower volatility. The RBI replenished foreign exchange reserves and substantially unwound its forward obligations, with the result that net foreign exchange reserves rose by almost US$ 3 billion between January and May (Table II.3). However, market trading remained more active than before, and increased particularly in the swap market, with turnover averaging US$ 2–3 billion per day between May and July (see Annex Table II.4). The higher level of activity, especially in forward markets, reflected increased consciousness about proactive foreign exchange management on the part of commercial entities. According to market participants, importers, in particular, were hedging forward exposure to a greater degree.

Table II.3.

India: Sale/Purchase of U.S. Dollars by the Reserve Bank of India, 1996–98 1/

(In millions of U.S. dollars)

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Source: RBI, RBI Bulletin.

Figures are based on value dates.

Includes spot, forward, and swap transactions which have been effected during the month.

Table II.4.

India: Foreign Exchange Market Trading, 1997–98

(Net currency purchases by group; in millions of US dollars)

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Source: Data provided by the Indian authorities.

Data only partially available.

15. Partly as a result of improved risk management, the subsequent rupee depreciation in May took place under substantially less volatile conditions as compared to November 1997. Following the nuclear tests conducted by India in mid-May, the rupee fell by 4 percent against the U.S. dollar within two weeks, and by another 3 percent thereafter before stabilizing around Rs 42.50 to the dollar in early July. According to market participants, the depreciation was accompanied by substantially less RBI intervention than in late 1997 (net reserves fell by US$650 million in May); however, dollar sales by the SBI were frequently reported to have slowed down the pace of the rupee decline.

16. Volatility in forward markets was also largely contained. In early June, forward premia began to rise as sentiments were affected by the Moody’s downgrade, uncertainty about the impact of international sanctions, and the decline in the Japanese yen. However, in a statement issued on June 11, the RBI reaffirmed its intention to support the rupee through monetary measures if necessary, while at the same time announcing a number of smaller measures to liberalize foreign exchange markets (see Table II.2). As volatility in other Asian markets subsided, this also contributed to a subsequent decline in forward premia.

C. Containing Exchange Rate Volatility

17. One of the major objectives of exchange rate management has been to contain exchange rate volatility (sharp movements in the exchange rate over a short period of the time) while allowing fundamental supply and demand factors determine the level of the rupee. To that end, the RBI has relied on a range of instruments, including monetary policy tools, market intervention and administrative measures. The impact of monetary policy instruments has proved successful in calming market sentiments in mid-January; the use of other instruments, however, has met with more mixed success. This section discusses the impact of RBI intervention and administrative measures on market volatility, and draws some lessons from the recent experience.

Intervention policy

18. Particularly in the initial phase of the depreciation, exchange market intervention by the RBI was sizeable (see Table II.3). Between August 1997 and January 1998, foreign exchange reserves (net of forward liabilities) declined by about US$5 billion. During that period, the RBI attempted to influence exchange rate movements with considerable intervention in forward markets (to check forward premia and thus dampen expectations of a further depreciation), and also at times strong intervention in spot markets.

19. However, the effectiveness of intervention proved limited amid turmoil in international markets and domestic political uncertainties. Although intervention in forward markets met with some success (see section D for a separate discussion of this issue), intervention in spot markets appeared at times unable to restore confidence to the market and slow the decline in the rupee. Several reasons for this were identified by market participants:

  • Apparently, the RBI tended to intervene in relatively small transaction amounts that had only limited effect on market developments, and the resulting uncertainty about the RBI’s policy objectives led to increased nervousness in the markets.

  • The RBI tried to calm markets on several occasions through official statements saying that the level of the exchange rate at the time was broadly appropriate, and that the RBI would intervene only to smooth volatility. However, as the rupee continued to depreciate, markets were left uncertain about the RBI’s motives.

  • During November 1997, the RBI intervened frequently, and there were also sizeable dollar sales by the SBI. These transactions tended to suppress the information content carried by normal market transactions, and other market participants began to develop a sense of panic as they felt unable to predict the future direction of the market.

  • Markets were left unclear about the amount of net foreign exchange reserves left with the RBI. Information on gross reserves became public on a weekly basis, but information on forward obligations incurred by the RBI was only available with a six-week lag. Consequently, the full extent of the RBI’s involvement in the market was unknown to participants which gave rise to speculation and uncertainty.

20. Intervention has been more limited in recent months, despite a drop in the rupee since May 1998 (by 7 percent) that was comparable in size to the depreciation in November 1997. Although there were several market reports that the RBI was intervening indirectly through private transactions with the SBI, there was considerably less uncertainty among market participants as market signals generally appeared undisturbed. In part, however, the stronger market confidence also rested on the widespread expectation that the RBI would tighten monetary conditions again should the rupee threaten to fall too quickly.

Administrative measures

21. In late November 1997, in addition to market intervention, the RBI resorted to a tightening of administrative controls, aimed at calming exchange rate developments by deterring arbitrage between domestic and foreign markets. These controls were successful in the sense that foreign exchange markets dried up somewhat as banks were constrained in their trading activities, and daily exchange rate volatility declined. However, this eventually required the virtual elimination of overnight trading limits by early January.

22. As described above, although the measures led to relatively greater stability, they did not prevent the further decline in the rupee that led to the monetary tightening in mid-January. The measures had two main effects on market confidence that offset their potential success:

  • The forward market came under renewed pressure. As the demand for forward cover by importers continued at a practically unchanged pace (see Chart II.3), the measures had limited the supply of forward dollars from commercial banks. The resulting increase in forward premia contributed to a deterioration in market sentiments.

  • The measures proved detrimental as newly gained market flexibility was restricted, and banks were again reduced to merely providing cover for trade-related activities. By reversing some of the recent liberalization measures, the process of market reform was interrupted and participants began to question the RBI’s commitment to a more liberal foreign exchange market.

23. Administrative restrictions were cautiously eased after calm was restored in the markets by mid-January. However, the RBI has continued to emphasize that it discourages both speculative and arbitrage activities, and thus banks remain cautious in engaging in forward transactions or keeping open currency positions.7 This has contributed to the relative stability of markets in the first half of 1998; however, forward premia have remained high as a result (see Chart II.4), making the purchase of forward cover more expensive.

Exchange rate volatility and transparency

24. Recent developments have shown that volatility in India’s foreign exchange markets—with its limited avenues for position-taking by banks—still originates mainly from shifts in leads and lags of trade-related transactions. These shifts are partly speculative in nature, and partly reflect the absence of professional cash-flow management in commercial entities, which results in the emergence of bandwagon effects in response to shifts in the exchange rate. Such effects tend to be reinforced in times of an uncertain market environment, and particularly if there is uncertainty about the RBI’s policy stance.

25. In light of this experience, two lessons can be drawn. First, efforts would need to focus on deepening exchange markets and further educating market participants about foreign exchange risk and instruments available to minimize that risk (notwithstanding improvements in risk management observed in the first half of 1998). Moreover, in moving to a more freely determined exchange rate in which swings in the exchange rate (both intra-day and over longer periods) may be greater than in the past, it will be important to ensure that the private sector has adequate means for managing and insuring against exchange rate risk. This places a very high premium on the rapid development of the forward exchange market. These issues are discussed in greater detail in the following sections.

26. Second, the effectiveness of the RBI’s operations would be enhanced by a more transparent information policy of the RBI. Although there are valid operational reasons that would justify some lack of transparency in day-to-day operations, the increased disclosure of information within a shorter time span would allow market participants to verify that actual RBI operations were in line with announced policy intentions.8 Such measures could include the following:

  • The RBI has already taken steps to enhance market transparency by publishing data on foreign exchange transactions, reserves, and forward obligations. However, there is still scope for providing more information to market participants, including on a more timely and disaggregated basis. In particular, there could be more rapid access to information on the RBI’s net foreign reserves position, disaggregated information on intervention amounts, and on the size and composition of its forward book.

  • The RBI at times conducts transactions directly with the SBI and/or larger public sector undertakings. As these transactions affect the RBI’s reserve position, market uncertainty could be reduced by their timely disclosure.

D. The Role of Forward Intervention

27. The importance of forward exchange markets in India has grown as regulations on forward currency trading have been gradually relaxed. The RBI has traded heavily in swap and forward markets in recent periods of currency turmoil, with net forward obligations reaching up to US$3 billion in January 1998 (see Table II.3).9 While partly a response to surges in demand for forward cover, the RBI’s activities have also been prompted by the perceived need to correct temporary imbalances in demand and supply conditions, or bring about an alignment of forward premia with interest rate differentials between domestic and international money markets. This motives are discussed in the following.

Why does the RBI intervene in forward markets?

28. It would be a matter of indifference whether RBI intervention took place in spot or forward exchange markets if these markets were efficient and well integrated. Both markets would be deep and broad and forward premia would reflect differentials in interest rates between home and abroad. A yield curve would emerge from borrowing and lending activity at each term, and capital would move quickly to arbitrage away differences in covered parity.

29. However, conditions for efficient markets do not yet exist notwithstanding recent measures to liberalize financial markets. Barriers to institutional participation across domestic markets remain and various regulations and practices distort prices, limiting domestic market integration. As a result, government securities, interbank, and money markets are not well developed and benchmark interest rates and a market-based yield curve are yet to emerge.10 Foreign exchange controls limit free movement of capital owned by residents and, to a lesser extent, nonresidents. Scope for foreign exchange dealers to bring about an alignment of prices on money market assets with international prices is limited due to low ceilings on international borrowing and limits (so called “gap limits”) restricting forward operations and position taking.

30. Under these conditions, the RBI has intervened in swap markets to achieve various objectives, depending on market circumstances, which are listed below.11 In this paper, swap transactions are regarded as a form of forward intervention since—given market segmentation—the RBI has used swaps largely to influence both forward and spot exchange rates. In general, however, swaps should be regarded similar to domestic money market operations and not as a form of exchange market intervention.12

31. The RBI’s objectives for forward intervention include:

  • Dampen expectations of downward exchange rate movement. Importers and exporters track forward premiums carefully, both as the cost of acquiring and maintaining hedges, but also as a barometer of market sentiment and movement of the rupee in the period ahead. During periods of a stable rupee, importers have tended to forgo insurance (save the premia cost) and forward premia remain low and stable (see Chart II.4). However, in response to a sudden downward movement in the spot exchange rate, the forward market tends to react abruptly and with force. Importers rush to cover exposed positions (usually covering several months of business at once), while exporters cancel forwards, withdrawing the supply of forward dollars from foreign exchange markets. Forward premiums increase rapidly, fueling expectations of further depreciation. In such circumstances, the RBI has attempted to counter market sentiment by selling forward dollars—in addition to spot intervention—to prevent or limit dramatic swings in the forward market.

  • Bring forward premia into consistency with domestic money market conditions. The RBI has employed foreign exchange swaps either to reinforce domestic monetary operations or substitute for domestic operations when forward premia have not reflected interest rate differentials between domestic and international markets. Other anomalies may arise. For example, segments (terms) of the forward market may shift out of alignment with interest rate differentials due to supply and demand conditions at each term. In these circumstances, the RBI may seek to bring various segments of the forward market into alignment by buying dollars at one term and selling dollars at another term in equal size (so-called switch operations).

  • Manage forward liabilities and assets. Once sizeable forward positions are built up—for example in early 1998—they need to be managed. As market conditions permit, the RBI undertakes forward transactions to (i) reduce the extent of forward liabilities and (ii) smooth the profile of maturing forward liabilities. The aim is analogous to domestic debt management operations, namely to minimize market disruption while refunding or retiring liabilities.

32. There is no evidence to suggest that the RBI has used forward transactions for reasons typically associated with imprudent reserve management. For example, some central banks have used forward intervention to: (i) defer a reduction in gross reserves, buying time for market conditions to reverse; (ii) leverage over the gross reserve position to increase the size and scale of intervention; or (iii) “window dress” the gross reserve position. Indeed, the publication of the RBF’s net reserve position (albeit with a delay of some weeks) has greatly reduced the scope and rationale for such transactions.

How effective has RBI forward intervention been?

33. Forward intervention should be assessed by whether policy objectives were achieved (in the context of the market situation) and at what risks. The RBI’s experience paints a somewhat mixed picture:

  • RBI intervention has been helpful to contain excessive fluctuations in forward premia, particularly during times of stress. The large size of forward intervention attests to the degree of order imbalance in forward markets during periods in which rate expectations shifted. Additionally, RBI operations—by being a counterpart to commercial banks—have assisted commercial banks in managing their foreign exchange positions. For example, RBI forward intervention has helped banks to remain within their exposure limits (although this could have been done equally in the spot market), and RBI swap and switch operations have assisted banks in managing the profile of forward assets and liabilities.

  • Forward intervention has not been entirely successful in stemming downward expectations. Forward premia embarked on an upward trend between November 1997 and January 1998, and although forward intervention likely slowed that trend, it took a strong monetary package to reverse expectations in mid-January, Thus, forward intervention by itself is likely to be insufficient to stem the tide of market sentiment.

  • The RBI’s swap activity has, at times, proved counterproductive. For example, in November 1997, the RBI attempted to stabilize the foreign exchange market by influencing forward rates, while leaving domestic interest rates unchanged. The attempt failed mainly because liquidity injected through the swaps added to pressure on the spot exchange rate.

Why the RBI should seek to limit forward intervention

34. Inefficient domestic and foreign exchange markets have been the main rationale for the RBI to intervene in forward markets. However, the following arguments suggest that large-scale forward intervention is at best a second-best instrument which reduces the efficiency of foreign exchange market signals, and carries substantial risks for the RBI’s balance sheet:

  • Murky signal to market. When the central bank enters the forward market to condition or influence expectations, the “signal” sent to the market can be difficult to interpret. For example, the market might read the intervention rate as the Central Bank’s view of what the rate might be in the future, which could increase speculative pressure on the spot rate today. Moreover, forward intervention may be construed as the central bank attempting to manipulate the market, which again could increase speculation.

  • Counterproductive operations. Forward intervention can conflict with monetary operations. To stabilize exchange market conditions, monetary operations which reduce the supply of domestic currency and raise domestic interest rates, will in turn put upward pressure on forward premiums. Intervention aimed at reducing forward premiums can undermine the original monetary tightening, and may create arbitrage opportunities, or worse, exchange rate guarantees.

  • Adds a risk premium. Without timely information on forward intervention/positions, participants face greater potential for exchange rate volatility, and thus increase the risk premium on a country’s currency. The risk premium is likely to increase at an inopportune time—during a period of currency turmoil. Although India already publishes such information, the timeliness of its reporting could be further improved.

  • Financial risk posed. There are examples of central banks that have incurred losses through forward interventions, and/or had great difficulties in meeting their commitments at a later stage. Moreover, under increasingly open capital accounts, market players can exercise considerable leverage in the forward market against the central bank, which could result in the erosion of the net reserve position.

E. Reforms for Improved Market Efficiency

35. The scope for excessive exchange rate volatility, particular in forward markets, would be greatly reduced if domestic markets would become deeper and more efficient. Although India’s foreign exchange markets have benefitted from various reforms that have been implemented in recent years, a large reform agenda nevertheless remains. Several outstanding issues are identified below.

Market access and functioning

36. With the progressive lifting of trade and capital account restrictions, Indian foreign exchange markets will eventually become deeper. However, market access could be improved in the short-term through liberalization measures that would also have the effect of making the market environment more competitive. Moreover, various regulations still impede efficient market functioning. Some of these stem from efforts to limit the scope of market activity during periods of market volatility; others originate from exchange controls. Liberalization measures that could be implemented would be:

  • Opening more substantially the window for high quality dealers to borrow on and lend to the international foreign exchange and money markets, subject to regulation of position limits;

  • Allowing qualified and competent nonbank financial intermediaries to obtain licences as authorized dealers;

  • Eliminating foreign exchange surrender requirements for exporters; and

  • Eliminating regulatory linkages between sources and uses of funds by authorized dealers and—to the extent consistent with the broader capital account liberalization—by corporates. For example, regulations that restrict end use of funds raised through NRI deposits could be further liberalized.

  • Exposing brokerage fees and prices for customer services and spreads to open competition. Prices of foreign exchange services among banks should no longer be fixed by the Foreign Exchange Dealers Association (FEDAI).

Integration of domestic and foreign exchange markets

37. Policy-related impediments to the development of fully integrated and efficient money and foreign exchange markets should be removed quickly. Among the most important measures affecting both domestic and foreign exchange markets would be:

  • Liberalization of access to the forward foreign exchange market (e.g., for FIIs and selected nonbank finance companies);

  • Further development of money and government securities markets: addressing, in particular, issues of the reserve requirement regime and the functioning the interbank market; the deepening of primary auctions of government securities and the broadening of the primary dealer system; the efficiency of the payments and clearing and settlement system; and the regulatory framework, and the sound and efficient functioning of markets;

  • Reduction of the segmentation of domestic money markets by: allowing selected nonbank financial institutions symmetric access to the interbank market; and further broadening access to the repo market as the government securities market is developed;

  • Liberalization of term interest rates: transition from direct management of term interest rates through primary auctions to indirect management through government open market operations in secondary markets; and

  • Improvements in cash management practices of both government and public sector enterprises to deepen term money markets across all maturities (inefficient cash management has contributed to a lumping of transactions in the call money market).

ANNEX: Foreign Exchange Market Structure and Central Bank Intervention

Market structure

38. The foreign exchange market in India is made up of two segments—the interbank and retail markets. The interbank market consists of commercial banks authorized by the RBI as foreign exchange dealers (ADs) and the Reserve Bank of India (RBI). The RBI intervenes through ADs. Merchants—importers and exporters—that require foreign exchange or local currency (for foreign exchange), buy and sell through ADs in the retail market segment, at bank counters or by telephone.

39. The types of foreign exchange transactions are driven by the needs of market participants to meet foreign currency obligations and hedge currency risk. Merchants sell or buy foreign exchange in the spot market (for delivery two days from the trade date), to meet foreign currency obligations and repatriate export earnings as they come due. Also, they may enter into forward transactions to guarantee the price for future delivery, hedging against currency movement between invoice billings and settlement. These forward transactions may be canceled (at a market-related cost) if merchants wishes to remove the hedge. In India, forward transactions are about 1/3 the size of spot transactions.

Central bank intervention

40. The RBI conducts transactions in the spot, forward and swap markets: what impact does each have on the exchange rate? Spot and outright forward intervention should have similar effects on the spot exchange rate because the impact on commercial banks* net foreign exchange position is the same. Whether intervention took place in the spot or forward markets, commercial banks would attempt to close the position in the spot market, and both would impact the spot rate similarly.13

41. By contrast, swap transactions do not have a direct effect on the spot exchange rate because they leave the net foreign exchange position unchanged. However, as swaps have an impact on domestic liquidity, and therefore money market conditions, they have an indirect effect on the spot exchange rate.

42. Do swaps impact on forward premia? If markets were efficient and capital was mobile the answer would be no. To illustrate, assume the central bank enters into a swap—buys dollars spot and sells them forward—with a view to reduce forward premia. If forward premia edge lower, market participants would quickly exploit the opportunity by borrowing dollars abroad and purchasing rupees in the spot market while simultaneously repurchasing dollars in the forward market. This action would push the forward premia up and balance the central bank’s spot and forward transactions. However, since such arbitrage possibilities in India are limited, swap intervention by the RBI tends to have a dampening impact on forward premia.

Data on foreign exchange transactions

43. The RBI has begun in April 1997 to publish monthly data on intervention and its net forward position, which are made available in the RBI Bulletin with about a six week lag (see Table II.3). Further detail on the composition of dollar sales and purchases, or the maturity structure of forward obligations is not provided. Weekly information on the RBI’s gross reserve position has already been made available in the RBI’s Weekly Statistical Supplement with a one week lag (both publications can be accessed from the RBI’s web site).

44. The RBI has also begun in April to publish information on daily volumes of foreign exchange market activity, based on data provided by major banks that account for 80–85 percent of total private foreign transaction volumes (so-called “reporting banks”). These banks report daily foreign currency transactions (sales and purchases) in spot, forward, and swap markets. The data also show the split between transactions with corporates, foreign investors, and non-resident Indians (merchant transactions) and transactions with other commercial banks, financial institutions, and the RBI (interbank transactions).

45. The data can be used to observe total market turnover (see Chart II.1) as well as net foreign currency purchases for merchants, non-reporting banks and the RBI, and reporting banks (see Chart II.3; aggregated to monthly data in Table II.4);

  • (i) Net merchant purchases are calculated by netting sales to merchants with purchases from merchants.

  • (ii) Netting out interbank transactions yields net purchases by non-reporting banks and the RBI, because transactions with reporting banks cancel out.

  • (iii) Finally, by definition, the sum of net purchases by merchants and non-reporting banks and the RBI has to equal net sales by reporting banks.

46. Since transactions by non-reporting banks account for only a small share of all transactions (and because the RBI apparently conducts its transactions mainly with reporting banks), the second item should broadly equal RBI intervention in foreign exchange markets.14


Prepared by Martin M¨hleisen. Section D on the role of forward intervention was initially drafted by Peter Dattels.


Trading in nondeliverable forwards (NDF) and futures is not permitted in India. There are, however, NDF offshore markets in Singapore and Hongkong. Although detailed information is not available, the offshore market is reportedly small, driven primarily by a few international banks represented both in India and abroad.


Although significant, these steps still limit the scope for arbitrage between domestic money markets and international markets. Both the ceiling on international borrowing and gap limits remain small by international standards. The RBI has also on occasion resorted to moral suasion by advising banks not to engage in arbitrage activities.


The SBI and its associate banks also account for 30 percent of assets of domestic and foreign commercial banks in India.


This behavioral pattern of importers, which has been observed frequently in recent years, is described in more detail in the section on forward intervention.


This analysis is based on transaction data for interbank and retail markets published by the RBI. The interbank market consists of commercial banks authorized by the RBI as foreign exchange dealers. Merchants—corporates, foreign investors, etc.—buy and sell currency through banks in the retail segment. The RBI’s information is based on data provided by major banks that account for some 80–85 percent of foreign exchange turnover (see Annex).


The RBI has not explicitly ruled out such operations; however, market participants have noted the absence of clear guidelines on which transactions are permitted.


This argument is supported by Enoch, C. (1998) (Transparency in Central Bank Operations in the Foreign Exchange Market) IMF Paper on Policy Analysis and Assessment, PPAA/98/2.


As forward intervention has declined in the first half of 1998, this position has been substantially unwound.


Primary market rates can be used to construct a yield for government securities, but these do not always represent market clearing rates while secondary markets in government securities are not sufficiently developed to construct a meaningful curve on a consistent basis, especially at longer maturities. Thus, pricing and arbitrage activities are made more difficult.


Contrary to earlier years, the RBI appears to have ceased to engage in outright forward transactions (see bottom panel of Chart II.3).


A swap transaction consists of two components—a spot and a forward leg. If the RBI wants to tighten domestic liquidity, it sells today dollars in exchange for rupees (spot leg), and commits to buy the same amount of dollars (from the same counterparty) for rupees on an agreed future date (forward leg) at a specified price. The swap has the same impact on domestic liquidity as a monetary operation (e.g., a repo) of the same size.


The major difference is that intervention in the spot market would withdraw domestic liquidity away—if intervention is not sterilized—and thus tighten money market conditions, which would lend further support to the exchange rate.


Spot intervention by the RBI is not identical to the change in foreign exchange reserves. Reserves are also affected by swap transactions, maturing swap or forward deals, and transactions conducted outside the market.

India: Selected Issues
Author: International Monetary Fund
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    Rupee/Dollar Exchange Rate

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    India: Daily Foreign Exchange Market Turnover (April 1997–July 1998) 1/

    (In millions of U.S. dollars)

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    India: Foreign Exchange Market Activity (April 1997–July 1998)

    (In millions of U.S. dollars; cumulative since April 1, 1997) 1/

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