As we have already specified that the Central Bank uses its Forex Reserves to stabilize the exchange rate during very volatile currency movement. The exchange rate has to be kept stable within a proper range to help the import and export industry. Let us visit the same with the example ofIndiaand RBI’s role to keep exchange rate stable.
Import and export industries are closely related with the exchange rate (USD: INR forIndia). Too much of Rupee appreciation hurts the export industry and too much of Rupee depreciation hurts the import industry severely as it affects the earnings and profitability.
Now why does the exchange rate vary so much?
It is mainly because of the US dollar supply within the country which drives the exchange rate in the money market. This can be explained by the basic economics Demand-Supply concept; too much US dollar inflow increases the dollar supply within the country and reduces the dollar value; which results in Rupee appreciation. At the same time too much of US dollar outflow decreases the dollar supply within the country and increases the dollar value; which results in Rupee depreciation.
High US Dollar inflow -> Increased Dollar Supply -> Reduced Dollar value or exchange rate – > Rupee Appreciation
High US Dollar outflow -> Decreased Dollar Supply -> Increased Dollar value or exchange rate – > Rupee Depreciation
When does it become too much volatile?
During the financial crisis time, too much US dollar outflow becomes a normal scenario which depreciates the Rupee quite significantly. This has happened recently when US dollar and Rupee exchange rate touched RS 50 per dollar mark.
During the bull market run and peak of the economic cycle, too much dollar inflow becomes a normal scenario which appreciates the Rupee quite significantly. This has happened during 2007-08 fiscal year when US dollar and Rupee exchange rate touched record RS 39.50 per dollar mark.
So how come RBI use Forex Reserves to check exchange rate?
As we have explained before the exchange rate is determined by the US dollar supply within the country, RBI can easily control the exchange rate by controlling the US dollar supply withinIndiathrough its money market operations. Being the central bank of the country, RBI has sufficient Rupee and sufficient Forex Reserves.
How does RBI control the US dollar supply within the country?
RBI controls the US dollar supply within the country very easily by buying or selling the US dollar through money market operations.
If US dollar supply is huge and Rupee appreciated significantly, RBI buys some dollars from the market directly using Rupee to reduce the dollar supply and increases the Rupee supply or liquidity. This transaction increases its Forex reserves and helps to depreciate the Rupee.
High Dollar supply and Rupee Appreciation -> RBI buys dollars -> Increases Forex Reserves and decreases Dollar Supply -> Rupee depreciates.
In the same way if US dollar supply is very low and Rupee depreciated significantly, RBI sells some dollars from its Forex reserves in the market directly and buys Rupee to increase the dollar supply and decreases the Rupee supply or liquidity. This transaction decreases its Forex reserves and helps to appreciate the Rupee.
Low Dollar supply and Rupee Depreciation -> RBI sells dollars -> Decreases Forex Reserves and increases Dollar Supply -> Rupee Appreciates.
This is how RBI controls the exchange rate using its Forex Reserves. If the Forex Reserves is sufficient then RBI can control the exchange rate for longer duration by buying or selling dollars in the market.