RBI’s Exchange Rate Strategy May Be Creating More Risks Than It Solves.

 
Between 2023 and 2024, the rupee-dollar exchange rate recorded its lowest volatility in over two decades. At just 1.8% average annualised volatility, the rupee appeared remarkably stable. This wasn’t a natural outcome of balanced capital flows or market-driven forces. It was the result of a deliberate and sustained strategy by the Reserve Bank of India (RBI) to suppress currency fluctuations.

Fig1. Volatility of the rupee-dollar rate

Since late 2022, the RBI has actively intervened in foreign exchange (FX) markets. It bought dollars to prevent the rupee from appreciating and sold them to prevent depreciation. In November 2024, the central bank sold over $20 billion—its highest-ever monthly spot market intervention. It also built a short position of around $65 billion in the offshore non-deliverable forward (NDF) market, which was originally created due to restrictions in India’s onshore markets.

These actions effectively held the rupee to the dollar for nearly two years. As a result, the IMF reclassified India’s exchange rate regime from a “floating” to a “stabilised arrangement.”

However, managing a near peg in a country with a relatively open capital account is not without consequences. There are two major problems with artificially reducing exchange rate volatility.

First, it creates what economists call “moral hazard.” If firms believe the rupee will stay stable, they feel less need to hedge their dollar borrowings. Hedging costs money; an implicit central bank guarantee of stability makes it seem unnecessary. By December 2024, unhedged external commercial borrowings (ECBs) reached $65.5 billion—about 34% of the total. The RBI itself flagged this as a risk in its Financial Stability Report, especially in relation to non-banking financial companies (NBFCs).

Second, artificially suppressed volatility can lead to mispricing of currency risk. The forward premium on the rupee—a rough proxy for market expectations—dropped from the usual 3–5% range to 1–2%. This suggests markets assumed the RBI would hold the line, reinforcing the perception that currency risk was negligible.

Fig 3. Forward premium and currency volatility

But no central bank can control exchange rates forever. Eventually, the fundamentals take over. And when expectations are misaligned with reality, corrections are often sharp. Once investors see that the RBI might not continue defending the rupee, they may rush to exit. The result can be a sudden spike in depreciation, just as the central bank’s ability to intervene gets stretched.

This is not a theoretical concern. Since November 2024, the rupee has depreciated from 84 to 87 against the dollar. This is modest, but it marks a clear departure from the tight band of the previous two years. The movement also reflects broader global trends—the US dollar has strengthened following the return of Donald Trump to the White House. But it also shows that the RBI may be stepping back from its heavy-handed currency management.

The bigger issue is that policy inconsistency can amplify financial stress. When firms have positioned themselves around the assumption of currency stability, any departure from that assumption—however justified—introduces balance sheet vulnerabilities.

So what’s the way forward?

Rather than trying to engineer low volatility, the RBI should let the rupee move in both directions. Allowing moderate, market-driven fluctuations will push firms to hedge risk, promote responsible foreign borrowing, and avoid speculative one-way bets on the rupee. It will also reduce the central bank’s burden of having to act as a continuous shock absorber for global volatility.

A flexible exchange rate, supported by transparent intervention when needed to manage disorderly market conditions—not to target levels—is a more sustainable policy. Currency stability is useful, but it is more effective when it arises from underlying economic strength, not prolonged intervention.

The rupee doesn’t need to be defended at all costs. It needs to be allowed to reflect real conditions—both domestic and global.