The Indian Rupee (INR) is under the watchful eye of the Reserve Bank of India (RBI), which is focused on maintaining stability and limiting volatility. This strategy, while effective in the brief term, has its complexities and potential long-term consequences.

The RBI’s unwavering commitment to maintaining a stable INR is the cornerstone of its monetary policy. By limiting the impact of external factors such as portfolio flows and changes in the economic outlook, the RBI has effectively kept the INR under control. This low-volatility environment helps improve the currency’s carry profile, enabling a tighter interest rate buffer and reducing the need to hedge currency risk, despite the low cost of doing so.

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However, this extended period of low volatility may hinder market price discovery and create a backlog of demand hedging when the volatility regime eventually changes. Moreover, the RBI’s strategy of building foreign exchange reserves by absorbing capital inflows may lead to a gradual depreciation of the INR over time.

The continued low INR volatility is a direct result of the RBI’s efforts to maintain stability. By containing spikes in exchange rate volatility, the RBI aims to decouple its monetary policy decisions from external influences. This policy has successfully kept portfolio flows to India largely unhedged, despite historically low hedging costs.

However, this stability comes with a number of challenges. The RBI may have overdone its efforts to control volatility, driving it to levels comparable to those of the pegged currency. Sustained low volatility may hamper INR price discovery and create pent-up demand for hedging. Moreover, the gradual change in trading volume has made it complex for the market to capture significant upside in carry as a lack of correlation with macro fundamentals remains.

One of the consistent policies of the RBI is to aggressively accumulate foreign exchange reserves. This strategy aims to create a buffer against future capital outflows. While the RBI is defending the INR against weakness, the risk of a policy change is increasing. The need to unwind brief forward positions created while defending the INR around 83.5/USD could further tilt the risk towards a gradual depreciation, increasing the likelihood of the USD/INR pair adopting a buy-after-dip strategy.

To understand the RBI’s intervention patterns, an analysis of key factors over the last decade reveals that the RBI is most sensitive to portfolio flows, with inflows being absorbed into reserves almost once. This consistent correlation with portfolio flows is partly due to the broader relationship between USD movements and portfolio flows to emerging markets.

Another issue is the competitiveness of the INR, particularly in promoting domestic production and import substitution. Recent swings in the trade balance, due to higher oil prices and larger deficits, have shown a higher correlation with USD strength. The real effective exchange rate (REER) index for the INR has been in a range-bound pattern for the past decade, although it is currently near the upper end of the range. While a long-term appreciation of the REER can be justified on the basis of productivity gains, further appreciation may be undesirable from a policy perspective.

The RBI’s diligent management of INR has helped maintain stability, but it also brings challenges. While the RBI continues to build its foreign exchange reserves and navigate the complexities of maintaining low volatility, the potential for gradual depreciation of the INR remains a key factor. This balancing act will be crucial in shaping the future of India’s monetary policy and the trajectory of the INR in the global market.

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X (formerly Twitter) – Aayush Khanna