Why Former RBI Deputy Governor Michael Patra Wants India to Tap the US Fed to Save the Falling Rupee

The exchange rate has been called by economists as a shock absorber. But with the rupee going from 89-per-dollar to 95 in a few months, is it performing the role of a shock absorber as it should?

I think it was Milton Friedman, the winner of the 1976 Nobel Prize in Economic Sciences, who was among the first prominent voices propounding the equilibrating properties of floating exchange rates in his 1953 essay ‘The Case for Flexible Exchange Rates.’ Since the advent of floating exchange rates, however, the experience has been quite the opposite. Exchange rate behaviour has been characterised by overshoots, self-fulfilling expectations, band-wagon effects, multiple disequilibria and several generations of currency crises.

Hence, all central banks monitor exchange rate movements closely and continuously and intervene in various ways to ensure orderly outcomes, because exchange rate volatility can have real economy consequences as well as financial instability.

Last week, the RBI capped banks’ daily open positions in the rupee at $100 million. Yet, the rupee breached 95-per-dollar. Has this measure failed?

The RBI has a distinct information and analytics advantage relative to all other stakeholders in the foreign exchange market. It also tends to act pre-emptively rather than reactively to market developments. Hence, my hunch is that the build-up of disproportionately large arbitrage positions was detected and had to be curbed, so that markets remain liquid and function normally, especially in the context of the troubled geopolitical environment. The success or failure of any measure has to be assessed in the context of the objective it seeks to achieve. In this case, it is the unwinding of large arbitrage positions. Let us see how that happens within the time limit given by the RBI.

You want the RBI to use the US Federal Reserve’s FIMA Repo Facility, akin to the RBI’s own repurchase facility for Indian banks. Can the use of FIMA — or even public knowledge of its availability — put an end to speculation against the rupee, which the RBI tried to do last week?

The objective of proposing access to the FIMA is to ensure that dollars are flushed continuously in and out of the market, so that market is liquid and deep with all regular demands for foreign exchange being satisfied. It would also economise on the use of the RBI’s foreign exchange reserves and, in fact, provide space to rebuild them. There is also some evidence from countries that have availed it that it has brought about reductions in foreign exchange swap basis spreads as well as in the sensitivity of the latter to daily changes in risk sentiment proxied by the VIX index. Some central banks have also reported stabilisation of capital flows to their economies on announcement effects.

Why has the RBI never used FIMA?

The FIMA was established in March 2020 as a pandemic response and in July 2021, it was made into a standing facility. In the period from 2020-21 to 2023-24, there were very large accretions to the foreign exchange reserves except in some months of 2022-23. In fact, high levels of reserves — the fourth largest in the world then — were maintained even in early 2024-25 up to July. Hence, the need for access to FIMA did not arise.

On February 28 — the day the West Asia war began — India and Japan renewed their $75 billion Bilateral Swap Arrangement. Are more such swap lines needed or can their usage signal some sort of desperation?

Since the global financial crisis, the lack of a truly global, democratically accessible financial safety net has been acutely felt. It has also been recognised that while crises can be global, the responsibility for financial stability is national. For many emerging economies, national holdings of foreign exchange reserves turned out to be the only recourse, especially in the context of managing global spillovers. Accordingly, apart from seeking governance reforms in multilateral institutions, these countries have sought to reinforce their crisis wherewithal with secondary buffers such as swap lines. It has been the experience that the existence of these swap lines has provided confidence to markets and discouraged speculative attacks on the exchange rate.

In my view, getting access to FIMA and using it would demonstrate that uninterrupted provision of dollar liquidity to the foreign exchange market in India has a stabilising influence and it precludes precautionary sales of US Treasury securities in New York which can be destabilising for the markets there. In time, this can pave the way for the establishment of a regular swap line. Faced with a storm, it is wise to get on to the biggest ship.

The RBI has always said the exchange rate is not a consideration while setting interest rates. Is it now?

The RBI has followed a clear assignment rule in which monetary policy is assigned the objectives of price stability and growth, while exchange rate stability is assigned to foreign exchange interventions, macroprudential measures and capital flow management. In my view, this assignment rule has worked well and should be persevered with. In fact, there are only two rare data points of monetary policy being deployed to defend the exchange rate – during the global financial crisis, and during the taper tantrum. We have come a long way since then in strengthening our policy frameworks, building buffers, and in securing macroeconomic and financial stability.

Is the inflationary impact from the war’s energy supply shock being underestimated? Apart from maybe a couple of economists, no one really seems to be predicting an interest rate hike by the RBI anytime soon.

As part of the preparations for the meeting of the MPC, teams in the RBI will simulate various scenarios in order to assess the balance of risks around the projections of inflation and growth. The impact of the geopolitical situation in terms of upside risks to inflation and downside risks to growth is too big an imponderable not to be simulated. Other related spillovers will also be taken into account, including the headroom provided by excise duty cuts on key inflation-sensitive petroleum products by the government. After that, the monetary policy decision is best left to the judgment of the MPC, which has wisely kept powder dry.