Here's why the Reserve Bank of India sells US dollars

Financial markets worldwide are facing intense selling pressures on extreme risk aversion due to the hawkish FOMC guidance and rate hike trajectory compounded by its Quantitative Tightening posture wherein it will suck out $95 bn ($60 bn in UST + $35 bn in MBS) a month from the markets. 'Flight to safety' has led to a spike in volatility across all asset classes, with several emerging market currencies experiencing downside pressures. Mismatches in US dollar liquidity have been accentuated across the world.

The RBI has to consider financial market conditions, impact of imported inflation and the acute shortage of US dollars (USD and/or $) in the market and accordingly decide to sell US dollars to keep the Indian Rupee (INR and/or Rs) from depreciating sharply. The INR has breached the psychological level of 80 to the US dollars.

How can the RBI sell?

USD sell/buy swaps: In order to provide liquidity to the foreign exchange market. The swaps are conducted through the auction route in multiple tranches. The auctions are typically multiple prices based i.e. successful bids will be accepted at their respective quoted premiums.

Spot and Forward markets: The central bank can not sell dollars either in the spot or forward market as the situation warrants or can sell in the spot and forward market at the same time to avert pressure on the INR. Such intervention is used to shield the rupee from excessive volatility.

If INR depreciates very rapidly it will lead to the import of inflationary pressures from abroad and worsen the inflation fight. For example, a past RBI study has shown that a 5 per cent depreciation in the rupee could push inflation higher by roughly 20 basis points and vice versa. Importantly, it can also sour the foreign institutional investor sentiment due to the rapidly depreciating INR.

What happens when the RBI sells dollars? It results in extinguishing an equivalent amount in rupees, thus reducing the rupee liquidity in the system.

The mechanism

The central bank sells off a part of its US dollar reserves and asks for INR in lieu. An example to illustrate the same: Suppose the RBI offers to sell $100 million at the cost of Rs 80 per dollar.

And then seeing the interest of the currency market, it announces that it will sell off $200 million more, hence the buyers get an opportunity to buy more US dollars at a time when demand for it is very high.

However, by doing so the INR in the currency market gets reduced by Rs 8,000 million, so there is less INR left in the market. And lower supply of INR causes the value of INR to rise or it gets costlier, so the next $200 million will get sold at Rs 479 per dollar. And this way the bidding process will continue.

Thus, the INR will appreciate against the USD shoring up its value and the confidence level in the currency.

(The author is the group chief economist, Mahindra & Mahindra)