Explainer: How the RBI Manages the Rupee

The rupee has hit its lowest since March

November 29, 2024

Market Update

Markets performed up 1 percent today after a larger selloff on Thursday. As a whole, this will be the first time Indian equities see back-to-back monthly losses since early 2023. Analysts see that foreign and domestic investors have wisened up to high market valuations which has broadly caused outflows, but are still investing in some sectors. Industrials, healthcare, and telecommunication have all gotten inflows due to expectations that high earnings multiples will continue to be met going into 2025.

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Explainer

How the RBI Manages Currency Fluctuations

After China’s stimulus package caused a roar in its markets, and the U.S. dollar appreciated further, the Reserve Bank of India has been under immense pressure to intervene in the country’s currency to prohibit it from depreciating too much. Often, the RBI maintains a soft limit of ₹84/$1, though this has been surpassed numerous times; the Indian rupee has hit new lows this fall, now at an exchange rate of ₹84.57 per dollar, the lowest since March. Now, more than ever, investors should understand the RBI’s methodology of currency controls; it is not as simple as tracking the exchange rate and automatically triggering the buying and selling of central bank reserves.

When the RBI chooses to intervene in foreign exchange markets, it usually is to fulfill two goals: limit the volatility of how much the rupee’s value is changing but also to align the exchange rate with the calculated equilibrium value. India’s economic narrative is undergoing a seismic shift, with the RBI embracing cutting-edge methodologies to align the exchange rate of the Indian Rupee with its equilibrium value. 

To do so, they have defined the fundamental equilibrium exchange rate (FEER), desired equilibrium exchange rate (DEER), behavioral equilibrium exchange rate (BEER), permanent equilibrium exchange rate (PEER), and nominal effective exchange rate (NEER). FEER is derived from internal and external balances such as maintaining inflation, current account balance, and saving/investment. DEER is more of a perceived measure that policymakers would want to see happen. BEER considers long-term fundamentals and short-term cyclical influences while PEER is purely long-term fundamentals. NEER on the other hand is the actual change in the rupee relative to a basket of nearly 40 currencies. Together, these frameworks allow for a nuanced assessment of the rupee's alignment with economic realities.

From RBI Bulleting, November 2024

The graph above compares various metrics to the actual currency fluctuation (REER). Since each metric involves complex valuations and datasets to project currency movements, the graph provides insight into how these metrics align with the actual currency and highlights the months where they diverge. BEER is generally a good indicator, while FEER provides important nuance but is not a singularly reliable metric: FEER is inherently backward-looking and is not calculated using projected growth rates.

Since 2000, the rupee, on a trade-weighted basis, has appreciated by 1 percent each year but NEER has depreciated at 2 percent per year led by inflation differentials between India and its trading partners. REER also shows how labor productivity and technology have grown dramatically leading to fundamental rupee appreciation, but there is also volatility since commodity price shocks have been more risky for India, especially with crude oil. 

There are numerous other insights such as BEER and PEER suggesting that the INR has held its ground, hovering close to equilibrium over the long term. FEER, however, paints a different picture, flagging occasional misalignments driven by trade volatility and fiscal pressures. These insights aren’t academic musings—they’re the backbone of policy formulation. Armed with these models, the RBI doesn’t just intervene in forex markets; it does so with surgical precision, smoothing volatility without pegging the rupee to a specific band.

The creation of these indicators has been very data-driven with various factors being exposed to large amounts of Indian data to discern key takeaways. The process of using these models gives tangible results such as regression equations detailing how much of BEER and PEER are decomposed in long and short-term factors plus the standard error expectations for both. For BEER, the RBI can see that relative GDP per capita and Net Foreign Assets are statistically significant in the long and short run. 

That being said, the RBI does acknowledge how some factors could be dislocated in long-term rupee valuation. FEER has interest rates as input but does not know what path rate policy will follow, just a vague understanding of the destination. BEER also uses past relationships to predict the future, but large structural changes distort that outcome as well.

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Written by Yash Tibrewal. Edited by Shreyas Sinha.

Disclaimer: This is not financial advice or recommendation for any investment. The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.

1 USD = 84.56 Indian Rupee