UPSC Prelims 2022 Q3: RBI OMOs, Forex Intervention — Explained

With reference to the Indian economy, consider the following statements:

1. If the inflation is too high, Reserve Bank of India (RBI) is likely to buy government securities.

2. If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market.

3. If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars.

Which of the statements given above are correct?

  1. 1 and 2 only
  2. 2 and 3 only
  3. 1 and 3 only
  4. 1, 2 and 3

Answer: (b) 2 and 3 only

Statement-wise explanation

  • 1: incorrect — Buying government securities is an open market operation (OMO) purchase. The RBI pays rupees to banks, which adds durable liquidity, and that is an expansionary step. To fight high inflation the RBI does the reverse: it sells G-secs to drain liquidity, alongside raising the repo rate. The statement has the direction backwards.
  • 2: correct — When the rupee falls quickly, the RBI sells dollars from its foreign exchange reserves in the spot and forward markets. This adds dollar supply and takes rupees out of the market, which slows the fall. The RBI's stated aim is to curb excessive volatility, not to defend a fixed rate. In 2022 the rupee hit record lows and reserves fell from their September 2021 peak of about US$642 billion as the RBI sold dollars.
  • 3: correct — If interest rates in the US or EU fall, the interest-rate gap in India's favour widens. Foreign portfolio money flows into Indian assets, dollar supply rises and the rupee tends to appreciate. The RBI usually buys these surplus dollars to stop sharp appreciation and to build reserves. This happened in 2020–21, when near-zero rates abroad helped push India's reserves to a then all-time high of US$586.1 billion on 8 January 2021 (Economic Survey 2020–21).

How to eliminate

Statement 1 can be settled from basic monetary-policy logic. Buying securities puts money into the system, and putting money in cannot be the cure for inflation that is too high. Once Statement 1 is out, three options go with it, because they all include it. Only the option with 2 and 3 is left. Statement 2 is also certainly true from basic knowledge: a central bank defends a falling currency by selling foreign currency. There are no absolute words here; the question is a pure direction-of-action test. Keep one rule for similar questions: anything that injects rupees (buying G-secs, buying dollars, cutting CRR) is expansionary, and anything that withdraws rupees (selling G-secs, selling dollars) is contractionary.

Know more

Two levers that move the same money

The RBI manages rupee liquidity through two channels. Domestic assets are government securities. Foreign assets are its dollar reserves. Buying either asset adds rupees to banks, and selling either one withdraws rupees.

Situation Likely RBI action Effect on rupee liquidity
High inflation Sell G-secs (OMO sale), raise repo rate Absorbed
Tight liquidity / growth slowdown Buy G-secs (OMO purchase) Injected
Rupee depreciating fast Sell dollars from reserves Absorbed
Heavy capital inflows, rupee rising Buy dollars, add to reserves Injected

OMO in India. According to the RBI, only outright purchases and sales of G-secs that change durable liquidity are counted as OMOs. Temporary liquidity is handled through repo and reverse repo under the Liquidity Adjustment Facility (LAF).

Interest-rate differentials. Foreign investors compare returns across countries. When rates in the US or EU fall, Indian bonds look relatively attractive, so dollars flow in. When the US Federal Reserve raises rates, as it did from March 2022, money flows out and the rupee weakens.

Sterilisation. Forex intervention changes rupee liquidity as a side effect. Selling dollars drains rupees. To offset this, the RBI often buys G-secs at the same time. This combination is called sterilised intervention. Buying dollars adds rupees, which can feed inflation, so the RBI may absorb the extra money through OMO sales or other tools.

Exchange-rate regime. India has a managed float. The RBI does not target any level or band. It intervenes only to smooth excessive and disruptive volatility.

In the news

In the months before the June 2022 exam, the Russia-Ukraine war and soaring crude prices pushed the rupee to record lows. The US Fed began raising rates in March 2022, and the RBI made an off-cycle repo rate hike on 4 May 2022 while selling dollars from its reserves. All three of the tested mechanisms were in the news together.

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