Capital Flows and Exchange Rate Volatility in India: How Crucial Are Reserves?

• DOI: http://doi.org/10.1111/rode.12171
• Date: 01 August 2015
• Published date: 01 August 2015
• Author: Renu Kohli

Capital Flows and Exchange Rate Volatility in India:

How Crucial Are Reserves?

Renu Kohli*

Abstract

This paper tests if the adequacy of reserves helps reduce exchange rate volatility in an environment of

financial globalization, market-determined exchange rate and macroeconomic imbalances. It exploits the

difference in the period after 2010 when India did not accumulate reserves but faced higher capital flow

pressures, relative to a previous managed-float period marked by significant absorption of surplus capital

flows. Along with other determinants, the sensitivity of rupee volatility is examined. The paper finds that

adequate reserve holdings significantly reduce exchange rate volatility irrespective of the exchange rate

regime; the effect is more through influence upon market sentiment and confidence than actual interven-

tion. It contributes to existing evidence on the role of reserves in mitigating exchange rate volatility amid

capital flow swings and offers insights into the policy environment depicted in the trilemma.

1. Introduction

How crucial are reserves for exchange rate volatility in a financially globalized envi-

ronment? The question arises as emerging market economies (EMEs) battle volatile

capital flows in a much transformed setting. Financial integration is now well

advanced in those countries that receive large volumes of capital flows. Most have

adopted flexible exchange rate policies following dangers of exchange rate pegs

exposed by crises in the 1990s (Fischer, 2001). These developments are juxtaposed

against a more capricious global financial cycle: capital flow magnitudes are enlarged

and tilted towards short-term portfolio flows (International Monetary Fund (IMF),

2011); global portfolio investors are more sensitive to global financial conditions

(IMF, 2014a); and a financially globalized environment is marked by co-movements in

asset prices, gross flows and leverage, driven by frequent changes in uncertainty and

fears that are interlinked with monetary conditions in the USA (Rey, 2013).

These forces bear with increased weight and intensity upon exchange rates of

recipient countries. Post-crisis, the impact of capital flows upon exchange rates, or

appreciation pressures, has been more sustained than historically; abrupt, steep cor-

rections have followed at times of capital flow reversals (IMF, 2013). Mounting con-

cerns about output costs of higher currency volatility and enhanced financial stability

risks have renewed search for safeguards.1Many EMEs have restarted stocking

foreign exchange (forex) reserves.2The role of reserves in reducting exchange rate

volatility assumes relevance in this context.

Changes in global financial conditions and exchange rate regimes have consistently

influenced the demand for international reserves. The literature has evolved

* Kohli: National Council of applied Economic Research, Parisila Bhawan, 11, Indraprastha Estate, New

Delhi 110002, India. Tel: +91-11-23379861-65; Fax: +91-11-2337-0164; E-mail: renukohli@yahoo.com. The

author wishes to thank an anonymous referee for very helpful suggestions and participants of the confer-

ence on “Exchange Rates, Monetary Policy and Financial Stability in Emerging Markets and Developing

Countries” held at the University of Leipzig, October 2014, for comments. The financial support of Foreign

and Commonwealth Office, Bilateral Programme Fund, is gratefully acknowledged.

Review of Development Economics, 19(3), 577–591, 2015

DOI:10.1111/rode.12171

© 2015 John Wiley & Sons Ltd