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The exchange rate of the Indian rupee is generally determined on the basis of the underlying supply and demand conditions of the local interbank market.
The Reserve Bank of India (RBI) sets daily rates for buying and selling the rupee against the US dollar simply by observing the interbank market to identify a market level and then setting daily rates accordingly. The spread on this effectively sets the limits on the day's trading for local banks.
Although the RBI has the power to adjust these rates during the day, it has rarely done so. The RBI will only deal at these rates with authorized dealers in India, and exchange controls require that dealers ascertain that legitimate underlying capital/current account transactions exist.
Daily turnover in the domestic interbank market is some US$1 billion-US$1.5 billion. Banks in India are only permitted to sell rupees to overseas parties; they are not allowed to purchase them either spot or forward. This creates the environment for a two-tier market where an offshore two-way market between a small number of banks exists. As volatility has declined, so has the number of participating banks and interbank spreads of between three and five paise are now normal on the standard traded amount of Rs 10 million.
The domestic swap market is mostly related to short-dated dollar/rupee swaps for commercial bank balance purposes. Forward cover is available through the use of outright contracts for up to six months with roll-overs at maturity if longer term exposures are involved.
Recent trends
The Indian rupee traded in a relatively narrow range for most of 1994 and 1995, generally just above the Reserve Bank US dollar buying rate of Rs31.37. Occasionally, month-end demand for US dollars drains the available supply and results in a temporary lift off this base. However, in late February 1995, rumours of a rupee devaluation momentarily forced US$/Rs above 32.00.
Substantial foreign exchange operations have been evident since 1994 as net capital inflows were matched with intervention and a build up of reserves. Reserves reached in excess of US$24 billion and the unwinding of much of the capital inflows has eased the upward pressure on the currency. The lack of any substantive changes to exchange rate policy in the 1995/96 budget suggests...