Managing the Rupee, Constraining the Market

The rupee is once again under pressure, and the debate has predictably split into two familiar camps viz., those who see policy overreach and those who see necessary restraint. The Reserve Bank of India’s move to tighten banks’ overnight open position limits sits at the centre of this tension. While some critics argue that such curbs distort price discovery, it is equally worth asking whether parts of the banking system have earned the right to complain.

In principle, a currency market functions through a delicate choreography of flows and intermediation. A dollar entering the system, say, for instance, through a foreign investor, does not remain with the initial authorised dealer bank. It moves through the interbank market, is matched with importers, or is temporarily warehoused by institutions willing to carry the position. This warehousing function is critical. At any given moment, demand and supply are rarely aligned, and banks bridge that gap by absorbing mismatches.

But this mechanism works well only when intermediation is disciplined. When banks begin to treat open positions not as a facilitative necessity but as an avenue for speculative gain, the line between market-making and position-taking starts to blur. In periods of rupee stability, this risk appetite often goes unnoticed, even rewarded. Yet when external pressures build, as they inevitably do in a tightening global environment, those very positions can amplify stress rather than absorb it.

It is in this context that the RBI’s actions need to be viewed. To argue that the central bank is merely constraining market function misses a key part of the story. If segments of the banking system have been building large, directional exposures while being fully aware of underlying currency pressures, then regulatory tightening is less an intrusion and more a corrective. Complaining about intervention after having leaned into the trade is, at best, inconsistent.

That said, the policy response is not without consequence. By curtailing banks’ ability to carry overnight positions, the RBI is also limiting the system’s capacity to intermediate flows. When a dollar demand arises and exporters are unwilling to sell at prevailing levels, someone must step in. If banks are constrained, the adjustment has to come either through sharper price movement or through the central bank’s own balance sheet.

The market rant is all about this: RBI has transitioned from a freewheeling regulator giving market wide latitude to arbitrage onshore versus offshore to getting panicky. Market feedback says that a built-up of offshore position is the trigger. In this regard netting of onshore and offshore exposures which allows such position build up is a recent push and that a policy should not be judged by its immediate ex-post results and rather should have waited. Switching between extremes is not a sign of a well thought out enablement. If there is a clear understanding that banks have been building positions, why wait till a sledgehammer is the only alternative?

This creates a paradox. If the objective is to allow the rupee to find its market-clearing level, then reducing intermediation capacity could, in fact, lead to more abrupt depreciation as prices are forced to adjust more quickly to entice supply. On the other hand, if such volatility is undesirable, and it usually is, the RBI inevitably becomes the residual supplier of dollars. In doing so, it risks turning itself into the market’s primary shock absorber, a role that expands precisely when private balance sheets are being restrained.

The result is a system caught between discipline and dependence. On one side, banks are being reminded that speculative excess will not be tolerated under the guise of market-making. On the other, the market’s natural ability to smooth imbalances is being weakened, increasing reliance on central bank intervention. Neither outcome is inherently wrong, but the combination demands careful calibration.

What makes the current episode particularly instructive is not the direction of the rupee, but the behaviour it reveals. Markets cannot demand the freedom to take risk in good times and then object to constraints when those risks begin to materialise. Equally, policymakers cannot expect smooth price discovery if the very channels through which prices adjust are narrowed.

The rupee’s brief appreciation followed by renewed weakness today is not a contradiction; it is the manifestation of these competing forces. Genuine external pressures are at play, but so are internal inconsistencies. In the end, a currency market needs both discipline and depth. Remove the former, and you invite instability; constrain the latter, and you risk making that instability sharper when it finally surfaces.