Official Intervention or exchange intervention refers to the buying and selling of foreign exchange in the market with a view to influencing the exchange rate. In a free market the rate of exchange is determined by the forces of demand and supply. Official intervention is an attempt to counter the effect of demand for and supply of the currency and keep the rate of exchange at a level desired by the government.
When the exchange value of the domestic currency is falling in the market, the government would intervene in the market and purchase it in large quantities (in other words, sell foreign currency in large quantities). This would prevent the rate from falling. This is known as ‘pegging up’ the value of domestic currency. To effectively carry out the operation, the government requires a large reserve of foreign currency.
Intervention may be for ‘pegging down’ the currency or keeping its value lower than the free market rate. When the rate of exchange of the domestic currency is rising in the market, the government may sell the currency in large quantities and thus bring it down. Large reserves of domestic currency are required for pegging down operations.
The intervention may also be for the purpose of stabilising the exchange rate and free it from short-term fluctuations. The government should be ready to purchase and sell the currency to any extent at specified rates. The market rates then tend to hover around these official rates. The government should have large reserves of both domestic currency and foreign currency to carry out the operation.
For the success of intervention two conditions are essential. First, the control of foreign exchange transactions should be centralised with the government. All proceeds of foreign exchange from exports and other transactions should be paid to the government. Similarly, all requirements of foreign exchange for imports and other payments should be obtained from the government.
Secondly, the government should have sufficient reserves of foreign currency and domestic currency. In practice, it is not difficult to have reserves of domestic currency as it can be created by printing more currency. Therefore, pegging down the currency is not so simple as to peg up. The government should acquire reserves of foreign currency, sufficient enough to have an effect on the exchange rate in the market by large-scale sales (of foreign currency).
Exchange intervention by RBI
RBI has the responsibility to maintain the external value of the rupee. Prior to 1993, Reserve Bank was obligated under the RBI Act, 1934 to buy and sell foreign exchange to authorised dealers. The exchange rates quoted to customers were based on RBI rates. The rupee was maintaining its value artificially stable due to frequent intervention in the market by Reserve Bank. Since 1993, Reserve Bank has no obligation to buy or sell foreign exchange to anyone. Yet RBI has retained the right to intervene in the market. The intervention is through US dollars.