Why did the RBI peg the exchange rate?

In a series of recent articles, we pointed out that in 2022, the Reserve Bank of India (RBI) abandoned the flexible exchange rate regime that had been in place for three decades and replaced it with a de facto peg against the dollar.

- Abhishek Anand, Josh Felman & Arvind Subramanian

We emphasized how this change cost the economy, resulting in an uncompetitive exchange rate and lost exports, overly tight liquidity at a time of decelerating growth, and heightened risks of speculative attacks. This begs an important question: Why did the RBI change policy?

The RBI must come out with an official explanation, but until it does, we can only guess. But there are a few reasonable hypotheses.

One common explanation is that it happened accidentally. That is to say, the RBI never meant to peg the exchange rate. Its real objective was to rebuild reserves after the country's foreign exchange cushion had been eroded in the middle of 2022. So, when capital started to flow into the country again, attracted by India's post-pandemic resurgence, the Central bank decided to buy up the dollars rather than allow the rupee to appreciate.

There is clearly something to this hypothesis, as the RBI has often preferred to build reserves rather than allow appreciation. But the explanation is surely incomplete. For a start, it does not explain why the RBI has since 2022 intervened repeatedly on both sides of the market, not just to prevent appreciation but also to forestall depreciation. Nor does it explain why the RBI fought so hard to preserve the peg when depreciation pressures arose in late 2024, even at the cost of expending sizeable amounts of the country's hard-won reserves.

A second hypothesis is that the RBI was focused on combatting inflation, and worried that a depreciation would undermine their efforts. It is true that inflation remained above the 6 per cent limit for some time after the