Week 8: Central Banks, FEMA 1999 & Currency Crises — Case Studies and Policy Responses

Learning Objectives

By the end of this session, students will be able to:

4-Hour Session Planner

This session blends institutional analysis (central bank operations, FEMA) with dramatic historical narrative (currency crises). Faculty should use the crisis case studies to make the theoretical material from Weeks 5–7 vivid and consequential.

1. Central Banks in the Foreign Exchange Market

1.1 Why Central Banks Intervene

Central banks are the most powerful participants in the foreign exchange market — not because they transact the largest volumes (commercial banks, hedge funds, and corporations collectively dwarf central bank volumes), but because they alone can create domestic money at will, hold reserves, change interest rates, and impose capital controls. Central bank intervention is the exercise of sovereign monetary power in the currency market, and understanding its objectives, instruments, and limitations is essential for the financial manager operating in an emerging-market currency like the INR.

Central banks intervene for four broad objectives, which often conflict and must be traded off:

1. Volatility Smoothing (the "leaning against the wind" objective): The central bank intervenes to reduce excessive short-term exchange rate volatility — not to prevent the rate from moving to its equilibrium level, but to prevent disorderly, self-reinforcing movements driven by herding and panic. The RBI's stated policy is to "smooth excessive volatility" without targeting a specific exchange rate level. This is the least controversial objective — even free-floating central banks occasionally intervene for this purpose.
2. Reserve Accumulation (the "precautionary" objective): The central bank buys foreign currency to build reserves as insurance against future external shocks. India's reserve accumulation from USD 5 billion (1991) to over USD 600 billion (2024) was driven primarily by this objective. Reserve accumulation keeps the domestic currency weaker (more competitive) than it would be in a free float — which is why it is sometimes criticised as a disguised export subsidy.
3. Maintaining Competitiveness (the "mercantilist" objective): The central bank intervenes to prevent the real exchange rate from appreciating and eroding export competitiveness. This objective is more controversial — it is explicitly discouraged by the IMF as a "beggar-thy-neighbour" policy. However, many emerging economies, including India, have de facto pursued this objective by accumulating reserves rather than allowing market-driven appreciation.
4. Financial Stability (the "lender-of-last-resort-in-FX" objective): The central bank intervenes to prevent exchange rate movements from triggering financial distress — particularly when the banking sector or corporate sector has significant unhedged foreign-currency debt. A sharp depreciation increases the domestic-currency burden of foreign-currency debt, potentially causing widespread insolvencies and a systemic banking crisis. The RBI's concern with unhedged ECB exposure among Indian corporates is a key driver of its depreciation-smoothing intervention.

1.2 How Central Banks Intervene — Instruments and Mechanics

Spot Market Intervention: The most direct form. The central bank buys or sells foreign currency (typically USD) against domestic currency in the interbank spot market. To prevent depreciation, the RBI sells USD and buys INR — the supply of USD increases (pushing the USD/INR rate down) and the supply of INR decreases (pushing the INR up). To prevent appreciation, the RBI buys USD and sells INR — the supply of INR increases and the demand for USD keeps the INR from strengthening. Spot intervention immediately affects the exchange rate and simultaneously affects the domestic monetary base (the rupees the RBI injects or withdraws change bank reserves and the money supply).

Forward Market Intervention: The central bank buys or sells forward contracts rather than spot. The advantage: forward intervention does not immediately affect the domestic monetary base (no rupees are created or destroyed at the time of the forward contract). The central bank can influence the forward rate — particularly important in markets where the forward rate is the primary reference for corporate hedging. The RBI uses forward intervention extensively — selling/buying USD in the forward market and later rolling over or settling the contracts.

FX Swaps: The central bank simultaneously transacts in the spot and forward markets — e.g., buying USD spot (injecting INR) and simultaneously selling USD forward (agreeing to absorb INR in the future). FX swaps allow the central bank to provide dollar liquidity to the market without permanently altering the monetary base. The RBI's "sell/buy swap" — selling USD spot (to support the rupee) and simultaneously buying USD forward (to replenish reserves in the future) — is a standard tool during depreciation episodes. The 2013 FCNR(B) swap scheme — where the RBI offered banks a subsidised swap to attract NRI dollar deposits — was a landmark use of swaps to raise ~USD 34 billion during the Taper Tantrum.

Verbal Intervention / Moral Suasion: Central bank officials make public statements about the exchange rate — expressing concern about "excessive volatility," "disorderly market conditions," or the rate being "out of line with fundamentals." Verbal intervention can move markets when the central bank has credibility — the market believes the words will be backed by action (reserve sales, rate hikes, or capital controls). The RBI's communication has evolved from extreme opacity (the 1990s) to greater transparency — regular post-policy press conferences, publication of intervention data (with a lag), and explicit statements about the exchange rate in the Monetary Policy Statement.

1.3 Sterilised vs. Unsterilised Intervention

This is one of the most important operational distinctions in central bank FX intervention. When the RBI buys USD (to prevent INR appreciation), it credits INR to the banking system — the monetary base expands. Unless the RBI takes offsetting action, this is unsterilised intervention — it increases the domestic money supply, exerts downward pressure on interest rates, and potentially fuels inflation. It is equivalent to expansionary monetary policy.

Sterilised intervention combines the FX operation with an offsetting domestic open-market operation. The RBI sells government securities to banks — absorbing the INR it just injected — leaving the monetary base unchanged. Sterilisation separates exchange rate policy from monetary policy: the RBI can buy USD to manage the exchange rate without expanding the money supply and compromising its inflation target.

The Cost and Limits of Sterilisation: Sterilisation is not costless. The RBI sells government securities (paying interest, typically 6–7%) to absorb INR liquidity created by buying USD (on which it earns interest, typically 2–4%). The sterilisation cost — the gap between the domestic interest rate paid and the foreign interest rate earned — is estimated at 2–3% of the sterilised amount annually. For India's USD 600 billion reserve portfolio, this implies an annual carry cost of USD 12–18 billion. Sterilisation also has operational limits: if the RBI runs out of government securities to sell (or if the banking system becomes saturated with government paper), it cannot sterilise further without creating new instruments (which the RBI has done through Market Stabilisation Scheme bonds).

2. The RBI's Exchange Rate Management — Policy and Practice

2.1 The RBI's Intervention Pattern — Asymmetric and Discretionary

The RBI's de facto exchange rate policy (discussed in Week 5) is implemented through a distinctive intervention pattern:

• Asymmetric intervention: The RBI intervenes much more aggressively to buy USD (preventing INR appreciation, accumulating reserves) than to sell USD (preventing INR depreciation). When capital inflows push the rupee toward appreciation, the RBI absorbs the inflows — it is a price-insensitive buyer of USD, its demand ensuring that the rupee does not strengthen beyond a certain (unannounced) threshold. When outflows push the rupee toward depreciation, the RBI "smoothes" the decline — it sells USD to prevent a rout but does not attempt to reverse the fundamental trend.
• Discretionary, not rule-based: The RBI does not announce a target exchange rate, a target band, or an intervention rule. It intervenes at times and amounts of its choosing — maintaining "constructive ambiguity" to keep speculators uncertain about when and how aggressively the RBI will act.
• Multi-instrument: The RBI intervenes in the spot market, forward market, and NDF (Non-Deliverable Forward) offshore market simultaneously. The NDF intervention — relatively new (the RBI began intervening in the offshore NDF market around 2019–20) — is designed to close the arbitrage gap between onshore and offshore INR rates, which can widen during stress episodes and create a parallel exchange rate.

2.2 Key RBI Intervention Episodes — An Analytical Chronology

2013 — The Taper Tantrum (RBI under D. Subbarao / Raghuram Rajan): The May–August 2013 episode was the most severe test of India's managed float since the 1991 crisis. FPI outflows totalling USD 12+ billion drove the rupee from ~54 to ~68/USD. The RBI's response was multi-pronged: (1) Spot intervention: Sold USD ~15–20 billion from reserves. (2) Liquidity tightening: Raised the Marginal Standing Facility (MSF) rate to 10.25% (300 bps above the repo rate), restricted bank borrowing under the Liquidity Adjustment Facility (LAF), and imposed cash reserve requirements on banks' foreign-currency deposits. (3) Capital controls (temporary and targeted): Reduced the Liberalised Remittance Scheme (LRS) limit from USD 200,000 to USD 75,000 per person per year; restricted gold imports (raising duties and imposing the 80:20 rule — 20% of gold imports had to be re-exported). (4) The FCNR(B) swap scheme: Offered banks a subsidised forward swap (3.5% fixed rate) to mobilise NRI foreign-currency deposits — raised ~USD 34 billion, stabilising the rupee and replenishing reserves. This episode demonstrated that the RBI's exchange rate management extends well beyond simple spot intervention — it encompasses interest rates, capital controls, trade policy (gold), and innovative swap structures.

2018 — Emerging-Market Selloff (RBI under Urjit Patel): The rupee depreciated from ~64 (January 2018) to ~74 (October 2018) against the USD — a 15% decline. Drivers: rising US interest rates (Fed tightening), widening Indian CAD (higher oil prices), and FPI outflows from emerging markets broadly (Argentina and Turkey were experiencing full-blown crises, and India was caught in the broader EM selloff). The RBI's response: sold USD ~25–30 billion from reserves (reserves fell from USD 426 billion in April to USD 393 billion by October), intervened in both spot and forward markets, and allowed the rupee to depreciate (rather than raising rates aggressively to defend it, as in 2013). The 2018 episode reflected the RBI's evolving approach — greater tolerance for fundamentals-driven depreciation, coupled with heavy intervention to prevent a disorderly rout.

2022–2023 — Post-COVID Dollar Surge (RBI under Shaktikanta Das): The US Federal Reserve's aggressive rate hikes (the most rapid tightening cycle in 40 years) drove the USD sharply higher against all currencies. The rupee depreciated from ~74 (January 2022) to ~83 (October 2022). The RBI's response: (1) Sold USD ~100+ billion from reserves (reserves fell from a peak of USD 642 billion in September 2021 to USD 525 billion by October 2022). (2) Intervened heavily in the NDF offshore market to close the onshore-offshore spread. (3) Liberalised capital inflows: expanded the FPI debt limit, raised ECB limits, relaxed NRI deposit rate ceilings. (4) Internationalised the INR: encouraged INR-invoicing of trade, enabled INR settlement through Special Rupee Vostro Accounts (SRVAs) with Russia and other countries. The RBI's approach in 2022 demonstrated a preference for using reserves to smooth depreciation (rather than raising rates aggressively) while actively liberalising the capital account to attract inflows — a "managed adjustment" strategy.

3. FEMA 1999 — India's Foreign Exchange Legal Framework

3.1 From FERA to FEMA — The Regulatory Transformation

The Foreign Exchange Regulation Act (FERA), 1973 was the legal framework governing foreign exchange transactions in India during the pre-reform era. FERA was draconian: all foreign exchange transactions were prohibited unless specifically permitted by the RBI; violations were criminal offences (punishable by imprisonment); the burden of proof was on the accused (you had to prove you were innocent); and the Act reflected the scarcity mindset of an economy with chronic foreign exchange shortages. FERA was a central pillar of the "license-permit raj."

The Foreign Exchange Management Act (FEMA), 1999 (effective June 1, 2000) replaced FERA entirely. FEMA reflected the post-1991 reality: India's foreign exchange position had transformed from scarcity to relative abundance; the economy was substantially more open; and the regulatory framework needed to shift from "control and prohibit" to "facilitate and manage." FEMA's key philosophical shift: all Current Account transactions are permitted unless specifically prohibited; Capital Account transactions are regulated — permitted to the extent specified by the RBI in consultation with the Government. Violations under FEMA are civil wrongs (not criminal), punishable by monetary penalties (up to three times the amount involved).

3.2 Key Provisions of FEMA

3.3 Key Regulatory Instruments Under FEMA — What the Financial Manager Must Know

• ECB (External Commercial Borrowing) Framework: Governed by RBI's Master Direction on ECB. Specifies: eligible borrowers (Indian corporates, NBFCs, infrastructure firms), recognised lenders, permitted end-uses (investment in real sector; prohibited for real estate, capital markets, equity investment), minimum maturity (3 years for most ECBs, 5 years for some categories), all-in-cost ceilings (benchmark rate + spread cap), and the routes (automatic route for most ECB within parameters; approval route for exceptions). For the financial manager, the ECB framework determines: can the firm borrow abroad, in which currency, at what cost, for what purpose, and under what reporting requirements?
• FDI (Foreign Direct Investment) Policy: The Consolidated FDI Policy (issued by DPIIT, Ministry of Commerce) specifies sectoral caps, entry routes (automatic vs. government approval), and conditions. FEMA delegates the operational implementation to the RBI. The financial manager must determine: can a foreign investor acquire equity (and up to what percentage) in the firm's sector? Can the Indian firm issue shares to a non-resident? What are the post-investment compliance requirements (reporting to RBI within 30 days, valuation requirements, pricing guidelines)?
• ODI (Overseas Direct Investment): Governs Indian firms' investments abroad — setting up subsidiaries, JVs, or acquiring foreign companies. The financial limit: ODI up to 400% of the Indian parent's net worth is permitted under the automatic route (recently liberalised). Higher amounts require RBI approval. The ODI framework determines how much capital an Indian MNC can commit abroad and through what structure (equity, loan, guarantee).
• LRS (Liberalised Remittance Scheme): Permits resident individuals to remit up to USD 250,000 per financial year for any permitted Current or Capital Account transaction (overseas education, medical treatment, investment in foreign securities, acquisition of immovable property abroad, gifts, donations). The LRS limit has been progressively liberalised — from USD 25,000 (2004) to USD 250,000 (2015), with a temporary reduction to USD 75,000 during the 2013 Taper Tantrum (since restored).

4. The Anatomy of Currency Crises

4.1 What Is a Currency Crisis?

A currency crisis is a sudden, large depreciation of a currency — typically 20–30% or more within a few months — accompanied by a sharp depletion of foreign exchange reserves, a spike in interest rates (as the central bank attempts to defend the currency), a loss of market access (the country can no longer borrow abroad at tolerable rates), and often a broader financial and economic crisis. Currency crises are not merely large exchange rate movements; they are regime changes — the collapse of the existing exchange rate arrangement and the forced transition to a new, weaker equilibrium.

Terminology Precision:

• Devaluation: An official, deliberate decision by the government/central bank to lower the value of the currency under a fixed (or heavily managed) exchange rate regime. Example: India's July 1991 devaluation — the RBI officially lowered the rupee's value from ~INR 21 to ~INR 26 per USD.
• Depreciation: A market-driven decline in the value of the currency under a floating (or managed-float) regime. No official announcement; the rate simply moves. Example: the rupee's decline from 54 to 68 in 2013 — this was depreciation, not devaluation.
• Revaluation: An official increase in the value of the currency under a fixed regime (the opposite of devaluation).
• Appreciation: A market-driven increase in the value under a floating regime (the opposite of depreciation).

4.2 Three Generations of Crisis Models

Economists have developed successive generations of models to explain why currency crises occur:

4.3 The Anatomy of a Crisis — Seven Stages

While every crisis is unique, most follow a recognisable sequence:

1. Boom / Inflow Phase: The country experiences large capital inflows — attracted by high growth, high interest rates, financial liberalisation, or global risk appetite. The inflows finance a widening CAD, a credit boom, and asset-price inflation (real estate, equities). The real exchange rate appreciates, eroding competitiveness.
2. Vulnerability Build-Up: The inflows create vulnerabilities: the CAD widens to unsustainable levels (5%+ of GDP); external debt rises, particularly short-term debt (maturing within 1 year); the debt is denominated in foreign currency but the borrowers' income is domestic-currency — a currency mismatch; the banking sector's non-performing loans rise (masked by rapid credit growth); reserves appear adequate in absolute terms but are small relative to short-term debt and potential capital outflows.
3. Trigger: A shock — external (global interest rate rise, commodity-price shock, contagion from a neighbouring country's crisis) or domestic (political crisis, sovereign downgrade, revelation of hidden fiscal or banking-sector losses) — triggers a reassessment of the country's risk. One or two large investors withdraw capital; others follow.
4. Sudden Stop (Capital-Flow Reversal): Capital inflows that financed the CAD abruptly stop or reverse. The country must now adjust its external position — it cannot continue importing at the previous level because it cannot finance the imports. The exchange rate comes under severe depreciation pressure.
5. Defence (Central Bank Intervention): The central bank intervenes — selling reserves, raising interest rates — to defend the currency. The defence buys time but at a cost: reserves deplete, domestic economic activity contracts (high interest rates crush investment and consumption), and the banking sector weakens further (borrowers cannot service loans at high rates).
6. Collapse: The defence fails — reserves are exhausted (or the central bank judges that further defence is futile and would merely waste remaining reserves). The exchange rate collapses — a large, discontinuous depreciation (30%, 50%, 100%+). In a fixed-rate regime, the peg is formally abandoned. In a managed float, the central bank ceases intervention and the rate plunges.
7. Adjustment and Aftermath: The depreciation begins the painful process of external adjustment: exports become competitive (boosting export volumes), imports collapse (they become prohibitively expensive in domestic currency), the CAD swings to surplus (or a much smaller deficit). But the balance-sheet damage is severe: firms and banks with foreign-currency debt face insolvency; the banking system requires bailout and restructuring (at massive fiscal cost); the economy enters a deep recession; and the country may require an IMF programme with associated conditionality. Recovery typically takes 2–5 years.

4.4 Early Warning Indicators

No single indicator predicts currency crises reliably, but a constellation of warning signs — particularly when several flash simultaneously — has predictive power:

• CAD exceeding 4–5% of GDP — particularly when financed by portfolio flows (FPI) rather than FDI.
• Short-term external debt exceeding reserves (violation of the Greenspan-Guidotti rule).
• Reserve adequacy declining: Import cover falling below 3 months; short-term debt cover falling below 1×.
• Rapid credit growth (especially real estate and consumer credit) — often a precursor to banking-sector stress.
• Real exchange rate appreciation (REER rising above long-run average) — signalling loss of competitiveness.
• External debt/GDP ratio rising rapidly — particularly when debt is foreign-currency-denominated and the private sector is the primary borrower (sovereign debt crises and private-sector debt crises have different dynamics).
• Political uncertainty / election cycle — markets dislike uncertainty about future policy direction.
• Global risk aversion (VIX index): A sharp rise in the VIX (the "fear gauge") is associated with capital outflows from emerging markets — it is the single most powerful external predictor.

5. Four Currency Crisis Case Studies

5.1 The Mexican Peso Crisis (1994–1995) — "The First Crisis of the 21st Century"

Background: Mexico had stabilised its economy after the 1980s debt crisis through the "Pacto" programme — a crawling peg against the USD, fiscal consolidation, trade liberalisation (NAFTA, effective January 1994), and extensive privatisation. Mexico was hailed as a reform success story. Capital inflows surged — attracted by high Mexican interest rates, the stable peg, and NAFTA-related optimism. The CAD widened to ~7% of GDP by 1994, financed overwhelmingly by short-term portfolio inflows (particularly into Mexican government bonds — tesobonos, which were USD-indexed).

Trigger and Collapse: A series of political shocks in 1994 — the Zapatista uprising in Chiapas (January), the assassination of the PRI presidential candidate Luis Donaldo Colosio (March) — eroded investor confidence. The government resisted devaluation (it was an election year). Reserves fell from USD 29 billion (February 1994) to USD 6 billion (December 1994). On December 20, 1994, the new government widened the exchange rate band (a 15% de facto devaluation). It was insufficient — capital outflows accelerated. On December 22, the peso was floated. It collapsed from 3.4 to ~7.5 pesos/USD by March 1995 — a 55% depreciation in three months.

Consequences: A deep recession (GDP fell 6.2% in 1995), a banking crisis (non-performing loans surged as interest rates spiked and borrowers with USD-indexed debt faced ruinous repayment burdens), and contagion to other emerging markets (the "Tequila Effect" — Argentina and Brazil experienced capital outflows). The US and the IMF assembled a USD 50 billion bailout package — the largest ever at that time. Mexico repaid the bailout ahead of schedule, and the economy recovered — but the social cost (poverty, unemployment, destruction of the middle class's savings) was enormous.

IFM Lessons: (1) Large CAD financed by short-term portfolio flows is a vulnerability even in a "reform success story." (2) Resisting devaluation until reserves are nearly exhausted is a classic policy error — by the time the government acts, the defence has consumed the reserves that could have been used for a more orderly adjustment. (3) Foreign-currency-indexed domestic debt (tesobonos) combined the worst features of foreign-currency debt (exposure to depreciation) and domestic debt (governed by domestic law, harder to restructure). (4) The crisis demonstrated the speed with which capital flows can reverse — from USD 20+ billion of net inflows in 1993 to similar outflows in 1995.

5.2 The Asian Financial Crisis (1997–1998) — Contagion Across the "East Asian Miracle"

Background: The "East Asian Miracle" — Thailand, Indonesia, South Korea, Malaysia, the Philippines — had delivered decades of 7–8% annual GDP growth, driven by export-oriented industrialisation, high savings and investment, and stable (mostly USD-pegged) exchange rates. By the mid-1990s, vulnerabilities had accumulated: (a) The USD pegs had become overvalued as the USD appreciated against the JPY (1995–1997), eroding East Asian export competitiveness. (b) Large short-term foreign-currency borrowing — Thai and Korean banks borrowed USD short-term in the Euromarket and lent long-term in domestic currency for real estate and industrial projects (a double mismatch: currency and maturity). (c) Weak financial regulation — connected lending, poor credit assessment, implicit government guarantees that encouraged excessive risk-taking. (d) The CAD had widened sharply — Thailand's reached 8% of GDP by 1996.

Trigger and Collapse — Thailand (July 1997): Speculators (led by hedge funds, most famously George Soros's Quantum Fund) began shorting the Thai baht in early 1997. The Bank of Thailand defended the peg — selling USD, buying baht, raising interest rates — but reserves fell precipitously (from USD 37 billion to near zero, including forward obligations that were off the central bank's disclosed balance sheet). On July 2, 1997, Thailand floated the baht. It collapsed from 25 to ~56 baht/USD by January 1998 — a 55% depreciation.

Contagion — Indonesia and South Korea: The crisis spread rapidly: Philippines floated the peso (July 11). Malaysia floated the ringgit (July 14). Indonesia floated the rupiah (August 14) — the rupiah collapsed from ~2,400 to ~17,000 per USD by January 1998, the most severe depreciation of any crisis country. South Korea — which had appeared relatively insulated — was revealed to have massive short-term foreign-currency debt (much of it held by Korean banks and chaebol that had borrowed abroad). The won collapsed from ~900 to ~1,700 per USD by December 1997, and Korea was forced into an IMF programme — a national humiliation for a country that had graduated from the developing-country category to join the OECD.

Consequences: The crisis countries experienced the most severe recessions since the Great Depression — GDP fell 13% in Indonesia (1998), 10.5% in Thailand (1998), 6.7% in South Korea (1998). Massive corporate and bank insolvencies; widespread unemployment; social and political upheaval (the Suharto regime fell in Indonesia). The IMF assembled rescue packages totalling over USD 100 billion. The crisis countries recovered — most by 2000–2001 — and the crisis prompted far-reaching reforms: floating exchange rates (the "fear of floating" was replaced by the fear of defending an unsustainable peg), strengthened financial regulation, and reserve accumulation as self-insurance against future crises (explaining the massive reserve build-up by Asian economies post-1998).

IFM Lessons: (1) The third-generation crisis model was essentially invented to explain this episode: the interaction of foreign-currency debt, weak financial regulation, and capital-flow reversal produces a crisis far more severe than macro imbalances alone would suggest. (2) The distinction between solvency and liquidity: Thailand and Korea were arguably solvent (their long-term growth potential was intact) but illiquid (they could not roll over short-term debt). The IMF's initial policy prescription — fiscal contraction and high interest rates in the midst of a financial panic — was controversial and, many argue, deepened the recession. (3) The crisis demonstrated that even "miracle" economies are vulnerable to capital-flow reversal if their financial systems are fragile — strong GDP growth does not insulate against currency crises.

5.3 The Russian Ruble Crisis (1998) — Fiscal Fragility Meets Commodity Shock

Background: Post-Soviet Russia had struggled with fiscal deficits throughout the 1990s — the government could not collect sufficient tax revenue (a dysfunctional tax system, widespread evasion, a barter economy that escaped taxation), and financed the deficit by issuing short-term rouble-denominated treasury bills (GKOs) at very high interest rates. The ruble was managed within a crawling band (the "ruble corridor"). Foreign investors, attracted by extremely high yields (often 50–100%+), poured into GKOs — but the debt was short-term (maturities of 3–12 months), creating a rollover vulnerability.

Trigger and Collapse: The Asian Crisis (1997) triggered an initial round of capital outflows from Russia. The central bank spent reserves defending the ruble band. Then, in 1998, the price of oil — Russia's primary export — collapsed (from ~USD 20/barrel to ~USD 10/barrel), devastating export revenues and the fiscal position. The government's debt rollover became impossible — each week, maturing GKOs had to be refinanced, and foreign investors were increasingly unwilling to roll over. On August 17, 1998, Russia simultaneously: (1) devalued the ruble (wider band, effectively a 30%+ devaluation), (2) defaulted on its domestic GKO debt (a forced restructuring that imposed large losses on both domestic and foreign creditors), and (3) declared a 90-day moratorium on commercial external debt payments. The ruble collapsed from ~6 to ~20 per USD by end-1998. The Russian default triggered the collapse of Long-Term Capital Management (LTCM), a highly leveraged US hedge fund that had massive positions in Russian and other emerging-market bonds — requiring a Fed-orchestrated bailout to prevent systemic fallout in the US financial system.

IFM Lessons: (1) Fiscal fragility — the inability of the government to raise sufficient revenue — combined with a commodity-dependent economy is a recipe for crisis when commodity prices fall. (2) Short-term domestic-currency debt held by foreign investors is vulnerable to the same capital-flow reversal dynamic as foreign-currency debt — because foreign investors can exit rapidly. (3) A simultaneous devaluation, domestic default, and external payments moratorium destroyed Russia's access to international capital markets for years — the reputational cost was enormous.

5.4 Indian Rupee Depreciation Episodes — 2013 and 2018

The 2013 Taper Tantrum: Context: India's CAD had widened to 4.8% of GDP (2012–13) — the highest since the 1991 crisis — driven by high gold imports, elevated crude oil prices, and slowing export growth. The CAD was increasingly financed by FPI debt flows (the "hot money" vulnerability). On May 22, 2013, US Federal Reserve Chairman Ben Bernanke testified to Congress that the Fed could begin tapering its quantitative easing programme "in the next few meetings." The statement triggered a global reassessment of emerging-market risk. FPI outflows from India surged. The rupee depreciated from ~54 (May 2013) to ~68/USD (August 2013) — a 20% decline in four months. The RBI's multi-pronged response — spot and forward intervention (~USD 15–20 billion), liquidity tightening (MSF rate at 10.25%), gold import restrictions, LRS limit reduction, and the innovative FCNR(B) swap scheme — eventually stabilised the rupee. The crisis narrowed the CAD sharply (to 1.7% of GDP by 2014) — partly through import compression, partly through gold import restrictions, and partly through the collapse in global crude oil prices (2014–2016).

The 2018 Episode: Less acute than 2013 but instructive: the rupee depreciated ~15% (from ~64 to ~74) driven by rising US interest rates, higher crude oil prices, and FPI outflows from emerging markets broadly (the "EM selloff" of 2018). The RBI's response was different from 2013: it allowed greater depreciation (reflecting an assessment that the depreciation was partly fundamentals-driven), sold ~USD 25–30 billion from reserves, and did not resort to capital controls or liquidity tightening. The CAD widened but remained under 2.5% of GDP — a more manageable level than 2013.

IFM Lessons from India's Episodes: (1) India's vulnerability to the "Taper Tantrum" demonstrated that even a country with a floating (managed-float) exchange rate is not immune to capital-flow reversal — the managed float cushioned the shock but did not eliminate it. (2) The FCNR(B) swap scheme was an innovative example of using the central bank's balance sheet to attract stable inflows — it demonstrated that crisis response can go beyond standard tools. (3) The 2018 episode demonstrated the RBI's "learning curve" — a shift from aggressive defence (2013) to managed adjustment (2018), reflecting greater confidence in reserve adequacy and the institutional maturity of India's FX market. (4) Both episodes underscore the structural vulnerability created by India's dependence on imported crude oil and the sensitivity of FPI flows to US monetary policy — the two factors that repeatedly interact to create INR depreciation episodes.

6. Scenario Debate: Crisis Preparedness for Indian Firms

Four persona cards. Each group analyses a firm's vulnerability to — and strategy for — currency crises and central bank policy shifts.

7. Fishbowl Debate: Should the RBI Allow the Rupee to Float Freely?

8. Unit 2 Synthesis — Exchange Rate Determinants

Unit 2 has equipped you with the analytical framework to understand, analyse, and (cautiously) forecast exchange rates — the central price in international financial management.

Bridge to Unit 3 (Foreign Exchange Market): Unit 3 moves from the macroeconomic analysis of exchange rates to the microstructure of the market in which they are determined — the FX market itself. You will study the participants, instruments, quotation conventions, and arbitrage mechanisms that make the FX market the largest and most liquid market in the world. The theoretical frameworks from Unit 2 — PPP, IRP, the Fisher Effect — will be applied directly to practical problems: computing spot and forward rates, identifying arbitrage opportunities, and designing hedging strategies.

9. Key Concepts & Terminology — Week 8

10. Session References & Further Reading

Required Reading

• Eun, C., Resnick, B., & Chuluun, T. — International Financial Management, McGraw Hill. Chapter 2: "The International Monetary System" (crisis sections). Chapter 8: "Foreign Exchange Exposure and Management."
• Apte, P. G., & Kapshe, S. — International Financial Management, McGraw Hill. Chapter 6: "Currency Crises and the International Monetary System."

Primary Sources — India

• FEMA, 1999 — The Act and RBI Master Directions. Available at: https://rbi.org.in
• RBI — "Intervention in Foreign Exchange Markets: The Approach of the Reserve Bank of India." BIS Papers No. 73.
• Prakash, A. — "Major Episodes of Volatility in the Indian Foreign Exchange Market in the Last Two Decades (1993–2013): Central Bank's Response." RBI Occasional Papers, Vol. 33, No. 1 & 2, 2012.

Crisis Literature

• Krugman, P. (1979). "A Model of Balance-of-Payments Crises." Journal of Money, Credit and Banking, 11(3), 311–325.
• Obstfeld, M. (1994). "The Logic of Currency Crises." Cahiers économiques et monétaires, 43, 189–213.
• Radelet, S., & Sachs, J. (1998). "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects." Brookings Papers on Economic Activity, 1998(1), 1–90.