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Capital Flows and Exchange Rate Volatility in India: How Crucial are Reserves?

This paper tests if the adequacy of reserves helps reduce exchange rate volatility in an environment of financial globalization, market-determined exchange rate and macroeconomic imbalances. It exploits the difference in the period after 2010 when India did not accumulate reserves but faced higher capital flow pressures, relative to a previous managed-float period marked by significant absorption of surplus capital flows. Along with other determinants, the sensitivity of rupee volatility is examined. The paper finds that adequate reserve holdings significantly reduce exchange rate volatility irrespective of the exchange rate regime; the effect is more through influence upon market sentiment and confidence than actual intervention. It contributes to existing evidence on the role of reserves in mitigating exchange rate volatility amid capital flow swings and offers insights into the policy environment depicted in the trilemma.