The Indian rupee rose sharply against the dollar last week. And the Reserve Bank of India (RBI) said that foreign exchange reserves were at a record $392.86 billion at the end of July. These developments should be seen against the backdrop of a very comfortable balance of payments situation, thanks to a combination of strong capital inflows and narrowing current account deficit.

Most of the traditional indicators of the real effective exchange rate suggest that the Indian rupee is overvalued. What needs to be done? Some have suggested that domestic interest rates need to be cut sharply to prevent further appreciation of the rupee. The Indian central bank should use interest rate policy to target inflation. Sterilized intervention in the foreign exchange market is a better tool to deal with the exchange rate challenge.

The increase in foreign exchange reserves—which went up by over $1.5 billion in the week ended 28 July—shows that the central bank has been buying dollars to keep the rupee down. It should continue to do so.

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