Emerging market economies often face acute challenges in the wake of sudden bouts of market volatility triggered by sharp capital outflows. Managing such turbulence—particularly when macroeconomic fundamentals offer limited support—requires a calibrated mix of conventional and unconventional policy responses. There is rarely a textbook solution to crises of this nature; central banks must deploy all available instruments with agility, while maintaining credible and consistent communication to anchor expectations.
The Genesis of Taper Tantrums
The Taper Tantrums were caused by the statement in May 2013 by Ben Bernanke, the then Chairman of the US Federal Reserve, that the Fed Reserve was considering gradually tapering its quantitative easing programme. The global market reaction was swift and brutal. Capital fled emerging markets to the safe haven of the US, causing virtually all emerging market (EM) currencies to tumble against the dollar. India had the dubious distinction of being one of the so-called “fragile five” – along with Brazil, Indonesia, South Africa and Türkiye – which were worst hit because of their weak macroeconomic fundamentals. For about six months, RBI was engulfed in a ferocious exchange rate defence as the Indian Rupee slid from around ₹58 to ₹69 to the dollar between May and September 2013, a depreciation of nearly 20 per cent in just four months.
Policy Objectives and Instruments
Following the lessons of the Global Financial Crisis (GFC), a view had emerged among central banks that it was possible to assign policy objectives neatly to specific instruments: monetary policy for price stability, macroprudential tools for financial stability, and capital flow measures for exchange rate stability. This framework looks elegant in theory but many pitfalls exist in practice. Experience shows that in the face of a serious exchange rate crisis, emerging market central banks have to deploy their entire policy arsenal – nimbly, creatively and iteratively.
Once this policy orthodoxy is shed, several instruments are available to combat exchange rate volatility: intervention in the foreign exchange market, capital controls, macroprudential measures, monetary policy, and communication. This may look like a luxury of options, but the reality is that none of them is either fully effective or entirely benign.
Forex Market Intervention
The first line of defence is almost always intervention in the foreign exchange market – selling dollars and buying the local currency. RBI did this continuously and, at times, aggressively. One important lesson is that a failed defence is worse than no defence at all. Intervention has to be credible. If markets see the central bank losing reserves while the currency continues to weaken, the central bank forfeits credibility. That can accelerate outflows and set off a self-fulfilling downward spiral.
Foreign exchange intervention often becomes a game of wits between market participants and the central bank. How much should central bank intervene? Does it sell in small dribbles or make one large statement intervention? Should central bank enter early in the trading day or towards the close? There are no textbook answers, but the overriding objective must be to preserve credibility.
Another important point is that exchange rates often overshoot. Sometimes the most uncomfortable policy choice is to do nothing. If fundamentals dictate depreciation, trying to engineer the precise trajectory of the exchange rate can be futile and costly.
Holding foreign exchange reserves is expensive, but emerging markets have learnt that reserves are essential self-insurance. In times of stress, there is no automatic lender of last resort for emerging economies in hard currency. The time-tested truth is that any amount of reserves looks like too much in good times, but too little in bad times.
Capital Controls
RBI also invoked capital controls. Designing capital control is complex and fraught with trade-offs. Should controls apply to inflows or outflows? Should they be price-based or quantity-based? Should they include lock-in periods or exit taxes?
In practice, RBI used a mix of measures: reduced the time allowed to exporters to bring in export proceeds, and required banks and corporates with external borrowings to bring unutilised funds onshore. These steps were aimed at increasing dollar supply and reducing speculative behaviour.
One of the most difficult aspects of exchange rate defence is dealing with speculative dynamics. When a currency is continuously depreciating, exporters delay conversion while importers rush to hedge. These “leads and lags” worsen imbalances and intensify pressure on the currency.
The policy objective, therefore, was to limit the ability of market participants – including banks – to amplify volatility. RBI restricted open foreign exchange positions, reduced trading limits for banks, and tightened rules on forward contracts. The idea was not to suppress the market but to prevent destabilising behaviour in abnormal conditions.
A major risk with capital controls is that policy experimentation itself can be costly. Markets must perceive the central bank as acting decisively and coherently. As someone once remarked, capital controls are like joining the mafia – easy to enter, but very difficult to exit.
Monetary Policy for Exchange Rate Defence
Central banks normally avoid using monetary policy for objectives other than inflation. But crises sometimes force them to do the unthinkable. After four months of an exhausting and exasperating battle with the exchange rate, RBI did the unusual: raised the policy interest rate by a full percentage point. The intention was less about mechanics and more about signalling the RBI’s absolute and undivided commitment to currency stability.
Communication
Finally, communication emerged as a powerful policy tool. Clear, timely and credible communication can shape expectations and influence outcomes. Conversely, hesitant or poorly timed communication can seriously worsen a crisis.
During the taper tantrum, the question most frequently asked was whether India had “enough” reserves. If central bank sounds uncertain, it risks triggering panic. If central bank sounds too confident, it may encourage complacency. The art of central banking lies in navigating this narrow path – conveying resolve without arrogance, realism without alarm.
Crossing the River by Feeling the Stones
Managing the taper tantrum was ultimately less about elegant models and more about judgement under pressure. The real challenge was not choosing the right instrument, but knowing when to act, when to pause, and how to maintain credibility when every option is imperfect.