Syllabus
GS Paper III – Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.
Context
In recent years, the Reserve Bank of India (RBI) has transitioned from a relatively flexible exchange rate regime to a more inflexible one.
Changes in India’s Exchange Rate Regime
Introduction
In recent years, the Reserve Bank of India (RBI) has transitioned from a relatively flexible exchange rate regime to a more inflexible one. This significant policy shift, though noted by a few experts like K P Krishnan and Sajjid Chinoy, has largely gone unnoticed. This oversight is surprising, given the far-reaching implications of this move. The change in the exchange rate regime has profound consequences for India’s economic landscape, affecting factors such as competitiveness, export performance, economic growth, and external resilience.
India’s Evolving Exchange Rate Regime: A Balancing Act
Understanding Exchange Rates
- What is an Exchange Rate? The price of one currency relative to another. It determines the value of goods and services across different countries.
- How are Exchange Rates Determined?
- Flexible Exchange Rate: Market forces of demand and supply dictate the exchange rate. Central banks typically don’t intervene.
- Depreciation: A decrease in the value of a currency.
- Appreciation: An increase in the value of a currency.
- Fixed Exchange Rate: The government sets a fixed exchange rate and intervenes to maintain it.
- Devaluation: A deliberate reduction in the value of a currency.
- Revaluation: A deliberate increase in the value of a currency.
- Managed Floating Exchange Rate: A hybrid approach where the central bank intervenes to influence the exchange rate.
- Flexible Exchange Rate: Market forces of demand and supply dictate the exchange rate. Central banks typically don’t intervene.
RBI’s Strategic Approach
The Reserve Bank of India (RBI) has employed a nuanced approach to managing India’s exchange rate:
- Strategic Intervention:
- Countering Downward Pressure: The RBI intervenes to stem depreciation during periods of significant capital outflow.
- Moderating Upward Pressure: The RBI intervenes to curb appreciation when exports and productivity surge.
- Building Foreign Exchange Reserves: The RBI accumulates foreign exchange reserves during periods of substantial capital inflow.
This strategic approach enables the RBI to balance competing objectives: price stability, economic growth, and financial stability.
India’s Tightening Grip on the Rupee: A Shift Towards Exchange Rate Rigidity
RBI’s Interventionist Stance
- Aggressive Reserve Deployment: The Reserve Bank of India (RBI) has adopted a more assertive approach to managing the rupee’s exchange rate.
- Curbing Depreciation: Since 2019, the RBI has actively intervened in the foreign exchange market, selling substantial foreign exchange reserves to prevent the rupee from depreciating.
- Countering US Monetary Tightening: In response to the US Federal Reserve’s aggressive rate hikes, the RBI divested over $105 billion in foreign exchange reserves between February and October 2022 to stabilize the rupee.
Economic Implications of the Shift
- Eroding Competitiveness: The RBI’s interventionist stance has led to a stronger real exchange rate, making Indian exports less competitive in global markets.
- Real Exchange Rate: The real exchange rate measures the relative price of goods and services between two countries. A stronger real exchange rate implies that Indian goods and services are relatively more expensive compared to foreign products.
- Stagnant Export Growth: The loss of competitiveness has contributed to subdued export growth, with non-oil exports averaging a mere 4.5% annually in dollar terms between 2018-19 and 2023-24.
The Virtues of a Flexible Exchange Rate Regime
Benefits of a Flexible Exchange Rate
- Reduced Reserve Burden: A flexible exchange rate system allows policymakers to maintain lower foreign exchange reserves.
- Automatic Balance of Payments Adjustment: Exchange rate fluctuations can naturally correct imbalances in the balance of payments.
- Economic Resilience: A flexible exchange rate enables the economy to respond to cyclical fluctuations and inflationary pressures.
- Inflationary Pressures: During periods of economic boom, a stronger currency can help curb inflationary tendencies.
- Export Competitiveness: A weaker currency can boost export competitiveness during economic downturns.
- Foreign Exchange Reserve Accumulation: A flexible exchange rate regime can facilitate the accumulation of foreign exchange reserves.
- Crisis Management: A flexible exchange rate can act as a shock absorber during periods of global economic turmoil, such as financial crises or currency panics.
- The Taper Tantrum: The 2013 Taper Tantrum, triggered by the US Federal Reserve’s tapering of its quantitative easing program, highlighted the importance of a flexible exchange rate in managing external shocks.
Challenges of a Fixed Exchange Rate
- Exchange Rate Misalignment: Determining the appropriate exchange rate is a complex and politically sensitive task.
- Fiscal Costs: Maintaining a fixed exchange rate can be costly, as governments may need to intervene in the foreign exchange market to defend the fixed rate.
- Moral Hazard: A fixed exchange rate can create a moral hazard problem, as economic agents may take on excessive foreign exchange risk, knowing that the government will intervene to stabilize the currency.
- Financial Market Development: A flexible exchange rate is essential for the development of sophisticated financial markets, including bond, currency, and derivatives markets.
A flexible exchange rate regime, therefore, offers several advantages over a fixed exchange rate system. It promotes economic stability, enhances policy flexibility, and fosters financial market development.
Balancing Act: A Framework for Exchange Rate Management
The Dilemma: A Delicate Balance
The optimal exchange rate regime is a perennial debate. While a purely flexible system offers numerous benefits, it can also lead to excessive volatility, which can disrupt economic activity and financial stability. Conversely, a fixed exchange rate regime, while providing currency stability, can limit monetary policy autonomy and hinder economic adjustment.
A Framework for Managed Flexibility
To strike a balance between these two extremes, a framework for managed flexibility can be adopted. This framework would involve setting a volatility band for the exchange rate.
- Volatility Band: A range within which the exchange rate is allowed to fluctuate freely.
- Intervention Trigger: When the exchange rate breaches the upper or lower limit of the band, the central bank intervenes to bring it back within the desired range.
Key Considerations for the Framework
- Setting the Band: The width of the volatility band should be determined based on factors such as the country’s economic structure, external shocks, and financial market depth.
- Intervention Tools: The central bank can employ various tools to intervene in the foreign exchange market, such as buying or selling foreign exchange reserves, adjusting interest rates, or using capital controls.
- Communication Strategy: Clear and transparent communication about the exchange rate regime and intervention policies can help to anchor market expectations and reduce volatility.
- Flexibility and Adaptability: The framework should be flexible enough to accommodate changing economic conditions and global shocks.
By adopting a managed flexibility approach, policymakers can aim to achieve a balance between exchange rate stability and economic flexibility. This framework can help to mitigate the risks associated with both pure floating and fixed exchange rate regimes, while promoting economic growth and financial stability.
Conclusion
the RBI’s recent shift towards a more inflexible exchange rate regime, while aimed at mitigating short-term volatility, has long-term implications for India’s economic growth and external resilience. A purely flexible exchange rate regime, while offering benefits like automatic balance of payments adjustment and reduced reserve burden, can lead to excessive volatility. Conversely, a rigid exchange rate regime can hinder economic adjustment and limit monetary policy autonomy. A balanced approach, such as a managed flexibility framework, can provide a suitable middle ground. By setting a volatility band and intervening judiciously, policymakers can aim to achieve a delicate balance between exchange rate stability and economic flexibility.
Related PYQ
Do you agree that the Indian economy has recently experienced V- shapes recovery? Give reasons in support of your answer. [UPSC CSE – 2021 Mains]
Practice Question
Discuss the recent shift in India’s exchange rate policy from a flexible regime to a more rigid one. Analyze the implications of this shift on India’s economic growth, trade balance, and financial stability. [250 words]
Guidelines to Answer the Question
- Introduction:
- Briefly introduce the concept of exchange rate regimes.
- Highlight the recent shift in India’s exchange rate policy.
- State the thesis statement: Discuss the implications of this shift on India’s economy.
- Body:
- Advantages of a Flexible Exchange Rate Regime:
- Automatic adjustment of balance of payments.
- Reduced pressure on foreign exchange reserves.
- Monetary policy autonomy.
- Enhanced economic resilience.
- Disadvantages of a Rigid Exchange Rate Regime:
- Loss of monetary policy autonomy.
- Risk of currency crises.
- Potential for misalignment of the exchange rate.
- Implications of India’s Shift:
- Impact on export competitiveness.
- Effect on domestic inflation.
- Consequences for foreign investment inflows.
- Potential risks to financial stability.
- Advantages of a Flexible Exchange Rate Regime:
- Conclusion:
- Summarize the key points discussed.
- Offer a balanced assessment of the shift in exchange rate policy.
- Suggest potential policy measures to mitigate the negative consequences of the shift.
- Conclude with a forward-looking perspective on India’s exchange rate policy.