Introduction
An Exchange Rate Mechanism (ERM) refers to a framework of procedures employed to regulate a country’s currency exchange rate relative to other currencies. It forms a critical component of a nation’s monetary policy and is typically administered by the central bank. While exchange rates are largely determined by global market dynamics—primarily the supply and demand of currencies—they are also influenced by a variety of economic factors, such as inflation, interest rates, and geopolitical developments.
This article outlines the structure and functioning of India’s exchange rate mechanism, with particular emphasis on the role of the Reserve Bank of India (RBI) in managing currency volatility and maintaining orderly market conditions.
1. India’s Managed Floating Exchange Rate Regime
India follows a managed floating exchange rate system, wherein the value of the Indian rupee is primarily determined by market forces but is subject to periodic intervention by the RBI. This hybrid approach allows the central bank to moderate excessive currency volatility without adhering to a fixed exchange rate framework.
- Market-Determined Exchange Rate:
The exchange rate is largely governed by the demand and supply of foreign exchange in the market. This mechanism reflects the prevailing macroeconomic conditions and investor sentiment. - Role of the RBI in Intervention:
The RBI actively participates in the foreign exchange market to:- Curb Excessive Volatility: To prevent abrupt or disorderly movements in the rupee’s exchange rate.
- Signal Policy Stance: To indicate the central bank’s monetary or exchange rate policy direction to market participants.
- Maintain Market Stability: To ensure smooth functioning and liquidity in the foreign exchange market.
2. Historical Evolution of Exchange Rate Policy in India
India has gradually transitioned from a fixed to a more market-oriented exchange rate system over several decades:
- March 1993:
The country formally adopted a managed float regime, shifting away from a dual and fixed exchange rate system. - August 1993:
India implemented the direct method of exchange rate quotation, wherein a fixed unit of foreign currency is expressed in terms of the domestic currency (e.g., USD 1 = ₹X). - Prior to 1991 Reforms:
The rupee was pegged to the British Pound and operated under a tightly controlled exchange rate regime, which limited currency convertibility and global market integration.
3. Key Exchange Rate Indicators
To assess the strength and competitiveness of the Indian rupee in global markets, two key indices are used:
- NEER (Nominal Effective Exchange Rate):
Represents the weighted average value of the rupee relative to a basket of foreign currencies without adjusting for inflation. - REER (Real Effective Exchange Rate):
Adjusts the NEER for relative price or inflation differentials between India and its major trading partners, providing a more accurate reflection of the rupee’s real value.
4. Rationale Behind Central Bank Intervention
The RBI undertakes intervention in the foreign exchange market for several strategic and economic reasons:
- To Prevent Real Exchange Rate Misalignment:
Global capital flows can create disequilibrium between the rupee’s real value and underlying economic fundamentals. - To Absorb External Shocks:
Volatile capital movements due to geopolitical events, global financial instability, or fluctuations in the U.S. dollar can adversely impact the domestic currency. - To Preserve Export Competitiveness:
By mitigating sharp appreciation of the rupee, the RBI supports the international competitiveness of Indian exports.
Conclusion
India’s exchange rate mechanism is a well-calibrated mix of market-driven pricing and strategic central bank intervention. The managed floating regime offers flexibility to respond to global economic shifts while ensuring domestic financial stability. Over time, this system has evolved in response to both internal economic reforms and global market developments, enabling India to better integrate with the international financial system.
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