CH 22: RBI's INTERVENTION AND FOREIGN EXCHANGE RATE MANAGEMENT
Q1: Discuss RBI's Intervention and foreign exchange rate management in India.
Ans: * INTRODUCTION:
~ India has undertaken various changes regard to its exchange rate management system.
~ These changes have been brought about taking into consideration various changes taking place throughout the world that influence the foreign exchange market.
~ At present, India has adopted the managed flexible exchange rate system that allows government intervention to bring the required stability in the exchange rate.
~ Being a member of the IMF, India followed the exchange rate system as per IMF policy from 1947-1971.
~ Under this policy, the exchange rate was fixed at 4.15 grains of fine gold.It maintained par value at +/- 1% using pound sterling as intervention currency.
~ In 1971, the Bretton Woods system collapsed and Indian rupee was peggedto US$ at Rs 7.50 and sterling at Rs 18.9677 with a 2.25% margin on either side.
~ From 1975 to 1992 Indian rupee was pegged to basket of currencies of India's major trading partners.
~ In 1992, the RBI introduced the Liberalised Exchange Rate Management System (LERMS)with 40-60 dual rates for converting export proceeds.
~ The Budget 1993-94 made Indian Rupee fully convertible on trade account and LERMS was withdrawn. Subsequently, in April 1994, Rupee was made fully convertible on current accountas well. Thus, all transactions of goods and services were converted at market rate without any restrictions.
*DISADVANTAGES OF FLEXIBLE EXCHANGE RATE:
~ Flexible exchange rate has the following negative effects:-
i) It creates uncertainty for exporters and importers as they remain unsure about the amount payable or receivable.
ii) It discourages investment and borrowingsdue to uncertainty and thus hampers economic growth.
iii) Under flexible exchange rate Macro-economic policies lose stability as they become prone to the wild fluctuations in the exchange rate.
iv) Flexible exchange rate may also give rise to irrational speculation that leads to destabilisation of the exchange rate.
v) It also results in poor international co-operationsince each country allows the exchange rate to be determined in the market that does not bind them to co-operate with other nations.
vi) Flexible exchange rate is inflationary in natureas it results in frequent increase in prices due to depreciation of traded goods. Moreover, appreciation of goods does not bring about a parallel reduction in prices.
vii) Under flexible exchange rate, depreciation of a currency may cause structural unemployment especially in developing countries.
~ To minimise these disadvantages, India has adopted the managed flexible exchange rate wherein the RBI selectively intervenes in the market to prevent wide fluctuations.
*EXCHANGE MARKET INTERVENTION:
~ ‘Exchange Market Intervention' is defined as the sale or purchase of monetary authorities with the aim of changing the exchange rate of their own currency vis-a- vis on or more currencies.
~ If there is too much demand for foreign currency, that currency will appreciate too much and depreciate the domestic currency. At this point, the central bank intervenes by releasing the foreign currency (from its reserves) in the market to stabilize the exchange rate.
~ Similarly, if there is too less demand for foreign currency, that currency will depreciate and the domestic currency appreciates too much. At this point, the central bank intervenes by purchasing foreign currency from the market to stabilize exchange rate.
*ARGUMENTS IN FAVOUR OF EXCHANGE RATE INTERVENTION:
i) APPROPRIATE EXCHANGE RATE:
~ The central bank may be in a better position to gather all the relevant information than the other participants in the market. Hence it can appropriately predict the future course of policies and their implications on the exchange rate. So, it can plan its intervention in the market according to the situation and influence the exchange rate. In absence of intervention, the market may indulge in speculation due to lack of accurate information.
ii) CONTROL OVER DISTORTIONS IN ECONOMIC ACTURTIES:
~ Exchange rate which deviate from the real exchange rate (in relation to the purchasing power parity) may lead to distortion in resource allocation between external and domestic sectors.
~ Undervaluation leads to inflationary pressure whereas overvaluation leads to higher rates of unemployment.
~ Either undervaluation or overvaluation brings in uncertainty and affects investment decisions. This can be controlled by intervention of the monetary authorities by making necessary adjustments in the exchange rates.
iii) SMOOTHENS ECONOMIC ADJUSTMENT PROCESS:
~ A persistent surplus or deficit in the balance of payments leads to changes in the exchange rate to correct the disequilibrium.
~ These changes may result in disturbances in the domestic economic activities.
~ Intervention can reduce such disturbances and their effects.
iv) OTHERS ARGUMENTS:
~ Managed flexibility facilitates economic growth due to proper flow of foreign trade.
~ Higher economic growth increases employment and improves the standard of living of the people.
~ Managed flexibility also facilitates higher investment due to growth potential which further boosts the economic growth of a nation.
*RBI AND EXCHANGE RATE:
~ In India, the exchange rate policy at present is guided by principles of monitoring and management based on the underlying demand and supply conditions.
~The following are the objectives of RBI's intervention:
•Determining the exchange rate movements in an orderly manner.
•Reducing excess volatility.
•Preventing the occurrence of destabilising speculation.
~ In order to carry out these objectives, the RBI tries to maintain adequate foreign exchange reserves so that it can conduct the intervention operation.
– CHANGE IN THE EXCHANGE RATE:
RUPEE-DOLLAR EXCHANGE RATE
Rs 45.99 per US dollar
Rupee depreciated by 12.5%
RS 50.062 per US dollar
Rs 46.629 per US dollar
Rupee appreciated by 9.2%
– RBI's INTERVENTION IN FOREIGN EXCHANGE MARKET TO MAINTAIN STABILITY:
– EXCHANGE RATES AND RBI'S INTERVENTION:
MONTHLY AVERAGE EXCHANGE RATE
NET SALE (-)
~ Thus, RBI's intervention majorly depends on the size of foreign exchange reserves. The adoption of full convertibility requires a large amount of foreign exchange reserves for intervention operation.
~ Under globalisation, exchange rate is likely to become highly liberal, thus increasing the responsibility of the central banks.
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