Exchange Rate Regimes

Exchange Rate Regimes

This article deals with ‘Exchange Rate Regimes .’ This is part of our series on ‘Economics’ which is important pillar of GS-3 syllabus . For more articles , you can click here .

Types of Exchange Rates

1 . Fixed Exchange Rate

  • When the central bank of a country itself decides the exchange rate of local currency to foreign currency .
  • Eg : Consider an imaginary situation where RBI fix exchange rate of 1$ = 10 ₹.  If excess dollars are entering in the market, the RBI will print more ₹ to absorb the excess dollars and if less dollars are entering the market, the central bank will sell the (previously acquired) dollars from its forex reserve to ensure ₹ doesn’t weaken.
  • It was in operational in India upto March 1992 .

Challenge : External Shocks & Fixed Exchange Rate

  • In some situation, if demand of  foreign currency in India increases exponentially, then previous equilibrium which was maintained by RBI will disturb. Initially, RBI will try to stabilize the situation by selling $s from its forex reserve. But, since RBI will not have infinite amount of dollars in its reserve ultimately it will be forced to be devalue ₹.
  • Hence, the biggest drawback of Fixed Exchange rate regime is that it is highly prone to external factors .

Side Note :Devaluation

  • This is used by Central Bank in the Fixed Exchange Rate Economy  to cope with situations as seen above.
  • Implications of above devaluation is as follows 
    1. Demand of foreign currency will decrease because ( say) what work can be earlier done with ₹10 lakh abroad will now need 11 Lakh . So, some people will abandon their plan.
    2. Exports of country will increase because for importer of other country, price of things coming from country which devalued its currency will decrease
1$ = ₹10 1 $ =11 ₹
1 Thumbs Up = ₹10  i.e.  $ 1 1 Thumbs up = 10 ₹ i.e. $ 10/11 

2 . Floating Exchange Rate

  • Central Bank of the country doesn’t intervene at all & exchange rate is determined by the market forces of demand and supply.
  • USA and UK are the major economies following this system
  • But in this case , exchange rate is very volatile .
  • Along with that, this system is also prone to currency speculation .

3. Managed Floating Exchange Rate

  • It is the middle path between the two extremes (floating and fixed).
  • In this, Central Bank will not decide the exchange rate . In the ordinary days, Central Bank will let the market forces of supply and demand decide the exchange rate. But if there is too much volatility, then Central Bank will intervene by buying or selling the foreign reserves to keep the volatility under control.
  • Canada, Japan , India (since 1992–93) etc. follow Managed Floating Exchange Rate.

Exchange Rate in India

1928 to 1948 ‘Rupee’ was linked with the British Pound Sterling .
1948 to 1975 After formation of IMF, India shifted to the fixed currency system and committed to maintain rupee’s exchange rate in terms of gold or the US ($ Dollar).
1975 to 1992 RBI started determining rupee’s exchange rate with respect to the exchange rate movements of the basket of world currencies (£, $, ¥, DM, Fr.) .
1992 India shifted to Managed Floating Exchange Rate .

NEER & REER

We keep on reading in newspaper that ₹ has weakened against $. Does that really mean ₹ is weak currency & has become fragile?  Nope , because US is not the only country we trade with & $ is not the only currency that we use to do all of our transactions

  1. If we want to objectively measure volatility of ₹, we have to compare volatility with multiple currencies .
  2. 1$= ₹50 or 1$ = ₹40 doesn’t decide demand of goods & services between India & USA . This also depend on relative Inflation .

For this we use NEER & REER

1 . NEER

  • Nominal Effective Exchange Rate
  • It is the weighted average of bilateral nominal exchange rates of home currency in term  of foreign currencies.

2. REER

  • Real Effective Exchange Rate
  • Weighted Average  of  nominal exchange rates adjusted for inflation. Hence, it captures inflation differentials between India & its major trading partners .
  • REER  = NEER X ( Indian Inflation (CPI)  / US Inflation ) .

What we get with help of NEER & REER?

  • If REER > 100 : currency is overvalued
  • REER < 100 : currency is undervalued

Trends

Indian ₹ is overvalued (since REER > 100) and according to Economic Survey , this is bad for Indian Exports)

Trends of REER

Purchasing Power Parity (PPP)

  • It is a hypothetical concept that tries to compare exchange rate of two currencies through their purchasing power in respective countries.
  • For example , if 1packet of bread in India costs ₹ 20 whereas it costs $2 in USA then Dollar to Rupee exchange rate (PPP) will be $1 = ₹ 10.
  • According to OECD, in PPP terms  $1=₹ 17 .
  • This exchange rate can happen in real life, if both the countries have Floating Exchange Rate without any intervention of the respective Central banks; and if the bilateral trade is free of protectionism.
  • If we look into GDP of various countries in terms of PPP, then India is the third largest economy of the world. The ranking is 1) USA , 2) China , 3) India , 4) Japan and 5) Germany .

The Great Fall of Indian Rupee

1947 
1990 
48 
2008 
1995 
0-1 $ 
2005 
= Rs conversion 
2018 
civilspedia.com 
2020

Why this happened ?

  • Turkish Currency Crisis : Americans started to sell their bonds and shares from Turkey . This thing spilled over to other ‘Developing economies’ (including India)
  • Capital moving out  because of rising interest rates in US making it more attractive to invest there.
  • In 2019-20 , India rupee continued to weaken towards $1=77₹ because Corona virus pandemic . Due to this,  foreign investors started pulling out money from India and investing in US .

What India did to fight ?

  • FPI investment limits relaxed to attract foreign investors to India .
  • Currency Swap Agreements like with Japan , India has 75 billion $ Currency Swap Agreement.
  • Currency Swap Agreements  with Indian Banks .
  • Agreement with countries like Iran to buy Crude Oil directly in ₹.