Exchange Rate Systems

Exchange Rate Systems

An exchange rate system refers to the method followed by a country to determine the value of its currency in relation to foreign currencies.

Types of Exchange Rate Systems

Exchange rate systems can be broadly classified into three types:

• Fixed Exchange Rate System
• Flexible or Floating Exchange Rate System
• Managed Floating Exchange Rate System

Fixed Exchange Rate System

• Under a Fixed Exchange Rate System, the central bank fixes the exchange rate which may not have any relation to market forces.
• India had the system till 1992 before trade account convertibility was introduced.

Flexible or Floating Exchange Rate System

• Under a Flexible Exchange Rate System, the exchange rate is determined by the demand and supply of currencies in the foreign exchange market.
• Under this system the central bank of the country never intervenes in the foreign exchange market
• Changes in demand and supply cause the currency to appreciate or depreciate.
  • Demand for Rupee ↑ → Rupee Appreciates
  • Demand for Rupee ↓ → Rupee Depreciates

Managed Floating Exchange Rate System (Dirty Float)

• A Managed Floating Exchange Rate System combines features of fixed and flexible exchange rate systems.
• The exchange rate is largely determined by market forces.
• However, the central bank intervenes in the foreign exchange market when required to manage excessive volatility or disorderly market conditions.

India

• India follows a managed floating exchange rate system.
• For example, if the rupee depreciates sharply against the US dollar, the RBI can sell dollars from its foreign exchange reserves in the foreign exchange market. This increases the supply of dollars and helps reduce pressure on the rupee.
  • Sharp Rupee Depreciation → RBI Sells Dollars → Supply of Dollars ↑ → Pressure on Rupee Reduces
• Similarly, if there is excessive appreciation of the rupee, the RBI can buy dollars from the market.
• The RBI’s intervention is generally aimed at containing excessive volatility and maintaining orderly market conditions, rather than maintaining the rupee at a fixed exchange rate or within a predetermined band.

Evolution of India’s Exchange Rate Policy

• Fixed Exchange Rate Regime: After Independence, India followed a fixed exchange rate system, in line with the Bretton Woods system. The Indian Rupee was pegged to the Pound Sterling, reflecting India’s historical links with Britain.
• 1975: Shift to a Basket of Currencies: After the breakdown of the Bretton Woods System in the early seventies, most of the countries moved towards a system of flexible/managed exchange rates. With the decline in the share of Britain in India’s trade, increased diversification of India’s international transactions together with the weaknesses of pegging to a single currency, the Indian Rupee was de-linked from the Pound Sterling in September 1975. The exchange rate subsequently came to be determined with reference to the daily exchange rate movements of an undisclosed basket of currencies of India’s major trading partners.
• However the basket-linked management of the exchange rate of the Rupee did not capture the market dynamics and the developments in the exchange rates of competing countries fully
• Hence, the Rupee’s external value was allowed to be determined by market forces in a phased manner following the balance of payment difficulties in the nineties.
• 1991: Two Step Adjustment: Following the Balance of Payments crisis, a significant two step downward adjustment of the Rupee was undertaken in July 1991. This marked the beginning of a gradual shift towards a more market determined exchange rate.
• 1992: LERMS: The Liberalised Exchange Rate Management System (LERMS) was introduced in March 1992, creating a dual exchange rate system.
  • 40% of Foreign Exchange Earnings → Official Exchange Rate
  • 60% of Foreign Exchange Earnings → Market Determined Exchange Rate
• 1993: Unified Market Determined Exchange Rate: A unified single market-determined exchange rate system based on the demand for and supply of foreign exchange replaced the LERMS effective March 1, 1993.
• Present Exchange Rate Policy: The Reserve Bank’s exchange rate policy focuses on ensuring orderly conditions in the foreign exchange market. For this purpose, it closely monitors the developments in the financial markets at home and abroad. When necessary, it intervenes in the market by buying or selling foreign currencies. The market operations are undertaken either directly or through public sector banks.