Evolution of India's exchange rate regime

Abstract

The paper analyzes the changing INR trends over the reform period, in the context of fundamental determinants of exchange rates. In the early reform years the chief concern was to limit appreciation from inflows, and from higher domestic inflation, given the trade deficit. So short-term nominal depreciation maintained a long-term real fix. But with two-way nominal variation, more objectives can be accommodated. We ask how the exchange rate contributed to three possible policy objectives—maintaining a real competitive exchange rate, neutralizing inflationary oil shocks, deepening foreign exchange markets and encouraging hedging. Depreciation allowed just before oil prices crashed compromised the second objective. Inadequate commitment to two-way movement, prior to the crisis, induced firms to take large currency exposures based on expected appreciation. After the crisis, capital flows were allowed to drive the exchange rate, aggravating inflation and acting against macro stabilization. Markets need some guidance to achieve policy objectives.