Demystifying exchange rate management - Outside View by S.S. TARAPORE

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Demystifying exchange rate management
Aug 25, 2015

The exchange rate of a currency is the rate at which it can be converted into another currency, essentially an international currency. The issue of the exchange rate comes up from time to time and a common man is often left bewildered at the intricacy of the subject. Cutting across the erudite complexities of exchange rate fixation is a rather naive question, which when one reflects is a very pertinent question; Why is not one US dollar equal to one British pound equal to one Indian rupee? If this was so, life would be simple but unfortunately, this cannot be so as the exchange rate is meant to reflect the relative strengths of different economies. The relative exchange rates reflect the macroeconomic performance of each country and a host of other parameters, in particular the relative inflation rates. In an increasingly globalised economy, developments in one country affect other countries. Again, some matters relating to the exchange rate impinge on the common man and as such there is much merit in fleshing out the core issues in a simplified manner. In this context, it is useful to discuss the historical evolution of the exchange rate of the Indian rupee over time.

Historical background

When the British Empire held sway over the world, the value of the British pound was expressed in terms of gold and countries like India had a fixed exchange rate vis-a-vis the British pound. As Britain, and other major currencies abandoned the Gold Standard in 1913, a period of intense turbulence emerged in international currency markets. There was an attempt to return to a Gold Standard in 1931, but this broke down within a short period. Later, the US dollar was pegged to gold and other major currencies had a fixed relationship with the US dollar. In the case of India, from 1926 to 1966, the exchange rate set by India was one pound equal to Rs 13.33.Even when the pound devalued its exchange rate in 1949, the rate of one pound equal to Rs 13.33 continued to hold. After the devaluation of the pound in 1949, India's exchange rate vis-a-vis the US dollar was US $ 1 equal to Rs 4.76.

Between 1949 and 1966, the US $-rupee rate remained unchanged as the pound - US $ rate remained fixed. But during this period, India experienced recurring foreign exchange crisis and a rigorous system of import control was instituted. To enable holding the exchange rate, an intricate maze of import entitlements and subsidies for exports was introduced and this was progressively intensified. As the system was breaking down, in June 1966 the pound-rupee peg was altered from Rs 13.33 to Rs 21 to the pound and this translated to a US$1 equal to Rs 7.50. When the pound was devalued in 1967, the rupee did not follow sterling and therefore appreciated to one pound equal to Rs 18 but the rate of US $ 1 equal to Rs 7.50 remained unchanged. When there was a cataclysmic change in 1971 with the US $ being delinked from gold, the rupee appreciated temporarily to US $ 1 equal to Rs 7.27. Through the decade of the 1970s, the Indian rupee showed small movements and from the 1980s there was a gradual depreciation of the rupee and the rupee was meant to be linked to an undefined basket and as such the movements could not be deciphered. With the foreign exchange crisis intensifying in 1990-91, there were two quick devaluations of the rupee on July 1 & 3, 1991- popularly known as two haircuts in three days amounting to around 20 per cent. In March 1992, there was a move to a dual exchange rate, one a fixed rate and the other a market rate and in March 1993, there was a unification of the exchange rates to what was deemed to be a market determined rate.

The RBI has two Real Effective Exchange Rates (REERs), first a 6- country index and second a 36-country index, both adjusted for inflation rate differentials. In the first half of the 1990s, the RBI explicitly followed the 6-country index but later moved away from such an explicit acceptance. At the unification of the exchange rate in March 1993, the nominal US $-rupee rate settled at Rs 31.37 and after 1995, it showed clear signs of a gradual depreciation. The latest nominal rate, as of August 18, 2015, was US $ 1equal to Rs 65.32.

Future movement of the exchange rate

What should be the future movement of the exchange rate? The REER for July 2015 shows an appreciation of 12 per cent on the 36-country index and a 25 per cent appreciation on the 6-country index. Looking at it differently, the long-term inflation rate differential between 1993 and now of 5.5 per cent per annum would require the US dollar- rupee nominal rate to be around US $ 1 equal to Rs 71. The exchange rate often becomes an emotional issue as depreciation is considered a failure of the authorities. It is necessary to recognise that the appropriate exchange rate is also contingent on conditions outside the control of the Indian authorities and as such it is an international adjustment process. The recent depreciation of the Chinese yuan would predictably accentuate the existing depreciation of the REER and this should justify the further depreciation of the rupee. An overvalued exchange rate is damaging to the economy as it adversely affects micro, small and medium industry which is export intensive. There is an erroneous view that a depreciation of the exchange rate should not be allowed to take place as it would generate inflationary pressures. It needs to be recognised that correction of the exchange rate strengthens the macroeconomic indicators and would eventually be consistent with a strong anti-inflationary monetary policy.

Please Note: This article was first published in The Freepress Journal on August 24, 2015. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


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