India’s exchange rate system has undergone significant changes over the decades, shifting from its historic link with the British Pound to adopting a more market-driven approach.
This article unpacks the key milestones in this evolution, explains the factors that influence currency value, and sheds light on the IMF’s recent classification of India’s exchange rate regime.
By the end, you’ll have a clear understanding of how global trade, inflation, and investments impact the rupee.
Q: What was the initial link of Indian currency with other currencies?
A: The Indian rupee was historically tied to the British Pound Sterling until 1948. This link had been fixed since 1928.
Q: What change occurred after the IMF was established?
A: After the creation of the IMF, India adopted a fixed currency system. The rupee’s value was maintained in terms of gold or the US dollar. In 1948, ₹3.30 was set as equal to 1 US dollar.
Q: When did India delink the rupee from the British Pound?
A: In September 1975, India separated the rupee from the British Pound. The Reserve Bank of India (RBI) began determining the rupee’s value based on the movements of a basket of global currencies, including the Pound (£), Dollar ($), Yen (¥), Deutsche Mark (DM), and French Franc (Fr). This system was a middle ground between fixed and floating exchange rates.
Q: When did India move to a floating currency system?
A: In the 1992–93 financial year, India shifted to a floating currency system. The method used was called the ‘dual exchange rate’.
Q: What is an exchange rate?
A: An exchange rate is the value at which one currency can be exchanged for another. For example, it shows how many rupees are needed to buy a dollar or a euro.
Q: Why do exchange rates matter?
A: Exchange rates are important because when we buy goods or services from other countries—like an American car or a Swiss vacation—we first need to exchange our rupees for the foreign currency. This process determines how much we pay for these international goods and services.
Q: What are the two types of exchange rates for the rupee?
A: The two exchange rates for the rupee are:
- The ‘official rate’
- The ‘market rate’
Q: How do the market and official exchange rates interact?
A: The market-based exchange rate, which changes daily, impacts the official exchange rate. However, the reverse is not true.
Q: Can the RBI intervene in the foreign exchange market?
A: Yes, the RBI can influence the forex market by adjusting the supply and demand of the rupee or foreign currencies.
Q: Do countries allow their currencies to float freely without intervention?
A: No, no economy has implemented a completely free-floating exchange rate system. Some level of intervention is needed because the foreign exchange market is highly speculative.
IMF’s Observation On India’s Exchange Rate
In December 2023, the International Monetary Fund (IMF) reclassified India’s exchange rate regime from a “floating” system to a “stabilized arrangement.” This classification emerged during the IMF’s Annual Consultation with India under Article IV, which is part of its regular surveillance of member economies.
The IMF’s remark can be interpreted as a critique of the Reserve Bank of India’s (RBI) approach to managing the rupee’s exchange rate. It suggests that the RBI’s “excessive management” has kept the rupee within a narrow range, likely in response to recent global market volatility.
Q: What determines the relative value of one currency against another?
A: The value of a currency depends on its demand. If Indians demand more US dollars than Americans demand Indian rupees, the exchange rate shifts in favor of the US dollar, making it more valuable and costly.
Q: What happens if the demand for the US dollar continues to exceed the demand for the Indian rupee?
A: If this trend continues, the US dollar becomes stronger, and the rupee weakens in comparison. This is reflected in a weakening exchange rate of the rupee against the dollar.
Q: How does trade in goods impact the exchange rate between two currencies?
A: If one country, like India, imports more goods from another country, such as the US, than it exports, the demand for the US dollar will rise compared to the Indian rupee. This increases the value of the US dollar, making the rupee weaker.
Q: How does trade in services influence currency demand?
A: If people in India spend more on services from the US, like education or software, than Americans spend on Indian services, the demand for the US dollar will surpass the demand for the rupee. This causes the rupee to weaken against the dollar.
Q: How do investments affect currency exchange rates?
A: If more Americans invest in India than Indians invest in the US, the demand for the rupee will increase, leading to a stronger rupee relative to the US dollar. Conversely, if investors pull out from India, the rupee weakens.
Q: How can inflation differences between countries affect the exchange rate?
A: Higher inflation in India compared to the US reduces the real return on investments in India. For example, if India has 6% inflation and the US has 0%, investors may find US markets more attractive. This can reduce demand for the rupee, weakening its value against the dollar.