EXCHANGE RATE

MANAGEMENT IN INDIA
GROUP-8
ARUNKUMAR K
JAGAN PRAVEEN
KIRTI RANJAN SAHOO
NIYATHI MAUN
SREEJITH MENON
SUDHEER TATIKONDA
VANYA PATHAK

CONTENTS OF STUDY
Introduction
Factors and Exchange Rate Models
Communication as an alternative
policy instrument
Regression Analysis
Conclusions

2.1 : Chronology of the Indian Exchange Rate

Year

The Foreign Exchange Market and Exchange Rate

1947-1971

Par Value system of exchange rate. Rupees external par value was fixed in terms of gold with the
pound sterling as the intervention currency.

1971

Breakdown of the Bretton-Woods system and floatation of major currencies. Rupee was linked to
the pound sterling in December 1971.

1975

1978
1978-1992

1990-1991
July 1991
March 1992

March 1993

To ensure stability of the Rupee, and avoid the weaknesses associated with a single currency peg,
the Rupee was pegged to a basket of currencies. Currency selection and weight assignment was
left to the discretion of the RBI and not publicly announced.
RBI allowed the domestic banks to undertake intra-day trading in foreign exchange.
Banks began to start quoting two-way prices against the Rupee as well as in other currencies. As
trading volumes increased, the Guidelines for Internal Control over Foreign Exchange Business
were framed in 1981. TableThe foreign exchange market was still highly regulated with several
restrictions on external transactions, entry barriers and transactions costs. Foreign exchange
transactions were controlled through the Foreign Exchange Regulations Act (FERA). These
restrictions resulted in an extremely efficient unofficial parallel (hawala) market for foreign
exchange.
Balance of Payments crisis
To stabilize the foreign exchange market, a two step downward exchange rate adjustment was
done (9% and 11%). This was a decisive end to the pegged exchange rate regime.
To ease the transition to a market determined exchange rate system, the Liberalized Exchange
Rate Management System (LERMS) was put in place, which used a dual exchange rate system.
This was mostly a transitional system.
The dual rates converged, and the market determined exchange rate regime was introduced. All
foreign exchange receipts could now be converted at market determined exchange rates.

FACTORS AFFECTING EXCHANGE RATES

Factor

Effect on Domestic
Currency

Interest rate increase

Appreciate

High Inflation

Depreciate

Trade surplus

Appreciate

Public debt increase

Depreciate

Improved Terms of trade

Appreciate

Current account deficits

Depreciate

Table 2.2: Reserve Banks Intervention in the

Foreign Exchange Market
(US$ billion)

Purchas Sale Net

Outstanding
e
Net Forward
Sales/ Purchase
(end-March)
1995-96
3.6
3.9 -0.3
1996-97
11.2
3.4
7.8
1997-98
15.1 11.2 3.8
-1.8
1998-99
28.7 26.9 1.8
-0.8
1999-00
24.1 20.8 3.2
-0.7
2000-01
28.2 25.8 2.4
-1.3
2001-02
22.8 15.8 7.1
-0.4
2002-03
30.6 14.9 15.7
2.4
2003-04
55.4 24.9 30.5
1.4
2004-05
31.4 10.6 20.8
0
2005-06
15.2
7.1
8.1
0
2006-07
26.8
0.0 26.8
0
2007-08
79.7
1.5 78.2
14.7
2008-09
26.6 61.5 -34.9
2.0
Source : Reserve Bank of India.

EXCHANGE RATE MODELS

The Flexible price monetary model
The Sticky price monetary model
Interest rate Differential model
Hooper and Morton model

MODELLING AND FORECASTING THE EXCHANGE

RATE

COMBINED MODEL ACCOMMODATING

MICRO STRUCTURE THEORY

GOALS OF EXCHANGE RATE MANAGEMENT

IN INDIA
To reduce volatility
Preventing the emergence of destabilizing speculative activities
Maintain adequate levels of reserves
Developing an orderly foreign exchange market
Manage Exchange Rates while considering needs of domestic market also

DETERMINATION OF EXCHANGE RATE

Ex
Rate
Rs/1$

Supply of $ by
Indian exporter

Re appreciates
$ depreciates

Demand for $
by Indian importer
Quantity of $

CONSEQUENCES OF DECLINING RUPEE

Increases the cost of imported goods gold and oil
Inflation increases
Implicit cost of India's foreign debt increases
Value of international investment portfolios changes
Value of international reserves changes
The cost to tourists in terms of the value of their currency changes

COMMUNICATION AS AN INSTRUMENT
Michael Woodford told an audience of central bankers assembled at the federal reserves 2001 Jackson
hole conference that:
successful monetary policy is not so much a matter of effective control of overnight interest rates as of
affecting the evolution of market expectations... [therefore,] transparency is valuable for the effective conduct
of monetary policy

Hours after the September 2001 terrorist attacks, the US federal reserve put out a two sentence
statement:
the federal reserve system is open and operating. The discount window is open to meet liquidity
needs.
Those two seemingly banal sentences had a remarkable calming effect on the US, and by extension, on the
global financial markets. The announcement effect was simply stunning.

Again Mario Draghis famous words that the ECB will do whatever it takes to save the euro
prevented, more than anything else, what many thought was an imminent collapse of the euro.
Both the above are emphatic examples of the potency of central bank communication.

COMMUNICATION IN EMERGING MARKETS

Standard interventions becoming ineffective due to
Larger FX Market Turnover
Rapid market deepening
Table 2.3 : Extent of RBI Intervention in Foreign exchange Market

RBI Intervention in
Foreign exchange Column 2 over 3
Foreign exchange
Market Turnover ($
(in per cent)
market ($ billion)
billion)
1
2
3
4
2002-03
45.6
1,560
2.9
2003-04
80.4
2,118
3.8
2004-05
42.0
2,892
1.5
2005-06
15.8
4,413
0.4
2006-07
26.8
6,571
0.4
2007-08
81.2
12,249
0.7
2008-09P
83.9
12,092
0.7
P: Provisional
Note : RBI Intervention includes both purchases and sales of US dollar by the RBI
Source : Reserve Bank of India.

NEED FOR COMMUNICATION TECHNICALLY

Nonstationarity (whether of the economy or the policy rule)
Learning that is a natural concomitant of such an environment
Non-rational Expectations
Asymmetric information between the public and the central bank.
If one or more of these conditions hold, central bank
communication can matter

COMMUNICATION AND FOREX MARKETS

RBI communication is more effective in FX Markets
Volatility is decreased at both daily and monthly frequencies
Empirical Results
Communication

Daily Volatility

Monthly volatility

Announcement on reserve
requirements

Decrease

Decrease

Higher charges for liquidity

injection

Increase

Higher payments for liquidity

absorption

Decrease

Decrease

More news

Decrease

Speeches

Decrease

Review

Increase

RECENT EXAMPLE : RBI ANNOUNCEMENT ON JULY 15TH

Market perception of likely tapering of US quantitative easing has triggered
outflows of portfolio investment, particularly from the debt segment.
Consequently, the rupee has depreciated markedly in the last six weeks.
Countries with large current account deficits, such as India, have been
particularly affected despite their relatively promising economic
fundamentals.

STEPS TAKEN
The marginal standing facility (MSF) rate is recalibrated with immediate effect to be 300 basis
points above the policy repo rate under the liquidity adjustment facility (LAF). consequently,
the MSF rate will now be 10.25 per cent. Accordingly, the bank rate also stands adjusted to
10.25 per cent with immediate effect.
The overall allocation of funds under the LAF will be limited to 1.0 per cent of the net demand
and time liabilities (NDTL) of the banking system, reckoned as RS.75,000 crore for this purpose.
The allocation to individual banks will be made in proportion to their bids, subject to the overall
ceiling. this change in LAF will come into effect from July 17, 2013.
The reserve bank will conduct open market sales of government of India securities of RS.12,000
crore on July 18, 2013. Details of the securities included for the OMO sale auction will be
announced through a separate press release tomorrow.
The reserve bank will continue to closely monitor the markets, the liquidity situation and the
macroeconomic developments and will take such other measures as may be necessary,
consistent with the growth-inflation dynamics and macroeconomic stability.

FACTORS IDENTIFIED
IDENTIFIED THREE INDEPENDENT VARIABLES:

Inflation

Interest Rates
Current Account
Deficit

Inflation Line Fit Plot

Interest Rate Line Fit Plot

100

exchange rate in us dollar

0

10

Inflation

15

exchange rate in us dollar

50
0

Interest rate

Exchange rate in US dollar

Predicted Exchange Rate in US dollar
Linear (Predicted Exchange Rate in US
dollar)

10 12 14 16 18 20

Exchange rate in us dollar

Predicted Exchange rate in us dollar
Linear (Predicted Exchange rate in us dollar)

RECOMMENDATIONS/SUGGESTIONS
MEASURES BY RBI:
USING FOREX RESERVES
RAISING INTEREST RATES
MAKE INVESTMENTS ATTRACTIVE- EASING CAPITAL CONTROLS

RECOMMENDATIONS/SUGGESTIONS
MEASURES BY GOVERNMENT
GOODS AND SERVICES TAX (GST), DIRECT TAX CODE (DTC)
FDI
DIESEL DECONTROL AND MEASURE TO INCREASE
EXTERNAL COMMERCIAL BORROWINGS (ECB)

THANK YOU