Has the exchange rate regime changed for the worse?

Over the past few years, the Reserve Bank of India (RBI) has radically altered the nation's exchange rate policy, shifting from a relatively flexible regime to an inflexible one.

- JOSH FELMAN & ARVIND SUBRAMANIAN

Over the past few years, the Reserve Bank of India (RBI) has radically altered the nation's exchange rate policy, shifting from a relatively flexible regime to an inflexible one. This change has been noted by a few commentators, including K.P. Krishnan and Sajjid Chinoy. But by and large it has not received the attention it merits.

This is unfortunate, since the shift has had important implications for the nation's competitiveness, its export performance, economic growth, and external resilience. Consider how.

To understand the radical nature of the current regime, we first need to grasp the policy that long preceded it. Ever since the liberalization in 1991, the RBI has pursued a flexible exchange rate policy.

It never allowed the rate to float completely freely. But it did allow the rate to move as needed.

Essentially, the RBI pursued a three-pronged strategy: (i) Allowing depreciation when capital outflows put downward pressures on the rupee; (ii) allowing appreciation when particularly rapid export and productivity growth created upwards pressure; and (iii) building up reserves during episodes of strong capital inflows.

This policy had two important advantages. First, it allowed the exchange rate to respond to cyclical market forces. This is apparent from Figure 1, which shows developments in the real effective exchange rate, that is, the rate adjusted for differences in inflation between India and its trading partners. One can see that the rate appreciated by 16 percent during the boom from 2002 to 2011, thereby dampening the excess demand and inflation that emerged during this period.