Essay About Real Exchange Rate Stabilisation And Exchange Rate Policy

Real Exchange Rate Stabilisation and Managed Floating: Exchange Rate Policy in India, 1993-99
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Real Exchange Rate Stabilisation and Managed Floating: Exchange Rate Policy in
India, 1993-99
Renu Kohli*
The paper examines the exchange rate management strategy of the Indian central bank after the shift to a
floating exchange rate regime in 1993. A policy reaction function tests for its intervention behaviour and
finds significant effort to lean against the wind during 1993-99. This is tempered with purchasing power
parity considerations as evidenced by the central banks response to deviations of the spot rate from
moving relative prices target. This indicates a real exchange rate stabilisation policy by the Indian
authorities.
Keywords: Exchange rate; intervention; exchange rate management; purchasing power
parity; real exchange rate; managed floating; exchange rate target;
JEL Classification Nos. E 58, F3, F31
The author is employed by the Reserve Bank of India and currently on deputation to ICRIER. The views
expressed here are however, the authors own and not of the institution to which she belongs. The support
of Ford Foundation is gratefully acknowledged. I am grateful to John Williamson, Montek Ahluwalia,
Michael Melvin, Prof. von Hagen, George Stadtman and Sanjib Pohit for helpful comments on an earlier
version of this paper and the excellent research assistance rendered by Richa Samant. The responsibilities
for errors are solely mine. All correspondence to be addressed to the author at [email protected].
Introduction
Economic theory predicts that a floating exchange rate will automatically adjust
balance of payments deficits through variations in the market price of foreign exchange
and insulate the domestic economy from external shocks. Since the authorities do not
have to intervene in the foreign exchange market, monetary policy can be assigned
exclusively to domestic objectives, giving complete monetary policy autonomy. These
propositions however, have been belied by the post-Bretton Woods experience with
freely floating exchange rates. Increased exchange rate volatility, misalignment from
equilibrium levels for long periods, prolonged current account imbalances and a rise in
capital mobility underscored the need to manage exchange rates. This consensus
emerged by 1985 and instances of intervention by respective central banks in support of
weak currencies, or to prevent exchange rate instability, have become fairly common
since. For instance, the Bank of Japan, from mid-1986 onwards rigidly tried to hold on to
the prevailing exchange rate level of the yen and prevent it from sliding downwards; so
did the United States in the 1980s. The Bank of England has been known to
systematically counter depreciation of the effective exchange rate of the pound and its
depreciation vis-Ðo-vis the US dollar. More recent examples include practically all
emerging market economies in Latin America and Asia that have shifted to floating
exchange rate regimes and the European Central Bank.
Likewise, India too is no exception to the concept of dirty floating. It switched
to a floating exchange rate regime in 1993 after a transitional phase of dual exchange
rates for two years. The post-float period is distinguished by remarkable exchange rate
stability, which is contrary to commonly observed experience, as countries that switch
from fixed to floating exchange rate regimes typically experience a rise in exchange rate
volatility. The floating of the rupee has also been accompanied by a rise in the frequency
and scale of intervention by the central bank in the foreign exchange market. These
features inspire the central question that this paper addresses, viz. the exchange rate
management strategy of the central bank. This question is addressed in the paper by
modelling a simple policy reaction function that tests for the intervention strategy of the
Reserve Bank of India between 1993-99. Explicit exchange rate policy objectives, viz.
exchange rate stability and preserving the international competitiveness of the domestic
economy, indicate a real targets approach to exchange rate management by the central
bank. We therefore test for two intervention strategies – leaning against the wind and
minimisation of deviations from a target level for the exchange rate. Using purchases &
sales of foreign currency by the RBI as proxy intervention data, we find its intervention
behaviour is characterised by a significant effort to lean against the wind, tempered with