Unshackling the Indian Rupee

Recent reports have highlighted the Reserve Bank of India's (RBI) active intervention in managing the rupee's exchange rate against the US dollar, which has raised concerns among economists and market participants. This shift from a flexible exchange rate policy to more active currency management has been described as problematic, as it may distort market signals and hinder economic growth.

Distortion of Market Signals

• Interventionist Currency Policy: The RBI's active role in buying and selling dollars to control the rupee's value has led to a significant reduction in exchange rate volatility, with the rupee-dollar volatility falling from an average of 5% to just 1.9% since 2023.
• Economic Principles at Stake: The move to fix the exchange rate goes against the fundamental economic principle that prices should be determined by market forces, not state intervention. In a market economy, the price system conveys crucial supply and demand information.
• Historical Lessons from Fixed Exchange Rates: India’s pre-1991 experience with fixed exchange rates led to significant economic distortions, including shortages of goods and foreign exchange, ultimately contributing to the 1991 economic crisis. Many emerging economies have since moved away from such systems.

Theoretical vs. Practical Implications

• Flexible Exchange Rate Advantages: Under the previous system, a flexible exchange rate helped to smooth out economic cycles. The rupee's appreciation during periods of growth helped prevent overheating, while depreciation during downturns supported exports and economic recovery.
• Real Exchange Rate Impact: The new policy has led to a real appreciation of the rupee, making Indian exports more expensive and potentially harming India's export-driven growth strategies, including the "Make in India" initiative.
• Shift from a Working System: The shift to an inflexible exchange rate system has undone a functioning, flexible mechanism that allowed for natural adjustments, leading to better long-term economic stability and competitiveness.

Transparency and Market Uncertainty

• Lack of Clear Communication: The RBI has not provided transparency regarding its currency policy, leaving private market participants uncertain about the central bank's intentions and future interventions.
• Market Confusion: The lack of clear guidelines has created confusion about when and how the RBI will intervene, making it difficult for market players to anticipate currency movements and adjust their strategies accordingly.
• Risk of Long-term Economic Costs: Without a clear and transparent policy, the long-term costs of artificially stabilizing the currency could outweigh any short-term benefits, potentially distorting the market and undermining India’s growth ambitions.

Practice Question:

Q. Critically analyze the implications of the Reserve Bank of India’s active intervention in managing the rupee’s exchange rate against the US dollar. Discuss the potential long-term economic costs of such a policy shift for India’s growth trajectory.