Exchange Rate Determination in India: Understanding the Dynamics of the Floating Rate System
The exchange rate of India's Rupee (INR) is determined by market forces, primarily through supply and demand dynamics. Unlike countries with pegged or fixed exchange rate systems, India transitioned to a floating rate system approximately two decades ago. This means the value of the INR is not determined by a fixed parity with other currencies but is instead allowed to fluctuate based on market conditions.
The Reserve Bank of India (RBI) used to manage the exchange rate through a pegged or fixed rate system, which was discontinued around two decades ago. In a floating exchange rate regime, if the Indian Rupee (INR) were to experience excessive devaluation or appreciation, the RBI may intervene to stabilize the market by buying or selling reserves to maintain the rate within a safe margin. Essentially, there is no single entity or individual 'fixing the rate' of the INR; its value is determined by the market.
Market Forces Driving Exchange Rates
Just like in the stock market, the direction and value of the INR are influenced by the balance of market forces, specifically supply and demand. When the demand for foreign currency outweighs the supply, the foreign currency appreciates against the Indian Rupee, leading to bearish conditions. Conversely, when the supply exceeds demand, the foreign currency depreciates, leading to bullish conditions.
Types of Exchange Rate Regimes
There are two primary regimes for determining currency exchange rates: floating exchange rate regimes and fixed exchange rate regimes.
1. Floating Exchange Rate Regime
In this system, the value of currencies fluctuates based on market forces. For instance, if the RBI has an ample supply of dollars, meaning a high incoming flow of dollars, or if the demand for dollars in the market is low, the dollar will devalue and the rupee will appreciate. Conversely, if the RBI has less dollars due to a higher outgoing rate of dollars for necessary imports, or if the demand for dollars is high, the dollar will appreciate and the rupee will depreciate. Factors such as inflation, interest rates, and economic policies in addition to market demand and supply also influence the exchange rate.
2. Fixed Exchange Rate Regime
In a fixed exchange rate regime, the RBI sets the value of the Indian Rupee. This regime is implemented to manage the exchange rate in relation to other currencies. The RBI might devalue the rupee, for example, from 160 to 170, to boost exports or reduce debt service burdens, or to shrink trade deficits. Occasionally, the RBI may also revalue the rupee upward. The same principles apply to other currencies to determine the exchange rate of the rupee with other currencies.
The Role of the Reserve Bank of India (RBI)
The Reserve Bank of India (RBI) plays a crucial role in managing the currency in India. It also oversees additional responsibilities such as regulating the country's credit system and using monetary policy to establish financial stability. The bank's headquarters are located in Mumbai, India. The RBI gained its authority in currency management based on the Reserve Bank of India Act of 1934, which specifically gives it the authority to issue currency notes. The bank has printing facilities in Dewas, Mysore, and Salboni.
RBI's Limitations and Responsibilities
While the RBI has significant powers in currency management, the government still retains significant control over the Reserve Bank's actions. The government decides which denominations are printed and the design of the banknotes, including security features. The RBI has the right to print currency up to 10,000 rupees. However, if the RBI wishes to print higher denominations, such as 20,000 or 50,000 rupees, the government would need to amend the Reserve Bank of India Act. Additionally, when the RBI estimates the demand for banknotes each year, it must file a written request for approval from the government officials before proceeding with printing. The final decisions are heavily influenced by advice from senior staff at the Reserve Bank.
Historical and Recent Events
A notable event occurred on November 8, 2016, when the Indian government took a surprising measure by discontinuing the 500 and 1000 rupee notes in circulation to curb counterfeiting and corruption. Individuals holding these notes were allowed to exchange them at banks, but by December 2016, banks no longer exchanged these notes. As a result, new 500 and 2000 rupee notes were issued.
Currently, the following denominations and coins are in circulation:
Notes: 5, 10, 20, 50, 100, 500, and 2000 rupee notes Coinage: 50 paise, 1, 2, 5, and 10 rupee coinsThis measure, combined with the RBI's role in managing the currency, underscores the complexities and significance of the exchange rate determination in India.