Real Exchange Rate Stabilisation and Managed Floating: Exchange Rate Policy in India, 1993-99

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 bank's 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 author's 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 renuk@icrier.res.in.

I. 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