Model Answer
0 min readIntroduction
India operates under a 'managed floating exchange rate' system, a nuanced approach where the exchange rate is primarily determined by market forces (demand and supply) but with active intervention by the Reserve Bank of India (RBI) to curb excessive volatility. This strategy aims to balance market efficiency with stability, protecting the economy from abrupt currency movements that could adversely impact trade, inflation, and financial stability. The RBI, as the custodian of India's foreign exchange reserves, plays a crucial role in maintaining orderly conditions in the foreign exchange market, ensuring that the rupee's value reflects fundamental economic conditions while mitigating speculative pressures.
RBI's Strategy for Exchange Rate Management
The Reserve Bank of India's exchange rate management strategy is guided by the overarching objective of maintaining external sector stability and ensuring orderly conditions in the foreign exchange market. It is not aimed at targeting a specific exchange rate level but rather at moderating volatility. This approach has evolved over time, moving from a fixed exchange rate system to the present managed float.
Key Objectives of RBI's Exchange Rate Management:
- Maintaining Orderly Market Conditions: The primary objective is to prevent excessive fluctuations in the rupee's exchange rate, which can harm trade, investment, and economic stability.
- Containing Volatility: RBI intervenes to smooth out short-term, speculative, or sentiment-driven volatility that does not reflect economic fundamentals.
- Supporting Export Competitiveness: While not targeting a specific rate, the RBI is mindful of the rupee's competitiveness to support exports.
- Inflation Control: Currency depreciation can lead to imported inflation, particularly for crucial commodities like crude oil. RBI intervention can help mitigate this.
- Building Foreign Exchange Reserves: Maintaining adequate foreign exchange reserves acts as a buffer against external shocks and provides confidence to investors.
Tools and Mechanisms of RBI Intervention:
The RBI employs a range of tools to manage the exchange rate:
- Direct Intervention in Spot Market: The RBI buys or sells foreign currency (primarily USD) in the spot market to influence the rupee's value. Selling dollars helps to curb depreciation, while buying dollars can prevent appreciation and build reserves. For example, during periods of strong capital inflows, the RBI might buy dollars to prevent excessive rupee appreciation, sterilizing the rupee liquidity injected through Open Market Operations (OMOs).
- Forward and Swap Operations: The RBI also uses forward contracts and currency swaps (e.g., USD/INR buy-sell swaps) to manage liquidity in the forex market and influence future exchange rate expectations. These are often used for liquidity management rather than direct exchange rate targeting.
- Monetary Policy Tools: Interest rate adjustments can indirectly impact exchange rates. Higher interest rates can attract foreign capital, leading to rupee appreciation, while lower rates can have the opposite effect.
- Capital Flow Management Measures: The RBI, in consultation with the government, can implement measures to regulate capital inflows and outflows to manage their impact on the exchange rate and overall financial stability.
- Verbal Intervention (Forward Guidance): Statements and guidance from the RBI Governor or other officials can influence market expectations and discourage speculative activities.
Recent Changes in India's Exchange Rate Policy
India's exchange rate policy has undergone significant evolution, especially since the economic reforms of 1991. From a fixed exchange rate system, it transitioned through various stages to the current managed float.
Evolution of India's Exchange Rate Regime:
| Period | Regime Type | Key Characteristics |
|---|---|---|
| 1947-1971 | Par Value System (Fixed) | Rupee's external par value fixed in terms of gold, linked to Pound Sterling. Aimed at stability but limited flexibility. |
| 1971-1992 | Pegged Regime (Basket Peg) | Post-Bretton Woods collapse, rupee initially linked to Pound Sterling, then to a basket of major currencies. RBI actively managed the rate within a band. |
| 1992-1993 | Liberalized Exchange Rate Management System (LERMS) | Introduced partial convertibility with a dual exchange rate (40% official, 60% market-determined), a transitional phase. |
| March 1993-Present | Managed Floating Exchange Rate System | Rupee's exchange rate largely determined by market forces, with RBI intervening to manage excessive volatility. Current Account Convertibility achieved in 1994. |
Recent Shifts and the Current Stance (Late 2024 - Early 2025):
In recent times, the RBI's approach has been characterized by a continued commitment to the managed float regime, but with some discernible shifts in emphasis and execution:
- Increased Tolerance for Rupee Movement: While the RBI's stated policy is to curb excessive volatility, there have been instances, particularly in late 2024 and early 2025, where the RBI has reportedly allowed the rupee to depreciate more freely in response to underlying demand for dollars, rather than defending a specific exchange-rate level. This suggests a shift towards allowing market forces a greater role when fundamental factors are clearly pushing the currency in a particular direction, aiming to prevent disorderly movements rather than resisting a trend.
- Focus on Preventing Disorderly Movements and Speculation: RBI Governor Sanjay Malhotra has reiterated that the central bank does not operate with any predetermined band for the rupee. The focus is on preventing extreme swings and speculative pressure, allowing the rupee to find its "correct level" based on market forces. This implies a more hands-off approach unless market conditions become genuinely disruptive.
- Strategic Use of Foreign Exchange Reserves: India's foreign exchange reserves have been a crucial buffer. While the RBI has intervened through dollar sales to cushion rupee depreciation, it has also strategically accumulated reserves during periods of capital inflows. As of November 28, 2025, India's foreign exchange reserves stood at approximately $686.2 billion, providing over 11 months of import cover. This robust reserve position allows the RBI flexibility in its interventions.
- IMF Reclassification: The International Monetary Fund (IMF) recently reclassified India's de facto exchange rate regime from a "stabilized" system to a "crawl-like arrangement" in November 2025. This reclassification suggests that the rupee's exchange rate stays within a 2% band around a trend for at least six months, implying that while not fully floating, it exhibits more flexibility than a truly stabilized system. The IMF's assessment encourages greater exchange rate flexibility for absorbing external shocks.
- Intervention in Offshore Markets: The RBI has also reportedly intervened in the offshore Non-Deliverable Forward (NDF) market, alongside the spot and forward markets, to manage currency dynamics and reduce arbitrage opportunities between onshore and offshore markets.
- Liquidity Management through Swaps: The RBI continues to use tools like USD/INR buy-sell swaps for liquidity management, as evidenced by the $5 billion three-year USD/INR buy-sell swaps announced in December 2025, which the RBI clarified were for liquidity operations and not direct rupee support.
Conclusion
The Reserve Bank of India's exchange rate management strategy is centered on a managed floating regime, aiming to balance market determination with interventions designed to curb excessive volatility. This approach protects the Indian economy from external shocks while fostering an environment conducive to trade and investment. Recent changes highlight a nuanced shift towards greater tolerance for market-driven currency movements, focusing on preventing disorderly conditions rather than defending specific levels. The accumulation of substantial foreign exchange reserves and the strategic use of various intervention tools underscore the RBI's commitment to maintaining macroeconomic and financial stability in an increasingly interconnected global economy.
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