We have completed a decade of liberalisation in the foreign exchange market. The exchange rate policy has been fashioned, more specifically after 1992, to enhance the role of market forces without disrupting the basic fabric of the market structure. There has been consistent effort to bring about selective linkage between the global and domestic money markets through the forex market. With these objectives in view over the years operational freedom both to the end users and the intermediaries have been extended
The Onset of Market Determined Exchange Rate
The major change came about in 1992 with LERMS and subsequently unified exchange rate in 1993 when RBI withdrew from fixing daily prices in currency. While the unification of exchange rates and a market determined exchange rate regime was a major step in the liberalisation process there was also progressive liberalisation of transactions both on current and capital accounts. The introduction of the direct quotation system in 1993 and the termination of RBI announcing it's buying and selling rates in 1995 were important miles stones in moving towards a market determined exchange rate.
The dilemma posed to the policy makers was to manage volatility without deviating from the path of market development.
How RBI as Market Regulator Dealt with Volatalities in Exchange Rate Movement
RBI's response to volatile exchange rate movements has been a combination of monetary policy and administrative measures together with intervention. A significant change in approach was made in 1998 following the sharp volatility experienced in international markets. The provisions, which allowed incentives for speculation to end-users and intermediaries, were identified and withdrawn. The focus of operation shifted directly from intervening in the market to identifying those demands that could rectify the imbalance viz. oils payments and bunched demands were smoothened by RBI. The RBI does not target any exchange rate or resist fundamentals. Thus leads and lags have become the major focus of exchange rate management. The RBI's operations have all along aimed at evening out the imbalances and smoothening the process of two-way changes. The market has developed greater strength, has become much deeper and liquid, credibility of the currency has enhanced in the eyes of the global players and greater confidence in the system among investors. The entire spectrum of relaxations which were temporarily withdrawn have been more or less restored. The Central Bank and the market participants are exploring issues at the frontiers and I do hope that tomorrows' deliberations will be constructive and enable us to jointly forge ahead.
A careful analysis of the RBI's stance would reveal the balance it had to establish between freedom on flows in the capital account and the need for increasing the degree of operational freedom to the market participants. The objective was to ensure efficient price discovery mechanism reflecting the economic fundamentals not distorted by the speculative instincts of a few. The issue of volatility is not the preoccupation of only the RBI. As recently as 20th September 2002 the Bank of England Governor stated and I quote -
"The recent volatilities seen in the financial markets are frustrating. The movements are disjointed from the economic fundamentals."
Earlier in the year in the context of the USD gyrations US Treasury Secretary stated :
"...The people who benefit from roiling the world currency market are speculators and as far as I am concerned they provide not much useful value."
RBI had to craft a careful strategy to address the elements of speculation without injuring the genuine interests of the market players. The endeavour to develop a deep and liquid market reflecting domestic and global realities within our constraints has been preserved
The market today provides freedom for risk management, freedom for asset substitution, freedom for taking limited view on rates by corporates without foreign currency exposures, freedom for anticipatory cover. The basic philosophy around which the market has been built is that any entrant to the market must have an underlying exposure. As stated by the Reserve Bank Governor, today we can look back at the developments with a reasonable degree of satisfaction.
The issue of capital account convertibility (CAC) is discussed in the second part of the speech and covered in the next article.
Observations made by the then Governor of RBI, Dr.Bimal Jalan about the policy of exchange rate management by RBI are appropriate in this context and are quoted here below:
"......what should be the correct or right policy stance for the management of exchange rate in India in the present environment? In RBI’s periodic credit policy statements, as well as other public statements, RBI has highlighted the main pillars of its strategy for the management of the exchange rate. These are: RBI does not have a fixed "target" for the exchange rate which it tries to defend or pursue over time; RBI is prepared to intervene in the market to dampen excessive volatility as and when necessary; RBI’s purchases or sales of foreign currency are undertaken through a number of banks and are generally discrete and smooth; and market operations and exchange rate movement should, in principle, be transaction-oriented rather than purely speculative in nature.
"It is perhaps fair to say that the actual results of the exchange rate policy followed by the RBI, since the Asian crisis in particular, have been highly positive so far. In addition to sharp increase in reserves and generally "orderly" movements in exchange rates with lower volatility, the confidence level of domestic and foreign investors in the Indian external sector policies is strong. India’s policies have also been described by the IMF as being "comparable to the global best practices" in a recent study of 20 select industrial and developing countries. Interestingly, a leading global news agency, in an international journal, has recently described India’s currency model as being "ideal" for Asia. India is now one of the very few developing countries which has set up its own clearing house for dollar-rupee transaction with the concurrence of the Federal Reserve System, New York"
[Quoted from the speech of Dr.Bimal Jalan, then Governor, RBI, delivered on August 14, 2003 at 14th National Assembly of Forex Association of India]