Exchange Rate Flexibility

Exchange Rate Flexibility

News: The International Monetary Fund (IMF) has recently reclassified India’s exchange rate regime from “floating” to “stabilized arrangement”. It was due to the rupee’s narrow trading range between 80.8 and 83.4.

What are the different views of the IMF and the Indian authorities on India’s foreign exchange rate regime?
• IMF: The IMF believes India should prioritize exchange rate flexibility to absorb external shocks. It suggests that foreign exchange interventions should be limited to situations of disorderly market conditions. It has been instrumental in India’s economic resilience, allowing for more effective management of high capital inflows and market fluctuations.
• India: Indian authorities believe that India’s exchange rate stability reflects improvements in India’s external position and that interventions have been used to prevent excessive volatility.

Key Findings by IMF:
• Foreign Exchange Reserves has reached a record high of $606.8 billion due to the capital inflows.
• Financial sector has become stable and resilient with sustained bank credit growth, low non-performing assets, and enough capital buffers. The sector remains strong and largely unaffected by global financial stress in early 2023.
• Employments have exceeded pre-pandemic levels, and despite the ongoing dominance of the informal sector, there has been progress in formalizing the economy.
• However, India’s current account deficit widened in FY23 due to the post-pandemic recovery in domestic demand and temporary external shocks.
• High public debt is a worrying sign.

Key recommendations given by IMF:
• Monitor financial stability and address arising vulnerabilities.
• Better regulatory and supervisory standards and need for public banks to strengthen financial reserves
• Need for structural reforms to reap India’s demographic growth

Important Terms
• A Floating Exchange Rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate. If the demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower.
• A Stabilized Arrangement is a type of exchange rate regime where the spot market exchange rate remains within a margin of 2% for 6 months or more. This classification implies an exchange rate in the spot market that remains within a 2% margin for six months or more and is not floating. The country’s authorities are willing to maintain the fixed parity through direct intervention.