Consequences of Changes to exchange rate System In India

Source: The post a flexible exchange rate can help absorb economic shocks by adjusting when bad news occurs has been created, based on the article “Lost a shock absorber: The economy would be more stable if the exchange rate fluctuated more” published in “Business standard” on 13th May 2024.

UPSC Syllabus Topic: GS Paper 3 – Indian Economy -Effects of liberalization on the economy

Context: The article discusses how a flexible exchange rate can help absorb economic shocks by adjusting when bad news occurs.

For detailed information on Exchange rate flexibility is a key shock absorber for India read this article here

What is the role of exchange rate flexibility?

Absorbs Economic Shocks: Exchange rate flexibility allows the currency value to adjust during economic disturbances, reducing impacts on other areas like stock prices and real estate.

Supports Export Competitiveness: When the rupee weakens due to bad news, it makes Indian exports cheaper and more attractive on the global market, helping businesses involved in international trade.

Mitigates Pressure on Financial Markets: By adjusting the currency value, other financial elements like stock and real estate prices face less volatility during economic downturns.

Historical Example: Since late 2022, the rupee has been more controlled, impacting its role as a shock absorber. Before this change, fluctuations in the rupee could respond to international incidents, such as disruptions in the Red Sea, benefiting export sectors.

What are the various policy decisions that have impacted the exchange rate?

Fixed Exchange Rate Implementation: In late 2022, the exchange rate was largely fixed at $82.8 to the dollar, significantly reducing the rupee’s flexibility to respond to economic changes.

Restrictions on Exchange-Traded Derivatives: Starting in early 2024, derivatives could only be used for hedging purposes, limiting speculative activities that affect currency valuation.

Changes to the Liberalised Remittance Scheme: Adjustments in August 2022 and July 2023 tightened controls over capital outflows, impacting the volume and flow of foreign exchange and thus influencing the exchange rate stability.

What are the consequences of recent Indian monetary policies?

Loss of Flexibility: Since fixing the exchange rate at approximately $82.8 to the dollar in late 2022, India has lost a crucial economic shock absorber, leading to less adaptability in handling financial disturbances.

Increased Market Volatility: A controlled exchange rate has exacerbated volatility in financial markets. Notable examples include significant swings in stock prices following the election wins by the Congress party in 2004 and 2009, as the exchange rate remained stable during these times, amplifying the impact on stock prices.

Stagnation in Export Growth: The shift to a more controlled exchange rate regime coincided with a halt in the growth of exports. Specifically, non-oil non-gold exports have been flat at around $55 billion a month starting from 2022, reflecting the challenges of a less flexible exchange system.

Question for practice:

Examine how recent Indian monetary policies have impacted exchange rate flexibility and its consequences on economic shock absorption, export competitiveness, and financial market volatility.