An exchange rate regime is a system that a country adopts to determine the value of its currency relative to other currencies. The two primary exchange rate regimes are the fixed exchange rate and the floating exchange rate. This discussion focuses on the fixed exchange rate regime with a specific focus on its application and implications in India.
What is a Fixed Exchange Rate?
A fixed exchange rate (or pegged exchange rate) is a regime where a country’s currency value is tied or pegged to another major currency, a basket of currencies, or a commodity such as gold. Under this system, the exchange rate is maintained at a set value, and the central bank actively intervenes in the foreign exchange market to maintain this fixed rate.
Mechanism of Fixed Exchange Rate
- Pegging to a Currency: In a fixed exchange rate system, the value of the local currency is pegged to a foreign currency, such as the US Dollar (USD), or to a basket of major currencies.
- Central Bank Intervention: The central bank maintains the fixed exchange rate by buying and selling its own currency in exchange for the foreign currency to which it is pegged. This ensures that the currency remains within a narrow band around the set exchange rate.
- Foreign Exchange Reserves: To defend the peg, the central bank must hold sufficient foreign exchange reserves. If the domestic currency is under pressure to depreciate, the central bank will sell its foreign reserves to buy its currency and maintain the fixed rate.
Historical Context: Fixed Exchange Rate in India
India has historically used different exchange rate regimes, including fixed exchange rate systems at various points in time.
1. The Bretton Woods System (1947-1971):
- Background: After gaining independence in 1947, India adopted the Bretton Woods system, where the Indian Rupee (INR) was pegged to the British Pound (GBP). The Bretton Woods system itself pegged the US Dollar (USD) to gold and other currencies, including the INR, to the USD or GBP.
- Fixed Rate: During this period, the INR was pegged at a fixed rate of ₹13.33 to 1 GBP.
- Central Bank Role: The Reserve Bank of India (RBI) managed this fixed exchange rate by intervening in the forex market, maintaining the peg, and using its foreign exchange reserves to stabilize the currency.
2. Post-Bretton Woods (1971-1991):
- Background: With the collapse of the Bretton Woods system in 1971, India moved to a regime where the INR was pegged to a basket of currencies, including the USD, GBP, Deutsche Mark, and Japanese Yen.
- Managed Peg: Although the peg was no longer to a single currency, the INR’s value was still maintained within a narrow band through RBI intervention.
- Economic Challenges: The fixed exchange rate system became increasingly difficult to maintain as India faced balance of payments crises, leading to a depletion of foreign exchange reserves.
Advantages and Disadvantages of Fixed Exchange Rate
Advantages:
- Stability in International Trade:
- Explanation: A fixed exchange rate provides stability and predictability in international trade. Businesses can plan their international transactions with confidence, knowing that exchange rate fluctuations are minimal.
- Example: During the fixed exchange rate era, Indian exporters could price their goods in foreign markets with certainty, knowing that the INR value relative to foreign currencies would remain stable.
- Control Over Inflation:
- Explanation: By pegging the currency to a strong and stable foreign currency, the country can import price stability and control inflation.
- Example: If the INR were pegged to the USD, a stable USD could help keep inflation in check in India, as the cost of imports would remain stable.
- Avoidance of Speculative Attacks:
- Explanation: In theory, a fixed exchange rate regime reduces the likelihood of speculative attacks on the currency, as the central bank commits to maintaining the peg.
- Example: Speculators might be deterred from betting against the INR if they know the RBI is committed to defending the currency at a fixed rate.
Disadvantages:
- Loss of Monetary Policy Autonomy:
- Explanation: In a fixed exchange rate system, the central bank’s ability to conduct independent monetary policy is limited because it must prioritize maintaining the peg over other economic objectives, such as controlling inflation or stimulating growth.
- Example: If the RBI had to maintain a fixed exchange rate, it might not be able to lower interest rates during a recession if doing so would put downward pressure on the INR.
- Vulnerability to External Shocks:
- Explanation: A fixed exchange rate can make a country vulnerable to external shocks, such as sudden changes in the value of the currency to which it is pegged.
- Example: If the INR were pegged to the USD and the USD suddenly appreciated due to global economic conditions, Indian exports could become more expensive and less competitive, harming the Indian economy.
- Pressure on Foreign Exchange Reserves:
- Explanation: Maintaining a fixed exchange rate requires large foreign exchange reserves. In times of economic stress, these reserves can be quickly depleted, leading to a crisis.
- Example: In the late 1980s and early 1990s, India’s fixed exchange rate regime contributed to a balance of payments crisis, as the RBI’s foreign exchange reserves were rapidly depleted trying to maintain the peg.
Example Scenario: India’s 1991 Balance of Payments Crisis
- Background: By 1991, India was facing a severe balance of payments crisis. The country had a fixed exchange rate regime with the INR pegged to a basket of currencies. However, the fixed exchange rate became unsustainable due to mounting external debt, fiscal deficits, and a sharp decline in foreign exchange reserves.
- Crisis: As India’s foreign exchange reserves dwindled to just a few weeks’ worth of imports, the RBI struggled to maintain the fixed exchange rate. The government was forced to airlift gold to pledge it as collateral for loans, but this was not enough to stabilize the economy.
- Solution: In July 1991, the Indian government, under Prime Minister P.V. Narasimha Rao and Finance Minister Dr. Manmohan Singh, decided to abandon the fixed exchange rate regime. India moved towards a more flexible exchange rate system, initially adopting a dual exchange rate regime and later transitioning to a managed floating exchange rate.
- Outcome: The move to a flexible exchange rate, combined with economic liberalization, helped stabilize the Indian economy. The INR was allowed to depreciate, which made Indian exports more competitive and attracted foreign investment, eventually restoring India’s foreign exchange reserves.
Conclusion
A fixed exchange rate regime offers stability and predictability, which can be beneficial for trade and inflation control. However, it also comes with significant risks, including the loss of monetary policy autonomy, vulnerability to external shocks, and pressure on foreign exchange reserves. India’s experience with fixed exchange rates, especially during the 1991 crisis, highlights the challenges of maintaining such a system in the face of economic difficulties. The shift towards a more flexible exchange rate regime allowed India to better manage its currency and respond to global economic conditions.
