Exchange Rate Systems & Currency Convertibility

Exchange Rate Regimes • Rupee Movements • REER/NEER • Convertibility • PPP

1. Exchange Rate – Meaning & Economic Role

The exchange rate is the price of one country’s currency in terms of another. Every cross-border transaction—an export of software, an import of crude oil, a student fee payment abroad, a foreign investor buying shares, or a government repaying external debt—ultimately passes through the exchange rate channel.

Because of this, the exchange rate directly affects:

• Trade competitiveness: by changing export and import prices in domestic currency.
• Inflation: via the cost of imported goods (fuel, food, capital goods).
• Capital flows: through expected returns to foreign investors after currency changes.
• External debt burden: since most debt is in foreign currency but income is in domestic currency.
• Monetary policy: interest rate changes influence capital flows and hence the exchange rate.

flowchart TB
  WM[IASNOVA.COM]:::wm
  A["Exchange Rate"]:::root --> B["Trade Competitiveness"]:::n1
  A --> C["Capital Flows"]:::n2
  A --> D["Inflation (Imported)"]:::n3
  A --> E["External Debt Burden"]:::n4
  A --> F["Monetary Policy Transmission"]:::n5

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2. Exchange Rate Systems: Fixed, Floating & Managed Float

Countries choose different exchange rate regimes depending on their economic structure, degree of openness and tolerance for volatility. In practice, no regime is perfect—each is a trade-off between stability and policy autonomy.

2.1 Fixed Exchange Rate System

Under a fixed system, the domestic currency is pegged at a pre-announced rate to another currency (e.g. US dollar) or a basket of currencies or to gold. The central bank must be ready to buy and sell foreign currency to maintain this peg.

• Examples:
  • Hong Kong dollar is linked to the US dollar (currency board arrangement).
  • Some Gulf countries (e.g. Saudi riyal) peg to the US dollar.
• Advantages: High exchange rate stability → predictable trade and investment decisions.
• Costs:
  • Low independent monetary policy (interest rates must broadly follow the anchor country).
  • Pressure on foreign exchange reserves if markets doubt the peg.
  • Vulnerability to speculative attacks if fundamentals are weak.

2.2 Floating Exchange Rate System

In a floating system, the value of the currency is determined entirely by demand and supply in the forex market. The central bank does not commit to maintain any specific level.

• Examples:
  • United States (US dollar).
  • Euro area (euro), United Kingdom (pound sterling).
• Advantages:
  • High monetary policy independence (policy can focus on domestic inflation and growth).
  • Automatic adjustment to external shocks—rates move to correct imbalances.
• Costs:
  • High short-term volatility in exchange rates.
  • Uncertainty for exporters, importers and borrowers.

2.3 Managed Floating Exchange Rate (India’s Choice)

Most emerging economies, including India, follow a managed float: the exchange rate is largely market-determined, but the central bank intervenes to smooth excessive fluctuations. There is no fixed “target” rate, but there is an implicit preference for an orderly path.

• Examples: India (rupee), Indonesia (rupiah), many other emerging market currencies.
• Advantages:
  • Combines benefits of flexibility and stability.
  • Central bank can lean against speculative or panic-driven moves.
• Costs:
  • Requires strong forex reserves and credible policy.
  • Exchange rate may not fully reflect fundamentals if intervention is excessive.

flowchart TB
  WM[IASNOVA.COM]:::wm

  A["Exchange Rate Systems"]:::root --> B["Fixed"]:::n1
  A --> C["Floating"]:::n2
  A --> D["Managed Float"]:::n3

  B --> B1["Pegged to a currency/basket"]:::note1
  B --> B2["High stability"]:::note1
  B --> B3["Low policy autonomy"]:::note1
  B --> B4["Example: Hong Kong, some Gulf states"]:::note1

  C --> C1["Pure market driven"]:::note2
  C --> C2["High volatility"]:::note2
  C --> C3["High autonomy"]:::note2
  C --> C4["Example: US, Euro area"]:::note2

  D --> D1["Market + RBI intervention"]:::note3
  D --> D2["Controls 'excess' volatility"]:::note3
  D --> D3["Balanced autonomy"]:::note3
  D --> D4["Example: India"]:::note3

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3. Rupee Appreciation & Depreciation

A currency is said to appreciate when it becomes stronger relative to another currency, and to depreciate when it becomes weaker. For example, if the rate moves from ₹80 per US$ to ₹78 per US$, the rupee has appreciated. If it moves from ₹80 per US$ to ₹84 per US$, the rupee has depreciated.

3.1 Rupee Appreciation – Economic Effects

• Imports become cheaper: crude oil, electronics, machinery cost less in rupees.
• Exports become costlier in foreign markets: may hurt export competitiveness.
• External debt burden falls: fewer rupees needed to repay each dollar of debt.
• Inflation tends to ease: imported goods become cheaper.

3.2 Rupee Depreciation – Economic Effects

• Exports become more competitive: foreigners pay fewer dollars for the same rupee cost.
• Imports become costlier: increases fuel and input costs.
• External debt burden rises: more rupees needed per dollar of repayment.
• Imported inflation: can feed into general price rise if depreciation is large and persistent.

flowchart LR
  WM[IASNOVA.COM]:::wm

  A["Rupee Movement"]:::root --> B["Appreciation"]:::n1
  A --> C["Depreciation"]:::n2

  B --> B1["Cheaper imports"]:::note1
  B --> B2["Exports lose competitiveness"]:::note1
  B --> B3["Lower inflation"]:::note1
  B --> B4["Lower rupee value of external debt"]:::note1

  C --> C1["Costlier imports"]:::note2
  C --> C2["Exports gain competitiveness"]:::note2
  C --> C3["Higher inflation risk"]:::note2
  C --> C4["Higher rupee cost of external debt"]:::note2

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4. NEER & REER – Conceptual Distinction

Individual bilateral exchange rates (₹–US$, ₹–€) do not capture the full picture for a country that trades with many partners. So, economists use effective exchange rate indices.

• NEER (Nominal Effective Exchange Rate):
  • It is a weighted average of the domestic currency’s bilateral exchange rates with major trading partners.
  • Weights are usually based on each partner’s share in trade.
  • Nominal means it only tracks the movement of exchange rates, without adjusting for inflation.
• REER (Real Effective Exchange Rate):
  • Starts from NEER but also adjusts for inflation differentials between the home country and its partners.
  • It reflects changes in relative price levels along with exchange rates.
  • Therefore, REER is a better measure of external competitiveness.

Think of it like this: if a country’s currency does not move much (NEER stable), but its inflation is much higher than its trading partners, then its goods become relatively expensive. REER will show an appreciation (loss of competitiveness) even when NEER appears flat.

flowchart TB
  WM[IASNOVA.COM]:::wm

  A["Effective Exchange Rates"]:::root --> B["NEER"]:::n1
  A --> C["REER"]:::n2

  B --> B1["Weighted average of
  bilateral nominal rates"]:::note1
  B --> B2["No inflation adjustment"]:::note1

  C --> C1["NEER + inflation
  differential"]:::note2
  C --> C2["Measures real
  competitiveness"]:::note2
  C --> C3["High REER ⇒
  possible overvaluation"]:::note2

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5. Currency Convertibility (Current & Capital Account)

Currency convertibility refers to how freely residents and non-residents can convert domestic currency into foreign currency and vice-versa for different types of transactions.

5.1 Current Account Convertibility

This relates to freedom for day-to-day international transactions:

• Payments for imports and receipts from exports of goods and services.
• Remittances, travel, education, medical treatment abroad.
• Interest payments, dividends and other current transfers.

India has effectively adopted full current account convertibility for residents (subject to some ceilings and reporting for individual remittances). This means that for genuine trade and current payments, there is no major restriction on converting rupees to foreign currency and vice-versa.

5.2 Capital Account Convertibility

This relates to investment and financial transactions:

• FDI, FPI, external commercial borrowings.
• Residents buying foreign assets (equity, property) abroad.
• Non-residents investing in domestic financial assets.

India follows a regime of partial capital account convertibility:

• Capital flows are liberalised more for non-residents investing in India (FDI, FPI under limits).
• Residents’ ability to invest abroad or borrow externally is liberalised but subject to limits and conditions.
• This cautious approach is meant to avoid sudden stops and crises seen in some fully open emerging markets.

flowchart TB
  WM[IASNOVA.COM]:::wm

  A["Currency Convertibility in India"]:::root --> B["Current Account"]:::n1
  A --> C["Capital Account"]:::n2

  B --> B1["Trade in goods & services"]:::note1
  B --> B2["Remittances, travel, education"]:::note1
  B --> B3["Largely fully convertible"]:::note1

  C --> C1["FDI, FPI, ECB, NRI deposits"]:::note2
  C --> C2["Residents' investments abroad"]:::note2
  C --> C3["Partially convertible,
  with limits & controls"]:::note2

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6. PPP vs Market Exchange Rate

The market exchange rate is the rate you see quoted in banks and currency markets. It reflects the outcome of current supply and demand, including trade flows, capital flows, speculation and policy intervention.

The Purchasing Power Parity (PPP) exchange rate is a hypothetical rate that equalises the price of a common basket of goods and services between two countries. It adjusts for differences in price levels and cost of living.

• Market rate:
  • Used for actual trade, investment and financial transactions.
  • Can be influenced by short-term flows and sentiment.
• PPP rate:
  • Used mainly for comparing living standards, GDP across countries.
  • Helps understand whether a currency is broadly undervalued or overvalued in terms of domestic purchasing power.

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7. Exchange Rate Management in India

India’s approach to exchange rate management can be summarised as “managed float with a focus on stability, not a fixed level”. The Reserve Bank does not announce any target rupee–dollar rate, but it actively intervenes to prevent disruptive or panic-driven movements.

• Objectives:
  • Maintain orderly conditions in the forex market.
  • Prevent speculative attacks and self-fulfilling crises.
  • Support export competitiveness without causing runaway imported inflation.
  • Preserve external sector sustainability (BoP, reserves, external debt).
• Instruments used:
  • Direct dollar buying and selling through authorised dealers.
  • Forex swaps and open market operations to manage liquidity impact.
  • Macroprudential measures and capital flow management when needed.

flowchart TB
  WM[IASNOVA.COM]:::wm

  A["India's Exchange Rate Policy"]:::root --> B["Managed Float Regime"]:::n1
  A --> C["RBI Intervention Tools"]:::n2
  A --> D["Key Objectives"]:::n3

  B --> B1["Market-based rate"]:::note1
  B --> B2["Volatility smoothing"]:::note1

  C --> C1["Dollar buy/sell"]:::note2
  C --> C2["Forex swaps, OMO, MSS"]:::note2

  D --> D1["External stability"]:::note3
  D --> D2["Export competitiveness"]:::note3
  D --> D3["Inflation control"]:::note3

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