Exchange Rate Trends and Management in India

Abstract

This paper evaluates developments in India’s nominal and real exchange rates over the past two decades, describing longer term trends as well as short-term movements and volatility. In addition, we evaluate the motivation and impact of exchange rate policy in India, including its interaction with domestic monetary policy. We find substantial divergences between nominal and real exchange rate trends, and between Indian multilateral and bilateral Rupee-USD longer-term exchange rate movements. Beyond long-term trends, Rupee exchange rate movements and volatility have evolved through several distinct episodes. In particular, exchange rate volatility increased markedly from the mid-2000s, especially since the Global Financial Crisis. The RBI used foreign exchange market intervention and an active capital control policy to influence the level and limit volatility of the exchange rate, an official policy objective. However, these policies have had limited effect on the exchange rate. Against a background of a trend increase in financial openness and, perhaps most importantly, increasing external shocks, the RBI appears to have accepted more instability in the exchange rate in favor of greater monetary independence. Since the GFC , however, greater monetary independence seems to have focused more on stimulating growth and employment rather than low inflation. Only since 2014 has the RBI focused on low inflation as a primary domestic objective.

We would like to thank Bryce Shelton for excellent research assistance, and Rose Cunningham, Mark Kruger, and Errol D’Souza for helpful comments. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada.

Appendix: Data Sources

Series	Source	Notes
Indian Rupee vis-à-vis US$	Bloomberg	Spot exchange rate
Nominal effective exchange rate—36-currency index (NEER36)	Reserve Bank of India	Index: 2004–2005 (April–March) = 100; Trade-based weights. Current series begins. Data prior to July 2005 spliced from the discontinued NEER series with earlier base year
Real Indian Rupee vis-à-vis US$	Bloomberg	Index: January 2001 = 100; spot exchange rate normalized by the authors to an index
Real effective exchange rate—36-currency index (REER36)	Reserve Bank of India	Index: 2004–2005 (April–March) = 100; Trade-based weights. Current series begins. Data prior to April 2004 spliced from the discontinued NEER series with earlier base year
Real price differential between India and trade-weighted 36 index (RP36)	Construction by authors	Index: January 2001 = 100. RP36 = NEER36/REER36
Real price differential between India and US$	Construction by the authors	India CPI/US CPI
Spot intervention	Reserve Bank of India
Forward intervention	Reserve Bank of India	Forward intervention series is a net amount outstanding. We take month-over-month level change to show intervention
Capital control liberalization indices (inflow and outflow liberalizations, including and excluding FDI)	Pasricha et al. (2015)	Weighted number of capital control actions, cumulated over time. Noncumulated, weighted data from source
Monetary independence Index	IMF IFS and Haver	Constructed by the authors using methodology in Aizenman et al. (2008). This measures the correlations between nominal short-term money market interest rates in India and the USA. Higher numbers indicate lower correlations, i.e., higher monetary policy autonomy. IFS data is used except for India between June 1998 and April 2006 (when the IFS series is missing). For this period, MIBOR data from Haver is used
Exchange rate stability Index	IMF IFS	Constructed by the authors using methodology in Aizenman et al. (2008). This measure is the normalized annual standard deviation of the monthly percentage changes in nominal INR/USD spot exchange rate
Capital account openness Index	Lane and Milesi-Ferretti (2007)	Total foreign assets and liabilities, as percentage of nominal GDP. Both measured in US Dollars