Foreign Exchange & Exchange Rate Policy

Introduction

Foreign exchange and exchange rate systems are central to the functioning of modern economies in an interconnected world. They determine the value of a country’s currency in relation to others, directly affecting trade, investment, capital flows, tourism, and economic stability. For a developing economy like India, foreign exchange management and exchange rate policy are not only technical issues but also strategic policy instruments to ensure growth, competitiveness, and macroeconomic stability.

This write-up explains in detail:

• What is foreign exchange
• What is an exchange rate
• The concepts of NEER (Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate)
• The difference between NEER and REER
• India’s current exchange rate policy and its implications

What is Foreign Exchange?

Foreign exchange (commonly abbreviated as Forex or FX) refers to:

• The system or process of converting one country’s currency into another.
• It also includes the global marketplace where currencies are traded.

In simple terms, if an Indian importer buys goods from the USA, payment has to be made in US dollars. For this, the importer needs to convert Indian rupees (INR) into US dollars (USD) through authorized foreign exchange markets or banks.

Key Components of Foreign Exchange:

1. Currencies – The most traded currencies are USD, Euro, Yen, Pound Sterling, and Yuan.
   
   
2. Forex Markets – A decentralized global market that determines exchange rates through demand and supply.
   
   
3. Participants – Central banks, commercial banks, exporters, importers, investors, and currency traders.
   
   
4. Reserves – Countries hold foreign exchange reserves (USD, gold, SDRs, etc.) to manage stability and international obligations.

Importance of Foreign Exchange:

• Facilitates international trade.
• Enables cross-border investment.
• Provides liquidity and stability to global markets.
• Helps governments in monetary and fiscal policy management.
• Critical for balance of payments (BoP) management.

What is an Exchange Rate?

The exchange rate is the price of one currency in terms of another. It tells us how many units of foreign currency can be obtained in exchange for one unit of domestic currency.

Example:

• If 1 USD = ₹83, this means one US dollar costs 83 Indian rupees.

Types of Exchange Rates:

1. Fixed Exchange Rate – Determined by government/central bank and pegged to another currency (e.g., gold standard era).
   
   
2. Floating Exchange Rate – Determined purely by market demand and supply.
   
   
3. Managed Float (Dirty Float) – A mix where market forces determine the rate, but the central bank intervenes occasionally to prevent volatility (India follows this system).
   
   
4. Dual/Multi Exchange Rates – Different rates for different transactions.

Nominal Effective Exchange Rate (NEER)

NEER is the weighted average of a country’s currency in relation to the currencies of its major trading partners, without adjusting for inflation.

• It is an index that reflects how strong or weak a currency is compared to a basket of foreign currencies.
  
  
• RBI calculates NEER using trade weights assigned to countries with which India trades the most.

Example:

If the Indian rupee depreciates against the USD but appreciates against the Euro, NEER takes into account these movements weighted by trade volume.

Interpretation:

• A higher NEER → Rupee is stronger relative to trade partners.
• A lower NEER → Rupee is weaker relative to trade partners.

Real Effective Exchange Rate (REER)

REER is the NEER adjusted for inflation differentials between India and its trading partners.

• It reflects the purchasing power parity (PPP) of the rupee in international trade.
  
  
• REER is considered a better indicator of external competitiveness than NEER because it accounts for inflation.

Example:

• If India has higher inflation than the USA, even if the NEER shows stability, the REER will show a depreciation because Indian goods become relatively more expensive.

Interpretation:

• A REER > 100 → Rupee is overvalued (Indian exports become expensive).
• A REER < 100 → Rupee is undervalued (Indian exports become competitive).

Difference Between NEER and REER

India’s Present Exchange Rate Policy

Historical Evolution:

1. 1947–1971 (Fixed Rate System) – Rupee was pegged to the pound sterling and later to the US dollar.
   
   
2. 1971–1991 (Controlled Float) – After the collapse of the Bretton Woods system, India adopted a managed exchange rate.
   
   
3. 1991 Crisis – Severe BoP crisis led to rupee devaluation and IMF-assisted reforms.
   
   
4. 1993 Onwards (Market-Determined Exchange Rate) – India shifted to a unified, market-driven exchange rate system.

Current Policy:

• India follows a Managed Floating Exchange Rate System (also called a “dirty float”).
• The rupee’s value is primarily determined by market demand and supply.
• However, the RBI intervenes in the forex market to curb excessive volatility, ensure orderly movement, and maintain competitiveness.

RBI’s Role in Exchange Rate Policy:

1. Forex Market Intervention – Buying/selling dollars to stabilize the rupee.
2. Building Forex Reserves – India holds over $600 billion reserves to ensure confidence.
3. Monetary Policy Coordination – Balances inflation, interest rates, and exchange rate stability.
4. Capital Flow Regulation – Regulates FDI, FPI, and external borrowings under FEMA.

Factors Influencing Exchange Rate in India:

1. Trade Balance – Current account deficit puts pressure on the rupee.
2. Capital Flows – FDI and FPI inflows strengthen the rupee.
3. Inflation Rate – Higher inflation reduces competitiveness and weakens the rupee.
4. Interest Rates – Higher domestic rates attract foreign investment, strengthening the rupee.
5. Global Dollar Strength – A stronger USD weakens emerging market currencies.
6. Geopolitical Tensions – Wars, oil shocks, or global crises affect India’s forex dynamics.

Significance of Exchange Rate Policy for India

1. Export Competitiveness
   • A stable yet slightly undervalued rupee supports Indian exports.
     
     
2. Import Management
   • A depreciating rupee makes imports costlier, affecting oil and electronics bills.
     
     
3. Inflation Control
   • Currency depreciation can lead to imported inflation.
     
     
4. Attracting Investments
   • A stable rupee boosts foreign investor confidence.
     
     
5. Economic Stability
   • Exchange rate stability is crucial for long-term growth.

Challenges in India’s Exchange Rate Management

1. Volatility in Global Markets – Sudden capital outflows during crises weaken the rupee.
   
   
2. Dependence on Oil Imports – Rupee is highly sensitive to crude oil prices.
   
   
3. US Dollar Dominance – Even minor Fed policy changes affect India’s currency.
   
   
4. Speculative Trading – Can destabilize markets.
   
   
5. Balancing Inflation vs Growth – RBI often faces a policy trade-off.

Recent Developments

1. Rupee Depreciation in 2022–23 – Due to global dollar strengthening and oil price rise.
   
   
2. Use of Rupee in International Trade – India promoting INR settlement for trade with countries like Russia.
   
   
3. Digital Currency (CBDC) – RBI launched pilot digital rupee, which may influence future forex management.
   
   
4. Focus on Resilience – RBI building record-high forex reserves to cushion shocks.

Conclusion

Foreign exchange and exchange rate management are vital components of India’s economic strategy. The transition from fixed exchange rates to a market-determined managed float reflects India’s integration with the global economy.

• NEER and REER provide tools to measure external competitiveness, with REER being more accurate as it adjusts for inflation.
• India’s present exchange rate policy is aimed at balancing stability with flexibility, ensuring exports remain competitive while protecting against excessive volatility.

As India aspires to become a $5 trillion economy and achieve Viksit Bharat 2047 goals, a stable and robust exchange rate framework will remain a cornerstone of sustainable growth.