Context:
The RBI has discontinued its flexible exchange rate regime in 2022 and is maintaining a de facto peg against the U.S. dollar.
Exchange Rate Policy
A flexible exchange rate is a monetary system where the exchange rate of a currency is determined by supply and demand in the foreign exchange market. It’s also known as a floating exchange rate.
- How it works
- The value of a currency changes based on supply and demand.
- When demand is low, the value of the currency goes down.
- When the demand for the currency is high, the value of the currency becomes more.
- At times, the central banks interfere to avoid steep fluctuations.
- Advantages
- It gives the currency a real value, brings about control of inflation, and one does not need large reserves.
- Examples
- United States, Japan, Australia, and The United Kingdom.
- Compare to fixed exchange rate
- In the case of fixed exchange rate, the government fixes the exchange rate.
- The government does not interfere with the exchange rate system of the currency under a flexible rate system.
Key Assumptions
- Accidental Event:
- The change could have been accidental, which may have been a consequence of an effort to rebuild India’s foreign exchange reserves after the outflow of capital in 2022.
- Inflation Curb:
- The RBI had tried to contain inflation by arresting rupee depreciation that would have aggravated inflationary trends.
- Political Factors:
- Some analysts believe that political forces for a more strengthened rupee may have acted to enhance the economic sentiment and reduce import cost.
- Role of External Commercial Borrowings (ECBs)
- ECBs had surged in early 2023 due to U.S. interest rates.
- Had the exchange rate been pegged, the threat of depreciation may have been lowered, and therefore, ECBs may have soared.
Unintended Consequences of the Peg
- Increased Currency Risk:
- The increase in ECBs raised exposure to currency risks, especially for firms with dollar-denominated debt.
- Erosion of Competitiveness:
- Defending the peg led to a decline in India’s competitiveness, particularly affecting exports.
- Capital Outflows:
- Resulted in a $70 billion decrease in reserves over several months.
External Commercial Borrowing
- An ECB is a type of funding that is not equity-based.
- ECBs can include commercial bank loans, credit from export credit agencies, and credit from multilateral financial institutions.
- ECBs can be beneficial because they offer lower interest rates, large amounts of funds, and relatively long terms.
- All entities, except for Limited Liability Partnerships, are eligible for ECBs.
Currency peg
A currency peg is a policy that ties a country’s currency to another country’s currency, or a basket of currencies. The goal is to keep a country’s currency stable so that it can compete in international trade.
Price-to-earnings-to-growth (PEG) ratio
A PEG ratio is a financial metric that investors use to evaluate a stock’s value. It compares a stock’s price-to-earnings (P/E) ratio to its earnings growth rate.
