Why Exchange Rate Stability Matters More Than Ever for India

On the exchange rate of the Indian rupee vis-à-vis the US dollar in 2025, two views rent the air. One saw the rupee in free fall: it has breached 90; 100 is inevitable. Everything from structural weaknesses, fading RBI defences, global trade barriers, limited productivity gains, shrinking shares of industry in value added and merchandise in total exports, sluggish manufacturing growth, low core GDP, and widening current account deficit, excluding transfers to the kitchen sink, was heaped on the hapless rupee. 

In the other view, which is of the International Monetary Fund (IMF), the rupee was classified as being in a crawl-like arrangement, which belongs in the category of soft pegs like the Hong Kong dollar or the Chinese yuan. A year ago, the rupee was classified by the same view as a stabilised soft peg arrangement in which the exchange rate must remain within a narrow margin of 2% relative to a statistically identified trend for six months or more.

For an arrangement to be considered crawl-like, it needs to involve an annualised rate of change of 1%, with the exchange rate appreciating or depreciating in a sufficiently monotonic and continuous manner. This implies that the currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative indicators, such as past inflation differentials vis-à-vis major trading partners or differentials between the inflation target and expected inflation in major trading partners. The rate of crawl can be set to generate inflation-adjusted changes in the exchange rate (backwards looking) or set at a predetermined fixed rate and/or below the projected inflation differentials (forward looking).

Can both views on the rupee be correct? After all, it is said that it takes at least two views to make a market, mysterious being its ways. Illustratively, those with underlying exposures such as export receivables, import payments, proceeds from bond issuances or contractual debt service payments want the level of the exchange rate, or its mean, to be stable. An unstable mean provokes risk-averse behaviour like delaying realisation of export proceeds or advancing import payments, with consequential effects on market activity, including the determination of the exchange rate.

For those without underlying exposures but wanting to price and transfer exchange rate risk, volatility or the distance from the mean, is the spice of life. They too make markets, thickening turnover and enabling price discovery in various segments of the foreign exchange (FX) market. 

Both actors must, however, be open to admitting a third view: that of the sentinel of stability, the central bank. While markets are upheld for being competitive, efficient and Darwinian in that they allow only the fittest to survive, they can also be idiosyncratic and even chaotic. History is replete with market errors such as exchange rate overshoots, self-fulfilling expectations, bandwagon effects and multiple disequilibria that can spill out of the boundaries of markets and onto real economic activity with deleterious consequences.

The reality, therefore, is that markets are prone to failure and often need to be intervened to produce competitive outcomes. From a broader perspective of macroeconomic and financial stability that serves the greater common good, the exchange is too important a variable to ignore in more ways than one, as it will be subsequently argued. Hence, all central banks have a view on the exchange rate and intervene in various ways to eschew disorderly market volatility while letting the exchange rate find its level.

The Reserve Bank of India (RBI) is no different, except that its choice of instruments of intervention typically devolves on market-based purchases and sales of foreign exchange that modulate market liquidity rather than more blunt instruments like monetary or trade policies that are, for instance, currently being used to engineer the depreciation of the US dollar.

How much of intervention is a judgment call, and widely diverse reactions to the issue reflect that it is not set in stone. In the view of those with genuine underlying exposures, as much as is needed to maintain the mean; in the other view that revels in volatility, none at all. In the third view, it is a function as much of the degree of tolerance of volatility from a macro-stability perspective as of the adequacy of the wherewithal for intervention.

In the IMF’s view, foreign exchange interventions are at best a complementary tool alongside monetary and macroprudential policies, to be used when shocks highlight frictions like shallow FX markets or unhedged currency exposure, or when inflation expectations are closely tied to exchange rate movements.

 In other words, interventions should be used only when large shocks cause disruptions in liquidity conditions and the malfunctioning of the market. Implicit perhaps is the assumption that in the throes of a crisis, a country has all the time in the world to determine the source of instability, how serious it is, and that policy action can be deployed on a graded scale with foreign exchange intervention at the bottom rungs of the ladder! The IMF opines that each country must somehow find the right mix for its unique challenges, requiring principle-based judgment in country-specific circumstances and vulnerabilities. It will, however, pronounce fair or foul in its wisdom, as countries have found in real life.

The IMF’s exchange rate view has a history that is deeply rooted in its belief that foreign exchange interventions are not kosher unless regulated by it. Under the Bretton Woods system, it controlled interventions to ensure that par values and margins were maintained. With the shock of floating exchange rates, all it could do was to enjoin members to avoid manipulating exchange rates to gain an unfair competitive advantage over other members.

This obligation frowned upon or, at best, limited the use of foreign exchange intervention. In its Integrated Surveillance Decision (ISD) of 2012, the IMF specified that “a member should intervene in the exchange market if necessary to counter disorderly conditions, which may be characterised inter alia by disruptive short-term movements in the exchange rate of its currency.” It did not envisage interventions being used more generally, nor did it preclude their use in non-disorderly situations.

Under its Integrated Policy Framework of 2020, the IMF’s attitude towards foreign exchange interventions has moved a little bit to what can best be described as an ‘only if’ approach: only if exchange rate flexibility is associated with costly frictions; only if shocks are large, posing significant risks to central bank objectives; only if interventions are not a substitute for a warranted adjustment of macroeconomic policies; only if integrated within the overall policy response; ...the caveats go on, effectively putting foreign exchange interventions outside the ambit of national policy action if the IMF’s guidance is to be followed in letter and spirit.

This article is Part I of a six-part weekly series on exchange-rate policy and financial stability by Dr Michael Debabrata Patra.

Part II will deal with why floating exchange rates, once sold as shock absorbers, have repeatedly amplified crises in emerging economies.
Part III will examine how volatile capital flows, not trade fundamentals, now dominate currency movements and shape central bank behaviour.
Part IV will set out a detailed proposal for strengthening the RBI’s foreign exchange intervention toolkit and reserve strategy.
Part V will assess why the IMF’s evolving surveillance and labelling practices risk undermining exchange-rate stability rather than preserving it.
Part VI will bring the argument full circle, asking what India’s fundamentals imply for the rupee, stability and policy credibility in an uncertain world.