Exchange Rate Systems: Fixed vs Floating & Rupee Convertibility

1. Types of Exchange Rate Systems

A. Fixed Exchange Rate

• Currency value pegged to another currency (e.g., USD) or gold.
• Example: China's yuan (managed peg), Bretton Woods system (1944-1971).
• Advantages: Stability in trade, reduces speculation.
• Disadvantages: Loss of monetary policy independence, requires high forex reserves.

B. Floating Exchange Rate

• Currency value determined by market forces (demand & supply).
• Example: US dollar, Euro, Japanese yen.
• Types:
  • Free float: Fully market-driven (e.g., USD).
  • Managed float: RBI intervenes occasionally (India's system).

Fixed Rate	Floating Rate
Central bank intervenes	Market determines rate
Stable but inflexible	Volatile but self-correcting
Risk of currency crises	Automatic balance of payments adjustment

2. India's Exchange Rate System

• Pre-1991: Fixed to GBP, then basket of currencies.
• 1991 Crisis: Shifted to Liberalized Exchange Rate Management System (LERMS).
• 1993: Adopted market-determined exchange rate (managed float).
• Current System: RBI intervenes to prevent excessive volatility (e.g., during COVID, Ukraine war).

3. Rupee Convertibility

A. Current Account Convertibility (1994)

• Allowed for trade in goods/services.
• Example: Import/export payments, foreign travel.

B. Capital Account Convertibility (Incomplete)

• Partial convertibility exists (e.g., FDI, FPI limits).
• Tarapore Committee (1997 & 2006): Recommended gradual CAC.
• Challenges: Volatility risks (e.g., 2013 "Taper Tantrum").

4. Key Concepts (Prelims Focus)

• REER & NEER: Real/ Nominal Effective Exchange Rate.
• Dollarization: Using USD instead of domestic currency (e.g., Zimbabwe).
• Currency War: Competitive devaluations (e.g., China vs USA).

5. Recent Developments

• INR Volatility: Hit ₹83/$ in 2023 (Ukraine war, oil prices).
• RBI Measures:
  • Forex reserves buffer (~$600 billion).
  • Dollar-rupee swap auctions.
• Internationalization of INR: Trade settlements in rupees with 18+ countries.

Conclusion

Understanding exchange rate systems is vital for UPSC Prelims (Economy). Focus on India's managed float, rupee convertibility, and RBI's role.