Volatility in the exchange rates of the Swiss franc, euro, British pound, Russian rouble, Korean won and Singapore dollar against the US dollar has a significant spill-over effect on the Indian rupee’s fortunes.

But fluctuation in the exchange rate of the domestic currency does not have the reverse effect, according to a new RBI working paper.

This one-way causality is particularly true for the Korean won and the Singapore dollar, with data showing that today’s closing level of the rupee is influenced by the past levels of these currencies, reflecting the time differences in trading among these markets.

In a similar fashion, the past values of Western currencies such as the Swiss franc, euro, British pound and rouble cause changes in the Indian rupee, implying an inter-linkage of the domestic currency to the currencies in advanced economies.

The evidence also points to bi-directional causality in changes in the rupee and the Brazilian real, implying a strong integration between these two leading emerging market economies’ currencies.

On the other hand, there was no significant causal relationship between the Japanese yen and the rupee during the 2005-11 period, as per the study.

It was found the spillover of volatility in all currencies on the Indian rupee had a considerable impact on the daily exchange rate of the rupee.

What is more, the magnitude of the spillover was broadly the same across countries, implying that the extent of volatility transmitted to the rupee from leading currencies was similar.

Containing volatility

However, the spill-over effect was not the only factor driving the recent volatility in the Indian rupee. The volatility in the exchange rate of the rupee is also driven by volatile capital flows and news and long-term factors, such as macroeconomic fundamentals, the balance of payments position and the stance of monetary and fiscal policies.

Since Independence, India’s exchange rate policy has transited from a par value system to a basket-peg and then to a managed floating exchange system. Under the managed flexible regime since March 1993, the objective has been to contain volatility through orderly market conditions without any explicit or implicit target for the exchange rate.

This could be interpreted as being more flexible during normal market conditions, but the accent shifts to management when the market turns disorderly.

The exchange rate regime in India can also be described as a “bounded float” with the removal of restrictions on many capital account transactions in the past few years.

While the RBI does not target the exchange rate, nor has a fixed band for nominal or real exchange rates to guide interventions, the capital account management framework helps in the bounded float.

Controls on capital account

There are still a few controls on capital account, such as limits on foreign direct investment in specific sectors and portfolio investment in equities.

There are also controls on debt inflows, driven by considerations of external stability, but they are altered relatively infrequently in response to changing macroeconomic conditions and not with a view to impact the daily movement of the exchange rate.

In excessively volatile market conditions, “smoothing” interventions are carried out to keep markets orderly and prevent large jumps that can induce further spirals.

The objective of these exercises is to find a balance between the short-term risk of sharp rupee depreciation and the medium-term risk of a loss of confidence in meeting external obligations.

arvind.jayaram@thehindu.co.in

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