As Rupee touches 90 vs US Dollar, International Monetary Fund (IMF) changed the classification of India’s exchange rate system from stabilized arrangement to crawling peg system. This reclassification is made as IMF finds that India is allowing Rupee to exchange with other currencies (mainly with US Dollar) as per market movements than as per a predetermined rate. IMF is the soft regulator of the global monetary system. IMF monitors exchange rate systems of its member countries and provides financial resources when countries have balance of payment deficits. IMF extends conditional loans and influences the monetary and fiscal policies of its borrower countries to achieve macroeconomic balance around the world.

The management of its currency’s exchange rate of a country is key for its investors to assess the impact. IMF laid a defined classification system for exchange rate arrangements of economies. Classifications by IMF are based upon the country’s monetary and forex actions rather than formal titles given by their respective central banks or governments. The degree of exchange rate flexibility may vary from fully fixed to fully floating depending on the regime adopted by the central bank from time to time.

In sole legal tender system, currency of another country is formally adopted as sole legal tender in the host country. Many countries do not have their own currencies and rely on US dollar, euro, or Swiss franc, etc. Ecuador, El Salvador, East Timor, Marshall Islands, etc countries use US dollar as their sole legal tender currencies. Currency board regime has legislative enforceability to exchange domestic currency with a specific foreign currency at a fixed exchange rate. In this regime, domestic currency is issued only against foreign exchange backed by foreign assets. Bosnia, Bulgaria, Darussalam, Estonia, etc countries have currency board regime.

Fixed peg regime has hard peg and soft peg. In hard peg, domestic currency is exchanged at a stated fixed rate of foreign currency. Bhutan, Nepal, Kuwait, etc have fixed peg exchange system. In soft peg, exchange rate is managed within a bandwidth. Denmark, Slovenia, etc have soft peg regime. In crawling peg regime, currency is adjusted partly and periodically in response to the changes in certain qualitative indicators such as inflation. Belarus, Romania, etc countries have crawling peg regime. Now India is also classified in this category.

In managed floating regime, exchange rate is managed within a float as per balance of payments, forex reserves, etc. Stabilized arrangement is a kind of managed floating system. Bangladesh, Ghana, Indonesia, Vietnam, etc have managed floating system. Finally in independent floating regime, exchange rate is completely market determined depending upon the supply & demand, strengths & weaknesses, inflation and other factors. Australia, Canada, Brazil, UK etc have independent floating regime.

Classification of exchange rate system does not require policy changes. In fact, regardless of the classification, IMF may impose its conditions while granting loans. However, the classification by IMF is considered authoritative and influences investors perception, capital flights, market confidence, and credibility of economic policy of a country.

In the recent months, Reserve Bank of India (RBI) interventions in the exchange rate of Indian Rupee were few with less volume. In the preceding period, despite RBI’s interventions expending huge forex reserves, exchange rate of Rupee could not be influenced much. This may have been one of the key reasons why RBI observed policy patience to let the Rupee float in general while currency is adjusted only when RBI’s critical response is required.

Recently, Indian Rupee touched all-time low of Rs. 90 per US dollar and marginally recovered to 89 levels. RBI opined that given the currency dynamics and the balance of payment system, it is not unusual for Rupee to depreciate 3% per annum. If the direction and magnitude of such depreciation continue, Rupee may see Rs. 100 per US dollar in 4 years from now. Exporters may enjoy some gains, but such a steep depreciation may increase inflation, may rise unemployment, and may drag the gross domestic product (GDP) growth as well.

At present, it appears that Rupee would be allowed to gradually depreciate. The reasons could be promoting exports, inviting capital, supporting imports with unidirectional gradual change in exchange rate, etc. Whether Rs. 100 per US dollar is imminent, conducive, harmful, or neutral will have various reasons and so does whether crawling peg exchange rate system is beneficial.

By Dr. Kishore Nuthalapati, CFO of BEKEM Infra Projects Pvt Ltd, Hyderabad.