erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

Managed Floating of the Exchange Rate in India

Renu Kohli (Indian Council for Research on International Economic Relations, India)

Abstract  

This paper examines the exchange rate management strategy of the Reserve Bank of India after the floating of the rupee in 1993. The research is motivated by two empirical observations. One, the remarkable stability of the rupee after the float runs contrary to experiences of other countries, all of which typically witnessed a rise in exchange rate volatility with the switch to a floating exchange rate regime. Two, there has been a significant increase in the intervention activity of the central bank after introduction of the float. We model a reaction function that allows testing for the intervention strategy of the central bank. The hypothesised intervention behaviour is drawn from the officially stated exchange rate policy stance. Two exchange rate management strategies, leaning against the wind and a hypothetical exchange rate target, are tested for, using Johansen’s cointegration technique. We find strong evidence of the existence of a moving nominal exchange rate target that is linked to deviations from changes in relative Indo-US prices. This indicates that the central bank’s intervention strategy is governed by a PPP rule and is aimed at minimising deviations of the spot rate from the target exchange rate. The impact of exchange rate changes upon foreign exchange reserves is then traced out using impulse response functions. We find that unanticipated exchange rate shocks (holding prices constant) have their maximum impact on foreign exchange reserves after one month with reserves recovering to the pre-intervention level in approximately 2-3 months. A surprise innovation to the hypothetical nominal exchange rate target (holding the spot rate constant) shows a periodic intervention response to price differentials. In other words, nominal exchange rate adjustments are brought about through intervention, when currency realignment is desired by the central bank.

Economic Research Center
Middle East Technical University
06531 Ankara Turkey
Phone: + 90 312 210 3044, 210 2003
Fax: +90 312 210 1244
e-mail: metuerc@metu.edu.tr