What Type of Exchange Rate Does India Have? A Comprehensive Trading & Macro Analysis

Here's what that means in plain terms. The rupee's value isn't locked by government decree, nor does it float entirely on market whims. Instead, the Reserve Bank of India lets market forces set the direction while stepping in selectively to prevent chaotic swings.

India picked the third alternative, and this decision has far greater implications than you might otherwise assume. Your inquiry into “what form is the exchange rate in India?” is a direct indicator of why USD/INR behaves as it does and why certain trading opportunities arise out of it.

How India's Managed Float System Actually Works

Initially, Oil prices rise. As India imports approximately 80% of all its oil, the resultant 20% crude oil price increase will cause Indian corporations to require an additional amount of USD to settle their respective obligations, resulting in an increased level of demand for USDs and a weaker Indian rupee. This is both mechanical and predictable.

Capital flows are far more important than trade flows. When a foreign investor buys an Indian share, the amount of dollars traded increases, therefore creating a stronger INR, whereas if that same investor were to sell the same shares during a stock market sell-off, the opposite would occur and the gradual strengthening trend for the INR would be reversed immediately. Capital flows change and fluctuate faster and further than trade flows.

How India Got Here: The 1991 Crisis and After

Since around 1988, India has pegged the rupee to the US dollar. Although this provided some stability in exchange rates, it also caused a problem: a very rapid depletion of India's foreign currency reserves. As of 1991, these reserves could only finance approximately two weeks' worth of imports, which led to India's currency crisis and subsequent request for assistance from the IMF.

The crisis resulted in a fundamental change in policy direction. The Indian government accepted that under contemporary financial conditions, floating currencies and flowing capital, an inflexible regime would not be able to function. Therefore, after ending the pegged exchange rate, India began allowing market prices to determine the value of the rupee in 1993.

Capital Controls: The Foundation Most People Ignore

All transactions in the current account can occur without restrictions; one can purchase and sell goods across the border with no issues. This is not the case, however, for capital account transactions. Foreign investors cannot take unlimited amounts of capital out of or into India without permission from the government, and Indian residents cannot take unlimited amounts of rupees out of the country under any circumstances.

Without these restrictions, India’s managed float would not be able to function. If, for example, $100 billion could go in and out of India based on fluctuations in market sentiment, the Reserve Bank of India would not be able to stabilise the rupee because it would not have enough foreign reserves to do so.

The Federal Reserve's Shadow Over Everything

When rates increase at the Fed, the US becomes a more attractive option for investment dollars, causing dollars to flow out of emerging markets into US assets, resulting in a weaker rupee. This has been the consistent outcome of decades of tightening cycles at the Fed.

The Reserve Bank of India (RBI) will be faced with a dilemma during these cycles of tighter monetary policy at the Fed: to deplete its reserves defending the rupee from depreciation, or allow it to depreciate, therefore exposing the economy to the risk of imported inflation. The RBI usually does both over time. For example, in the 12 months prior to the start of The Fed's aggressive tightening policy cycle, the RBI's reserves will decline by 4-6% while the rupee will weaken by approximately 3-5%.