For anything to qualify as money whether it is Rupee, Dollars, Euro, gold, it must have three qualities-The measure of value, general acceptability as a medium of exchange and the store of value. Since Rupee in India contain all the three attributes, is accepted as money in India but internationally, it is not universally acceptability because a resident in China may not accept the Rupee as a medium of exchange for the export of mobile hand sets. Similarity Indian exporter will not accept Yuan, the Chinese currency as mode of payment. In that care, dollar is the international acceptable currency. Therefore every country had to convert its currency into Dollar for international transaction, and the rate at which the domestic currency is exchanged with the external foreign currency, it is called as foreign exchange rate or the forex rate. In other words, the exchange rate is the price of one currency in terms of other.

The exchange rate systems are primarily of two forms-

1. The fixed exchange rate system

Under this system the monetary authority of the country fixes the price of domestic currency is terms of major currencies like Dollar, Pound, Euro, Yen etc. Such a system provides stability in the market as the traders being assured of the future rates can conduct business smoothly. Further this system wipes out the volatility in the market and hence there is no speculation in the system. Though this system provides stability in the market but it puts too much onus on the monetary authority as the authority is responsible for maintaining the fixed exchange rate system. If RBI fixed the exchange rate at Rs 50/$, then in order to maintain that rate, RBI will have to keep a reserve of foreign exchange. If market force pushes the exchange rat to Rs 52/$, then RBI will sell the dollars from its reserves to keep exchange rate at Rs 50/$ and if market forces appreciates the exchange rate at Rs 48/$ then RBI will purchase the dollars from the market to maintain the rate at Rs 50/$.

2. Flexible Exchange Rate System

In this system, the exchange rate is determined by the forces of demand and supply and there is no intervention by the monetary authority. It is based on the principle of Laissez-faire. In this system the exchange rate moves automatically and freely to equate the supply and demand. It does not allow the surplus of deficit to build up and eliminates the problem of scarcity or surplus of any currency. Theoretically, there is no need for foreign exchange reserves when exchange rates are moving freely. In a country where there is scarcity of dollars, the authority will allow the currency to depreciate to clear tha scarcity instead of supplying Dollars from its reserves to maintain the exchange rate system.

These are the two extreme cares of foreign exchange system but in reality, there are other intermediate system followed by different countries.

 Source: Edwards and Savastano, National Bureau of Economic Research

Exchange Rate system in India

Before liberalization India was pursuing a fixed exchange rate regime where till 1946, it was fixed with British pound sterling and after that it was linked with the Dollar. Though the exchange rate is determined in almost every major currencies but it is primarily linked with the dollar as most of international trade is conducted in terms of dollar.

In 1992-93, Liberalized exchange rate system (LERMS) was initiated which was a form of dual exchange rate system. Under terms, Rupee dollar exchange rate system, exporters were allowed to convert 60% of their forex earning at market rate while the balance 40% was converted at official rate. In 1993-94, the uniform market exchange was introduced where 100 % conversion of rupee under flexible exchange rate system was allowed for almost all transaction of current account. In 1994-95, Rupee was made fully convertible on current account.

Rupee Vs Dollar in India

The period of 2001 to 2011 had been very tumultuous for the exchange rate of Rupee against US $. While in July 2007, it reached the 9 year high and closed at Rs 40.9/$, in November 2011, it depreciated 19% since August 2011 to close at all time low Rs 52.28/$. In the first half of the present decade, Indian economy was one of the fastest growing economies with strong macroeconomic indicators like huge forex reserves, low debt- GDP ratio, low current account deficit etc which were instrumental in bringing huge inflow of Dollar in the form of FII, FDI, NRI deposits etc. The ample dollar supply coupled with unprecedented export performance further augmented the dollar supply, ultimately resulting in the steep appreciation of Rupee. The latter half of the decade witnessed two crises in quick succession - the global financial crisis in 2008 and the Euro Debt crisis of 2010-11. The 2008 crisis in the west resulted in the withdrawal of FIIs, decline in FDI and sluggish export performance resulting in the scarcity of dollar supply, resulting in the depreciation of Rupee against the US $. The weak macro economic indicator further added to the woes. With fiscal deficit exceeding the rate limits, high rate of inflation, high current account deficit along with the series of corruption seams and the policy paralysis resulted in low confidence among the foreign investors about Indian economy.

Though the Euro crisis of 2010 is much less in the magnitude if compared to the crisis of 2008 which was the worst crisis is since great depression in 1930s, the impact of the Euro crisis on India is found  to be much adverse than that of U.S. sub prime crisis. In fact, India weathered the 2008 crisis better than most of the other economic. India’s huge foreign exchange reserves of $314 billion in 2008 played crucial role in cushioning the impact of the shock of 2008 crisis. The current reserves at $308 billion are almost at same level but situation is a little more worrisome as the current forex reserve –GDP ratio of 16.5% is one of the lowest in Asia. The current India GDP is around Rs 48.8 lacks crores.  Further India’s current account deficit in 2007-2008 was 1.3% of GDP but in March 2011, it widened to 2.6% of GDP. Inflation rate in double deficit is further aggravating the crisis the situation. This high rate of inflation inflates the production cost making Indian products less competitive in the international marked further putting the pressure are current account deficit. If there are less dollar inflows to fund the current account deficit, only recourse available in the flexible exchange rate system is the depreciation of Rupee. In order to prevent the Rupee further from depreciation, RBI will have to sell dollar in the forex market which will erode the forex reserves. 

But more worries are in store for 2012. According to Avinash Celestine and Mishita Mehra, the current stock of NRI deposit is around $52 billion, of which $43 billion will mature by June, 2012. The total volume of short-term debt due for payment next year comprises NRI deposits, foreign borrowing by companies, Government’s borrowing is of around $137 billion. Further the portfolio investments which are very volatile in nature and can flow out of country at any time (As seen in 1999 East Asian crisis are in 2008 in India). Such reserves accounted for $142 billion in September 2011. The portfolio investment along with the short term debt payable in next year constitutes 88% of forex reserves while during 2008 crisis; they were 57% of total reserves. Further, currently the Indian forex reserves are enough to fund the imports of around 10 months which is lowest since 2011. Thus the current scenario predicts a growing future for Indian Rupee at least in short term.

If India has to grow at around 10% per annum in the 11th and 12th five year plan, the current account deficit is bound to increase due to the investment demand and to fund this deficit, India had to regain the confidence of foreign investors, and make itself a favorite investment destination. For that matter, the efforts had already been started exemplified by 51% FDI is Multibrand retail and 100% FDI in single brand retail. Government is also contemplating to allow 26% FDI in domestic airlines by foreign airlines. Currently foreign airlines are barred from investing in India aviation sector. 

Further, to infuse the dollar supply, RBI had raised interest for NRI deposits the norms for the companies to borrow funds from the foreign markets has been further liberalized. All these measures are meant to increase the dollar supply to check the depreciation of Rupee.

For the sustained and inclusive growth, the stable exchange rate system along with low inflation, stable interest rates etc are required. Such factors are conducive for the investment demand which is an important prerequisite for faster growth in the developing countries. There are many instruments present in the quiver of RBI to maintain the stability in the exchange rate of rupee but they will not provide the sustainable solution until and unless the macroeconomic indicators of the economy are strengthened. Such indicators will be improved by the initiation of second generation of reforms as the country is feeling the reform fatigue of the 1991 reforms.

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