That swing has been made possible by a shift in forex management policy that was forged in the fire of the balance-of-payments (BoP) crisis of 1991.
Triggered by the oil price shock of the 1970s, and compounded by the extremely tight monetary policy followed by then US Federal Reserve Chairman Paul Volcker (the federal funds rate hit a high of 22 per cent in the early 1980s), India was forced to approach the International Monetary Fund (IMF) for some assistance.
The front page of Business Standard on July 2, 1991, reflecting on the first of the two-step devaluation of the rupee done in response to the BoP crisis
“Consequently, India’s external reserves declined steeply, and we had no foreign exchange to import even such essential commodities as diesel, kerosene, edible oil, and fertiliser,” then Prime Minister P V Narasimha Rao said on July 9, 1991, days after he was sworn in.
In the years since, India’s forex management framework has moved from a tightly controlled regime with precariously low reserves to having one of the world’s largest reserve buffers —bolstered further in the aftermath of the Covid-19 pandemic — and a market-determined exchange rate. It has added various tools to its arsenal that have held it in good stead, including recent measures, such as concessional swap window, to shore up reserves in response to a new war in West Asia.
The transition was gradual. The government first undertook a two-step devaluation of the rupee in 1991 before introducing the Liberalised Exchange Rate Management System (LERMS) in 1992, which allowed a dual exchange rate. By 1993, India had moved to a unified market-determined exchange rate system.
At the same time, the country began opening its capital account in phases. Foreign direct investment (FDI) was liberalised, external commercial borrowings were allowed, and foreign institutional investors (FIIs) were granted access to Indian equity markets.
The next major milestone came in 1994 when India accepted Article VIII obligations of the IMF, effectively making the rupee convertible on the current account.
This enabled businesses and individuals to undertake trade-related and other current account transactions with fewer restrictions.
As capital flows increased during the 2000s, the Reserve Bank of India (RBI) increasingly found itself managing the consequences of large foreign inflows. Rather than targeting a specific exchange rate, the central bank focused on limiting excessive volatility in the currency market.
“The basic tenet of the RBI’s foreign exchange policy has remained the same over the years,” says Shailendra Jhingan, Head of Treasury and Economic Research at ICICI Bank. “The objective has been to manage undue volatility rather than defend specific levels of the currency.”
The approach also coincided with a period of sustained reserve accumulation. As foreign investment and export earnings surged in the 2000s, the RBI regularly purchased dollars from the market to prevent sharp appreciation of the rupee while simultaneously building foreign exchange reserves.
As a result, India’s reserves rose from less than $6 billion during the 1991 crisis to over $300 billion by the late 2000s, creating a crucial buffer against external shocks.
That buffer proved useful during successive episodes of global stress. The Asian Financial Crisis in 1997-98, the dot-com bust in 2000, and the Global Financial Crisis in 2008 all tested the resilience of India’s external sector.
While the rupee came under pressure during these episodes, the RBI relied on a mix of spot market intervention and regulatory measures to stabilise conditions.
Crisis manager: Then Prime Minister P V Narasimha Rao used the BoP crisis to bring in economic reforms File photo: PTI
The taper tantrum of 2013 marked another defining moment in India’s forex management journey. The US Fed, which had cut rates to near zero after the Global Financial Crisis in a bid to boost demand, signalled that it would begin withdrawing monetary stimulus.
As a result, capital fled emerging markets, triggering a sharp fall in some of the emerging market currencies. India was termed one of the “fragile five” economies — along with Brazil, Indonesia, Turkey, and South Africa — because of its vulnerability to capital outflows and currency depreciation.
The Indian currency depreciated over 20 per cent in a matter of months, exposing risks in India’s extenal balances and highlighting the importance of reserve buffers.
In the 2000s and 2010s, there were periods of relative stability followed by sudden shocks that led to sharp adjustments in the currency, says Jhingan. “We saw such episodes in 1998, 2000 and again during the 2013 taper tantrum.” In response to these crises the RBI built stronger buffers through higher foreign exchange reserves, and India’s external account became stronger, he adds. “As a result, the currency has generally shown greater stability and rupee movements have been fairly orderly over the past decade,” Jhingan adds.
More tools in the armour
Alongside reserve accumulation, the central bank also broadened its intervention toolkit. While spot dollar purchases and sales remained the primary instrument, the RBI increasingly began using forward contracts and, more recently, the non-deliverable forward (NDF) market.
“The RBI has moved from pure spot transactions to taking positions in the forwards and NDF markets, where contracts are often rolled over,” Sabnavis says. “This has been a more innovative approach pursued in recent times.”
The central bank has also frequently used regulatory measures to curb excessive speculation during periods of stress. These have included special windows for oil importers, changes in hedging rules, adjustments to open position limits and measures to accelerate the repatriation of export proceeds.
Meanwhile, capital account liberalisation has continued, albeit cautiously. Over the years, more sectors have been brought under the automatic route for foreign investment, restrictions on overseas investments by Indian companies have been eased, and the Fully Accessible Route (FAR) was introduced to facilitate foreign investment in select government securities.
“From the rupee’s perspective, the focus has always been on limiting foreign exchange volatility,” says Gaura Sen Gupta, Chief Economist at IDFC FIRST Bank. “The RBI is likely to persist with gradual liberalisation of the capital account.”
Today, India’s foreign exchange management framework stands in sharp contrast to the regime that existed in 1991. Foreign exchange reserves have hovered around $700 billion in the past few years, which is among the top five countries in the world.
Moreover, the exchange rate is largely market-determined, foreign exchange reserves are among the largest globally, and the central bank has a wider range of instruments to manage volatility.
Though the rupee continues to face periods of stress from global shocks, geopolitical tensions and fluctuations in capital flows, the RBI’s core philosophy remains largely unchanged: It allows markets to determine the direction of the currency, while intervening to prevent disorderly movements.
Three-and-a-half decades after liberalisation, India’s forex strategy has evolved from crisis management to ensuring stability, reflecting both the growing depth of domestic markets and the country’s stronger position in the global financial system.
