6. Economics Notes 44

Elaborate Notes

Exchange Rate Policy: The Bretton Woods System

The Bretton Woods system represents a pivotal chapter in modern international economic history, establishing a framework for monetary and exchange rate management that governed global finance from the end of World War II until the early 1970s.

• Historical Context and Genesis: The system was conceived at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, USA, in July 1944. Attended by delegates from 44 Allied nations, its primary objective was to prevent a recurrence of the economic chaos that had plagued the interwar period, characterized by competitive devaluations and protectionist trade policies that exacerbated the Great Depression. The chief architects were John Maynard Keynes of the United Kingdom and Harry Dexter White of the United States. While Keynes proposed a global central bank issuing a new international reserve currency called ‘Bancor’, the final agreement largely reflected White’s plan, which placed the US dollar at the center of the system.

• Mechanism: The Gold-Exchange Standard:

  • The Bretton Woods system was a fixed exchange rate system, often described as an “adjustable peg” system.
  • The US dollar was the anchor of this system. The US government guaranteed the convertibility of the dollar to gold at a fixed rate of $35 per ounce.
  • Other member countries pegged their national currencies to the US dollar at a fixed parity. For example, the British Pound might be pegged at £1 = $2.80.
  • By pegging to the gold-convertible dollar, other currencies had an indirect link to gold, creating a gold-exchange standard.
  • While the rates were fixed, they were not immutable. A country facing a “fundamental disequilibrium” in its balance of payments could, with the approval of the newly created International Monetary Fund (IMF), devalue its currency.

• Characteristics and Objectives:

  • Stability: The primary goal was to stabilize international exchange rates to facilitate post-war reconstruction and promote global trade and investment.
  • Economic Recovery: It was designed to provide a stable financial environment for nations to recover from the devastation of World War II.
  • Reserve Currency: The US dollar became the world’s primary international reserve currency, used for international payments and held by central banks.
  • Standardization: It standardized international monetary payments by creating a predictable system for currency conversion.
  • Institutional Framework: Two key institutions were established:
    1. International Monetary Fund (IMF): To oversee the international monetary system, ensure compliance with the rules, and provide short-term financing to countries experiencing temporary balance of payments difficulties.
    2. International Bank for Reconstruction and Development (IBRD): Now part of the World Bank Group, it was initially created to finance the reconstruction of war-torn Europe.

• Collapse of the Bretton Woods System (1968-1973):

  • The Triffin Dilemma: In his 1960 book, Gold and the Dollar Crisis: The Future of Convertibility, economist Robert Triffin identified a fundamental flaw. For the world to have enough liquidity (dollars for trade), the US had to run a persistent balance of payments deficit. However, a continuous deficit would lead to an accumulation of dollars abroad far exceeding the US gold reserves, eventually undermining confidence in the dollar’s convertibility and causing the system’s collapse.
  • US Fiscal Strain: In the 1960s, the US government’s spending on the Vietnam War and domestic ‘Great Society’ programs led to high inflation and a worsening current account deficit, flooding the world with dollars.
  • Depletion of US Gold Reserves: As confidence in the dollar waned, countries, notably France under President Charles de Gaulle, began demanding gold in exchange for their dollar holdings, significantly depleting US gold reserves.
  • The “Nixon Shock”: On August 15, 1971, facing dwindling gold reserves and speculative attacks on the dollar, US President Richard M. Nixon unilaterally suspended the direct convertibility of the US dollar into gold. This act effectively dismantled the central pillar of the Bretton Woods system.
  • Final Collapse: After attempts to re-establish fixed rates (the Smithsonian Agreement of December 1971) failed, the system officially collapsed in March 1973, when major world currencies began to float freely against each other.

• Reasons for Failure:

  1. Liquidity and Confidence Problem (Triffin Dilemma): The system’s dependence on the US dollar created an inherent instability.
  2. Adjustment Mechanism Failure: The system lacked an effective mechanism to compel surplus countries (like Germany and Japan) to revalue their currencies or deficit countries (like the US) to contract their economies, leading to persistent imbalances.
  3. Seigniorage and “Exorbitant Privilege”: A term coined in the 1960s by French Finance Minister Valéry Giscard d’Estaing, it referred to the undue advantage the US enjoyed. It could finance its deficits by printing dollars, which other nations were compelled to hold as reserves, effectively receiving an interest-free loan from the rest of the world.

Flexible Exchange Rate System

Following the collapse of the Bretton Woods system, the world transitioned to a system where currency values are primarily determined by market forces.

• Mechanism: A flexible or floating exchange rate is determined by the forces of demand and supply in the foreign exchange (forex) market.

  • Demand for a currency (e.g., INR) increases when foreigners wish to buy Indian goods and services (exports), invest in India (FDI, FPI), or speculate on the rupee’s appreciation.
  • Supply of a currency increases when Indian residents wish to buy foreign goods and services (imports), invest abroad, or speculate on the rupee’s depreciation.
  • An increase in demand or a decrease in supply leads to appreciation (currency becomes stronger). A decrease in demand or an increase in supply leads to depreciation (currency becomes weaker).

• Impact of Global Monetary Policy:

  • Policies like Quantitative Easing (QE) by the US Federal Reserve involve increasing the money supply. This increases the global supply of dollars and lowers interest rates.
  • This encourages investors to seek higher returns in emerging markets like India, leading to increased capital inflows through External Commercial Borrowings (ECBs), Foreign Direct Investment (FDI), and Foreign Institutional Investment (FII/FPI).
  • This influx of dollars increases their supply in India’s forex market, causing the Indian Rupee to appreciate.

• Managed Floating or “Dirty Float”:

  • In practice, very few countries follow a pure free float. Most, including India, operate under a managed floating system.
  • This is a hybrid system where the exchange rate is largely market-determined, but the central bank (the Reserve Bank of India) intervenes to manage excessive volatility.
  • If the rupee depreciates too rapidly, the RBI may sell dollars from its forex reserves to increase dollar supply and stabilize the rupee. Conversely, if the rupee appreciates too sharply (hurting exporters), the RBI may buy dollars.
  • Sterilization: When the RBI buys dollars, it injects an equivalent amount of rupees into the banking system, which can be inflationary. To neutralize this effect, the RBI simultaneously sells government securities through Open Market Operations (OMO) to absorb the excess rupee liquidity. This coordinated action is known as sterilization.

• Key Terminology:

  • Depreciation/Appreciation: These terms are used in a flexible exchange rate system to describe changes in currency value due to market forces.
  • Devaluation/Revaluation: These terms refer to the deliberate, official downward or upward adjustment of a currency’s value by a government or central bank under a fixed exchange rate system.
  • Dutch Disease: An economic phenomenon where the rapid development of one sector of the economy (e.g., discovery of natural resources or a surge in capital inflows) leads to a decline in other sectors. The large inflow of foreign currency causes the domestic currency to appreciate, making manufactured exports less competitive and imports cheaper. The term was coined by The Economist in 1977 to describe the manufacturing decline in the Netherlands following the discovery of the Groningen natural gas field in 1959.

Exchange Rate Management in India

India’s exchange rate policy has evolved significantly, especially since the economic reforms of the early 1990s.

• Pre-1991 Regime: India followed a fixed exchange rate system, where the rupee was pegged to a basket of currencies of its major trading partners. The exchange rate was managed by the RBI.

• Liberalised Exchange Rate Management System (LERMS) (1992-1993):

  • Introduced in the Union Budget of 1992-93 on the recommendation of the C. Rangarajan Committee, LERMS was a transitional mechanism following the 1991 Balance of Payments crisis.
  • It established a dual exchange rate system:
    1. Official Rate: 40% of all current account receipts (from exports, remittances) had to be surrendered to the RBI at an officially fixed, lower exchange rate. This was used to finance essential imports like petroleum, fertilizers, and life-saving drugs.
    2. Market Rate: The remaining 60% of receipts could be converted at a market-determined exchange rate. All other imports and capital account transactions were conducted at this market rate.
  • This system effectively acted as a tax on exporters and subsidized certain imports.

• Market-Determined Exchange Rate Regime (March 1993 - Present):

  • Due to the stability LERMS provided and a healthy build-up of forex reserves, India moved to a unified, market-determined exchange rate system in March 1993.
  • India follows a managed float policy. The RBI does not target a specific exchange rate level but intervenes to curb excessive volatility and maintain orderly market conditions.

• Factors Influencing Exchange Rate:

  1. Inflation: A country with consistently higher inflation than its trading partners will see its currency depreciate over time, as its purchasing power erodes.
  2. Current Account Deficit (CAD): A high and persistent CAD implies that the demand for foreign currency (for imports) exceeds its supply (from exports), putting downward pressure on the domestic currency.
  3. Political and Economic Stability: A stable political and macroeconomic environment attracts foreign investment, strengthening the currency.
  4. Speculation: If market participants expect a currency to depreciate, they will sell it, creating a self-fulfilling prophecy.
  5. Interest Rate Differentials: Higher domestic interest rates can attract foreign capital seeking better returns, leading to currency appreciation (subject to the Interest Rate Parity theory).

• The J-Curve Effect:

  • This economic theory describes the short-term impact of a currency depreciation on a country’s trade balance.
  • Initially, a currency depreciation worsens the trade deficit. This is because import contracts are often priced in foreign currency, so the domestic currency value of imports rises immediately. Export volumes do not increase instantly as it takes time for foreign consumers to respond to lower prices.
  • Over time, as exports become cheaper and more competitive, their volume increases. Simultaneously, more expensive imports lead to a fall in import volume. This gradually improves the trade balance, tracing a ‘J’ shape on a graph.
  • The Marshall-Lerner Condition is a key theoretical underpinning: for a depreciation to improve the current account, the sum of the price elasticities of demand for exports and imports must be greater than one.

Nominal Exchange Rate and Real Exchange Rate

It is crucial to distinguish between different measures of the exchange rate to understand a country’s true international competitiveness.

• Nominal Exchange Rate (NER): This is the most commonly quoted rate. It is the price of one currency in terms of another (e.g., ₹83 per $1). It is determined by the market forces of demand and supply in the forex market and does not account for differences in price levels between countries.

• Nominal Effective Exchange Rate (NEER):

  • NEER is an index that measures the value of a domestic currency against a weighted average of a basket of foreign currencies.
  • The weights are assigned based on the share of each country in India’s foreign trade. The RBI compiles a 40-currency NEER index.
  • An increase in the NEER index indicates an appreciation of the rupee against this basket of currencies, meaning it has become stronger on average. This can make exports more expensive. NEER is not adjusted for inflation.

• Real Effective Exchange Rate (REER):

  • REER is the NEER adjusted for the inflation differentials between the home country and its trading partners.
  • It is considered the most accurate measure of a country’s international trade competitiveness.
  • Formulaically: REER = NEER × (Domestic Price Index / Foreign Price Index).
  • An increase in the REER indicates an appreciation in the real value of the currency. This means that Indian goods are becoming more expensive relative to goods from its trading partners, which can harm export competitiveness and encourage imports. A REER value above the base year (e.g., >100) suggests the currency is overvalued in real terms.

• Purchasing Power Parity (PPP) Exchange Rate:

  • PPP is a theoretical exchange rate based on the “law of one price”, which posits that identical goods in different countries should cost the same when expressed in a common currency.
  • Example: If a basket of goods costs ₹2,500 in India and the same basket costs $100intheUS,thePPPexchangerateis₹25per$1.
  • The PPP rate eliminates differences in price levels and is used by institutions like the IMF and World Bank to make more accurate comparisons of economic output (GDP) and standards of living across countries.
  • A well-known informal example is The Economist’s Big Mac Index.

• Relationship and Trade Competitiveness:

  • The trade competitiveness of a country is fundamentally determined by its Real Exchange Rate (RER).
  • The RER can be defined as the ratio of the nominal exchange rate to the PPP exchange rate.
  • RER = (NER × Foreign Price Level) / Domestic Price Level or simplified as RER ≈ NER / PPP Exchange Rate.
  • When RER is high, domestic goods are relatively expensive, and foreign goods are relatively cheap, indicating low competitiveness. When RER is low, domestic goods are relatively cheap, indicating high competitiveness.

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Prelims Pointers

• The Bretton Woods conference was held in 1944 in New Hampshire, USA, with 44 participating nations.
• It established the IMF and the IBRD (World Bank).
• The Bretton Woods system was a fixed exchange rate system, also known as the gold-exchange standard.
• The US dollar was pegged to gold at a fixed rate of $35 per ounce.
• The Triffin Dilemma, identified by economist Robert Triffin, highlighted the inherent instability of using a national currency (USD) as the global reserve currency.
• The Nixon Shock of August 15, 1971, involved President Nixon ending the direct convertibility of the USD to gold.
• The Bretton Woods system formally collapsed in 1973, leading to a system of floating exchange rates.
• Depreciation and Appreciation are terms used for currency value changes in a flexible/floating exchange rate system.
• Devaluation and Revaluation are terms for deliberate government actions in a fixed exchange rate system.
• India currently follows a Managed Floating exchange rate system, also known as a Dirty Float.
• LERMS (Liberalised Exchange Rate Management System), introduced in 1992-93, was a dual exchange rate system in India.
• The J-Curve illustrates that a country’s trade deficit initially worsens after a currency depreciation before improving over the long term.
• Marshall-Lerner Condition: For depreciation to improve the trade balance, the sum of export and import price elasticities must be greater than one.
• NEER (Nominal Effective Exchange Rate) is a trade-weighted average of a currency against a basket of other currencies, not adjusted for inflation.
• REER (Real Effective Exchange Rate) is the NEER adjusted for inflation differentials. It is a key indicator of a country’s trade competitiveness.
• PPP (Purchasing Power Parity) is a theoretical exchange rate that equalizes the price of an identical basket of goods and services in two countries.
• Dutch Disease: Refers to the negative impact on an economy when a sharp inflow of foreign currency (e.g., from natural resource exports) causes the domestic currency to appreciate, harming the manufacturing sector.
• Sterilization is a central bank action to neutralize the impact of its foreign exchange operations on the domestic money supply.

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Mains Insights

GS Paper III: Indian Economy

1. Debate: Fixed vs. Flexible Exchange Rate Systems

   • Arguments for Fixed Rate (Stability): Provides certainty for international trade and investment, disciplines domestic monetary policy, and can anchor inflation expectations. However, it leads to a loss of monetary policy autonomy and makes the economy vulnerable to speculative attacks, as seen in the 1997 Asian Financial Crisis. Maintaining the peg can also require vast foreign reserves.
   • Arguments for Flexible Rate (Autonomy): Allows for automatic adjustment of the balance of payments (a deficit leads to depreciation, which self-corrects the deficit). It grants the central bank independence to pursue domestic objectives like inflation control and growth. However, it can lead to high volatility, creating uncertainty for businesses and potentially triggering “currency wars” (competitive devaluations).
   • India’s Choice: India’s managed float is a pragmatic middle path, aiming to combine the benefits of market-based adjustment with the stability provided by central bank intervention to curb excessive volatility.

2. The Policy Trilemma (Impossible Trinity)

   • This economic principle states that a country cannot simultaneously have all three of the following: a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose two out of the three.
   • Case of India: India has opted for an independent monetary policy and has progressively liberalized its capital account, but not fully. By choosing a managed float instead of a fixed rate, India navigates this trilemma, retaining control over its monetary policy while managing capital flows to a certain extent. Events like the “Taper Tantrum” of 2013, when hints of US monetary policy tightening led to massive capital outflows from India, highlight the challenges of managing this balance.

3. Exchange Rate Management and ‘Make in India’

   • An overvalued currency (indicated by a high REER) makes a country’s exports more expensive and its imports cheaper. This can severely undermine domestic manufacturing initiatives like ‘Make in India’ by making Indian goods uncompetitive both globally and domestically against cheaper imports.
   • Analytical Question: Should the RBI actively manage the rupee’s value to keep it slightly undervalued to boost exports, similar to the strategy historically employed by countries like China? This is a contentious debate. While an undervalued rupee helps exporters, it also increases the cost of imports (especially oil and capital goods), can fuel domestic inflation, and may invite accusations of currency manipulation from trading partners.

4. Impact of Global Financial Shocks on India

   • As an open economy, India is highly susceptible to global financial developments. A tightening of monetary policy by the US Federal Reserve can trigger capital outflows from India, causing the rupee to depreciate sharply.
   • RBI’s Response: The RBI’s role becomes critical. It must decide whether to intervene by selling dollars (which depletes forex reserves) or to raise interest rates to attract capital (which can slow down domestic economic growth). This highlights the complex trade-offs involved in managing a floating currency in a globalized world.

GS Paper I: Post-independence India

• The shift from a fixed, controlled exchange rate regime to the LERMS in 1992 and then to a market-determined system in 1993 was not just an economic policy change. It was a fundamental component of the broader LPG (Liberalisation, Privatisation, Globalisation) reforms that marked a definitive break from the socialist-oriented, inward-looking economic model of the preceding decades. This policy shift symbolized India’s integration with the global economy.