Exchange Rate Regimes and Forex Management for UPSC

Regimes: Fixed, Floating and Managed

What is an Exchange Rate?

An exchange rate is the price of one currency expressed in terms of another. If ₹83 is needed to buy US$1, the rupee–dollar exchange rate is ₹83 per US dollar. Exchange rates link national economies and influence trade flows, investment, inflation and macroeconomic stability. How the rate is determined depends on the exchange rate regime adopted by the country’s monetary authority.

Fixed or Pegged Regime

In a fixed exchange rate system the monetary authority fixes the value of the domestic currency relative to an external standard. Historically this standard could be gold or another currency such as the US dollar or pound sterling. The central bank commits to buy or sell foreign currency at the announced par value to keep the exchange rate within a narrow band. To maintain the peg the authority must hold large foreign reserves and is often forced to adjust domestic interest rates and monetary policy to defend the peg. Fixed rates provide stability and reduce transaction risk but limit policy independence and can lead to misalignments if the peg does not reflect economic fundamentals.

Flexible or Floating Regime

Under a flexible (floating) regime the value of the currency is allowed to fluctuate according to supply and demand in the foreign exchange market. Exporters, importers, investors and speculators decide the rate through their trading activity. The central bank does not announce a target rate, and intervention is minimal or absent. Flexible rates allow automatic balance of payments adjustment and give policymakers greater freedom over domestic interest rates and money supply. However, they can experience sharp volatility, creating uncertainty for traders and investors.

Managed Floating Regime

Most modern economies operate between these extremes. A managed floating (also called dirty float) regime combines market determination with discretionary intervention. The currency is free to move but the central bank occasionally buys or sells foreign currency to smooth excessive fluctuations, build or deplete reserves or signal policy stances. This hybrid approach aims to capture the benefits of flexibility while limiting disruptive volatility. India, Brazil and many emerging markets follow managed float systems.

Devaluation, Revaluation, Depreciation and Appreciation

Under a fixed regime the central bank can devalue its currency—officially lowering the peg—to make exports cheaper and address external imbalances. The opposite, a deliberate increase in the peg, is called revaluation. Under flexible regimes the currency may lose value due to market forces; this market‑driven decline is called depreciation. A market‑driven increase is called appreciation. Distinguishing these terms is important for prelims questions.

India’s Exchange Rate History

Immediately after Independence the rupee was linked to the pound sterling under the par value system. From 1947 to 1971 the external value of the rupee was fixed at 4.15 grains of fine gold. When the Bretton Woods system collapsed in 1971 India maintained a peg—first to the US dollar and then simultaneously to the pound sterling—allowing limited adjustments. In response to declining UK trade and changing global patterns, the rupee was delinked from the pound in 1975 and linked to a basket of 14 currencies representing major trading partners; the basket was later reduced to five currencies. During this “adjustable peg with band” period the RBI set a nominal rate and intervened daily to keep the rupee within about ±5 % of the basket value.

Persistent trade deficits, a widening current account gap and dwindling reserves in the late 1980s culminated in a balance of payments crisis in 1991. To secure IMF assistance India undertook a two‑step downward adjustment (devaluation) of roughly 18 % on 1 and 3 July 1991. The following year the Liberalised Exchange Rate Management System (LERMS) introduced a dual exchange rate: 40 % of foreign exchange earnings were surrendered at the official rate and 60 % were converted at a market rate. This dual system was short‑lived. On 1 March 1993 the two rates were unified and the rupee moved to a market‑determined system. Current account convertibility arrived in August 1994, allowing the rupee to be freely converted for trade transactions. Since then the RBI has allowed market forces to determine the rupee’s value but has intervened to quell disorderly movements—a managed floating regime.

Over the decades India’s exchange rate management has adjusted to global shocks. During periods of heavy capital inflows, such as the 2000s, the RBI purchased foreign currency to prevent excessive appreciation and built sizeable reserves. In episodes of capital outflow, such as the taper‑tantrum in 2013 or the trade‑tension crisis of 2025, it sold dollars to smooth depreciation. The International Monetary Fund’s 2024 Article IV report reclassified India’s de facto regime from “floating” to stabilised arrangement for late 2022–2024, reflecting sustained intervention to anchor the rupee within a narrower band.

Managed floating has become a pragmatic choice for India: it allows the rupee to reflect economic fundamentals while giving the RBI the discretion to lean against speculative pressures. The central bank’s strategy since 2019 has been three‑pronged: (i) allow the rupee to depreciate during periods of capital outflows or terms‑of‑trade shocks; (ii) permit appreciation when productivity gains and strong export growth exert upward pressure; and (iii) build reserves during episodes of strong inflows by purchasing foreign currency. This “lean‑against‑the‑wind” approach aims to minimise volatility while avoiding persistent misalignment of the real exchange rate.

REER versus NEER: Measuring Currency Competitiveness

Understanding NEER

The Nominal Effective Exchange Rate (NEER) is a trade‑weighted geometric average of a country’s bilateral exchange rates against the currencies of its major trading partners. For India, the RBI constructs NEER indices using a basket of six currencies (primarily for monetary analysis) and a broader basket of 40 currencies representing countries that account for roughly 88 % of India’s merchandise trade. These indices have a base value of 100 in 2015–16. An increase in the NEER signifies an appreciation of the domestic currency in nominal terms; a decline suggests depreciation. Because NEER does not account for price differences between countries, it tells us about the rupee’s international price but not its purchasing power.

Understanding REER

The Real Effective Exchange Rate (REER) adjusts the NEER for relative price levels (typically using consumer or wholesale price indices). In other words REER equals NEER multiplied by the ratio of domestic prices to foreign prices. If domestic inflation is higher than that of trading partners, the REER will appreciate even if the nominal exchange rate is unchanged. As a result REER is considered a more accurate gauge of external competitiveness: a rising REER implies that domestic goods are becoming relatively more expensive than foreign goods and therefore exports may lose competitiveness, while imports become cheaper.

Key Differences

The table below compares NEER and REER on important parameters.

In recent years the 40‑currency NEER has trended downward—falling about 32 % between 2004–05 and 2023–24—indicating nominal depreciation of the rupee against a broad set of currencies. However, the rupee’s REER has mostly remained above 100 since 2014, meaning that the rupee has strengthened in real terms due to higher domestic inflation. A persistently high REER raises concerns about export competitiveness, and policymakers watch it closely. The RBI’s Monetary Policy Committee, operating under a flexible inflation targeting framework, considers REER movements when assessing the stance of monetary policy. If REER overshoots significantly, the central bank may lean towards lowering interest rates or intervening in the forex market to weaken the rupee.

In 2015–16 the RBI expanded its NEER/REER basket from 36 to 40 currencies to reflect India’s evolving trade pattern. New entrants included Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania and Ukraine, while Argentina, Pakistan, the Philippines and Sweden were dropped. The broader basket increased trade coverage from 84 % to roughly 88 % of India’s merchandise trade. Base year values are periodically rebased; currently the indices use 2015–16 = 100.

Forex Reserves: Composition, Levels and Significance

What Are Foreign Exchange Reserves?

Foreign exchange reserves are external assets held by a country’s central bank to back its domestic currency and meet foreign obligations. They provide a buffer for international payments, support confidence in the currency and allow interventions in the forex market. India’s reserves comprise four main components:

• Foreign Currency Assets (FCA): Holdings of foreign currencies and securities, such as US Treasury bonds, euro‑denominated assets and deposits. FCAs form the bulk of India’s reserves.
• Gold Reserves: Physical gold held by the RBI. Gold provides diversification and can serve as collateral during crises. As of March 2025 the RBI held around 879.6 tonnes of gold; it added nearly 57 tonnes in FY2024–25.
• Special Drawing Rights (SDRs): An international reserve asset created by the IMF. SDRs represent potential claims on the currencies of IMF members. India’s SDR holdings were around US$18.7 billion in mid‑2025.
• Reserve Position with the IMF: This represents India’s reserve tranche and borrowing rights. It was about US$4.6 billion in October 2025.

Current Level and Trends

India’s foreign exchange reserves have expanded dramatically over the past three decades—from under US$6 billion in 1991 to around US$697.8 billion as of 10 October 2025. This makes India the fifth‑largest holder of forex reserves after China, Japan, Switzerland and the United States. The breakdown of reserves on that date was roughly US$572 billion in foreign currency assets, US$102 billion in gold, US$18.7 billion in SDRs and around US$4.6 billion as India’s reserve position at the IMF. The RBI reports these figures weekly. Reserves fluctuate with valuation changes and the RBI’s market operations; for example a stronger US dollar reduces the value of non‑dollar assets when expressed in dollars.

The COVID‑19 pandemic and subsequent global uncertainty saw reserves surge past US$600 billion as capital inflows remained robust and oil prices moderated. They peaked near US$705 billion in September 2024 before moderating due to the RBI’s interventions and valuation losses. Despite occasional declines, reserves remain comfortable, covering roughly 11–12 months of imports and around 95 % of India’s external debt. The import cover well exceeds the commonly used benchmark of six months, providing a substantial safety cushion.

Why Maintain Large Reserves?

High forex reserves serve multiple policy objectives:

• Exchange rate stability: Reserves allow the RBI to intervene in the market to smooth excessive volatility. For instance, in December 2024 the RBI sold over US$69 billion to counter rapid rupee depreciation.
• Confidence and creditworthiness: Ample reserves reassure investors and rating agencies that the country can meet its external obligations, thereby supporting sovereign credit ratings and attracting foreign investment.
• Import and debt cover: Reserves finance imports (especially energy and essential commodities) and provide a buffer to service external debt. With reserves covering almost a year of imports, India can withstand external shocks such as oil price spikes.
• Policy autonomy: Reserves provide monetary authorities flexibility to pursue domestic objectives without being forced into abrupt macroeconomic adjustments. They can also support rupee‑denominated trade settlements with partner countries.
• Emergencies and contingencies: During crises such as the 2025 trade dispute with the United States or global financial turbulence, reserves serve as an emergency fund for stabilisation measures.

Risks and Management

Although large reserves are reassuring, they carry costs and risks. Maintaining reserves entails holding low‑yielding foreign assets instead of investing domestically; the opportunity cost rises when domestic interest rates exceed returns on foreign securities. Reserves can also be eroded by capital outflows, commodity price shocks and valuation changes when the dollar strengthens. To mitigate these risks, the RBI diversifies its portfolio across currencies and maturities, increases its gold holdings and enters into bilateral currency swap agreements—such as the US$75 billion rupee–yen swap line with Japan renewed in February 2025—to access liquidity if needed.

RBI’s Toolkit for Managing the Rupee

Market Operations

The RBI’s primary instrument for exchange rate management is direct intervention in the foreign exchange market. Interventions can be categorized into spot, forward and swap operations:

• Spot Transactions: The RBI buys or sells dollars (or other hard currencies) in the spot market. When the rupee is under depreciation pressure the RBI supplies dollars, increasing availability and damping the exchange rate. Conversely, during periods of excess appreciation it absorbs dollars to prevent the rupee from strengthening too much and to build reserves.
• Forward and Non‑Deliverable Forwards (NDFs): The central bank can enter into forward contracts—agreements to buy or sell currency at a future date and pre‑decided rate. Forward transactions allow the RBI to influence expectations without immediately affecting liquidity. Non‑deliverable forwards settled in rupees (in offshore markets) have become important as speculative positions accumulate there. To counter volatility the RBI intervenes indirectly in offshore NDF markets through state‑run banks.
• Foreign Exchange Swaps: Swap operations involve simultaneous buying and selling of currency on different dates. In a sell‑buy swap the RBI sells dollars in the spot market and agrees to buy them back forward; this drains rupee liquidity temporarily. In a buy‑sell swap the RBI buys dollars spot and sells them forward, injecting rupees while neutralising the liquidity impact at the maturity of the swap. Swaps help manage liquidity and the maturity profile of the RBI’s dollar holdings. Notable operations include the US$5 billion sell‑buy swap maturity in mid‑2025, which withdrew ₹43,000 crore from banking system liquidity.
• Indirect Intervention via Banks: Rather than appearing in the market directly, the RBI can conduct operations through state‑owned banks. This masks the central bank’s hand and helps reduce signalling effects that could excite speculators.

Sterilisation and Liquidity Management

Foreign exchange interventions alter the domestic money supply: buying dollars releases rupees into the banking system, while selling dollars absorbs rupees. To prevent such changes from undermining the inflation target or disrupting monetary conditions, the RBI undertakes sterilisation. Sterilisation neutralises the liquidity impact of interventions using instruments such as:

• Open Market Operations (OMOs): The RBI buys or sells government securities in the domestic market. Selling securities absorbs excess rupee liquidity created by dollar purchases; buying securities injects liquidity when the RBI sells dollars.
• Liquidity Adjustment Facility (LAF): Under the LAF the RBI conducts repo and reverse repo auctions to manage day‑to‑day liquidity. Variable rate repo/reverse repo operations allow flexible absorption or injection of liquidity at market rates.
• Market Stabilisation Scheme (MSS) Bonds: Introduced in 2004, the MSS enables the government to issue special securities (market stabilisation bonds) specifically for sterilisation. The proceeds are kept in a separate account with the RBI and cannot be used for government expenditure. MSS bonds help withdraw large amounts of liquidity when capital inflows are heavy.
• Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR): By raising the CRR (the share of deposits banks must keep with the RBI) or adjusting the SLR, the central bank can absorb liquidity. During the 2025 rupee turmoil the RBI’s mid‑year reductions in CRR were partly offset by large FX interventions, highlighting the balancing act between liquidity and exchange rate management.
• Foreign Currency Non‑Resident (Bank) Deposit Schemes: The RBI can incentivise non‑resident deposits by allowing banks to offer higher rates on FCNR(B) deposits. Mobilising such deposits, along with issuing sovereign bonds like “Masala Bonds”, can bring in foreign currency to bolster reserves without distorting domestic liquidity.
• Bilateral Currency Swaps and Contingent Lines: Agreements with other central banks—for instance the rupee–yen and rupee–dirham swap lines—provide emergency access to foreign currency. Drawing on these lines does not affect domestic liquidity directly and therefore complements the RBI’s toolkit.

Guiding Principles of Intervention

The RBI states that it does not target a specific level of the exchange rate. Its interventions aim to curb undue volatility, maintain orderly market conditions and build reserves when feasible. Interventions are also informed by the Real Effective Exchange Rate: a sustained REER appreciation beyond its medium‑term trend may prompt the RBI to lean towards depreciation to preserve export competitiveness. Conversely, when imported inflation is high or oil prices spike, the RBI may support the rupee to anchor inflation expectations.

Critics argue that persistent intervention can artificially prop up the rupee and result in an overvalued real exchange rate, hurting exports and growth. The IMF’s classification of India’s regime as a “stabilised arrangement” reflects concerns that the rupee is kept within a narrow band. Policy debates revolve around whether the RBI should allow more flexibility and focus strictly on inflation targeting or continue its current pragmatic approach that balances external stability and domestic objectives.

For UPSC Prelims and Mains

For Prelims

• The par value system lasted from 1947–1971; the rupee was pegged to the pound sterling.
• India’s current exchange rate regime is a managed float; the RBI intervenes to control volatility without fixing the rate.
• LERMS (1992–93) introduced dual rates; they were unified in March 1993 leading to a market‑determined system.
• NEER is a trade‑weighted index of nominal exchange rates; REER adjusts NEER for relative inflation.
• The RBI’s forex reserves comprise FCAs, gold, SDRs and the IMF reserve position. As of October 2025 reserves were about US$698 billion.
• MSS bonds (introduced in 2004) are issued for liquidity sterilisation and cannot be used for government spending.
• An appreciation of the REER indicates that domestic goods are becoming relatively costlier than foreign goods, reducing export competitiveness.
• Devaluation is a deliberate reduction of the fixed exchange rate; depreciation is a market‑driven fall in a flexible regime.

For Mains

• Discuss the evolution of India’s exchange rate regime from a fixed peg to the current managed float. Explain the reasons for key policy shifts and assess whether the present arrangement strikes an appropriate balance between stability and flexibility.
• Evaluate the importance of REER and NEER as indicators of external competitiveness. How should policymakers respond if the REER remains above its long‑term trend for an extended period?
• Examine the composition and adequacy of India’s foreign exchange reserves. What metrics (import cover, debt cover) indicate sufficiency? Discuss the costs and risks of holding large reserves.
• Analyse the RBI’s intervention toolkit, including spot operations, forwards, swaps, sterilisation instruments (OMOs, MSS bonds, CRR/SLR changes) and FCNR(B) deposits. Under what circumstances should each tool be used?
• Critically assess whether the RBI’s interventions have impeded export competitiveness. Should India move towards a more freely floating rupee, or is a stabilised arrangement justified given external vulnerabilities?

Quick Facts

• The 40‑currency NEER and REER indices use 2015–16 as the base year (index = 100) and cover roughly 88 % of India’s trade.
• India’s forex reserves peaked near US$705 billion in September 2024 and stood around US$697.8 billion on 10 October 2025.
• Foreign currency assets account for about 82 % of India’s reserves; gold constitutes roughly 15 %, SDRs around 3 % and the IMF position less than 1 %.
• The RBI added over 57 tonnes of gold in FY2024–25, taking total holdings to around 879.6 tonnes.
• Managed floating allows the rupee to depreciate or appreciate but empowers the RBI to intervene during episodes of excess volatility.
• The Market Stabilisation Scheme, introduced in April 2004, issues special bonds solely for sterilising capital inflows and preventing liquidity overhang.
• Current account convertibility was achieved in August 1994, though capital account convertibility remains partial.
• The IMF reclassified India’s de facto regime as a stabilised arrangement for December 2022–October 2023 due to frequent interventions.

UPSC Previous Year Questions (Selected)

The following questions are adapted from past UPSC exams to reflect the themes discussed above. Brief answers are provided for self‑assessment.

1. With reference to the liberalisation of the Indian economy in 1991, which of the following occurred?
   1. Share of agriculture in GDP increased enormously
   2. Share of India’s exports in world trade increased
   3. Foreign direct investment inflows increased
   4. India’s foreign exchange reserves increased enormously
   Select the correct answer using the code below:

   Answer: 2, 3 and 4 only. After 1991, exports, FDI inflows and foreign exchange reserves rose, while agriculture’s share declined as services gained prominence.

2. Which of the following items constitute the current account in the balance of payments?
   1. Balance of trade (exports minus imports of goods)
   2. Foreign assets
   3. Balance of invisibles (services and transfers)
   4. Special Drawing Rights
   Select the correct answer using the code below:

   Answer: 1 and 3 only. The current account records trade in goods and services and transfers; foreign assets and SDRs belong to the capital/financial account and reserves.

3. Consider the following statements:
   1. NEER is a trade‑weighted average of bilateral exchange rates.
   2. REER adjusts NEER for relative price levels.
   3. An increase in REER always improves export competitiveness.
   Which of the statements is/are correct?

   Answer: 1 and 2 only. An increase in REER generally indicates loss of competitiveness because domestic goods become relatively expensive.

4. What is the Market Stabilisation Scheme (MSS)?

   Answer: MSS is a sterilisation instrument introduced in 2004 allowing the government to issue bonds specifically for absorbing excess liquidity created by capital inflows. The proceeds are kept with the RBI and cannot be spent by the government.

Practice MCQs

1. Which of the following best describes a managed floating exchange rate?
   A. A fixed rate anchored to gold and not allowed to vary.
   B. A currency whose value is determined entirely by market forces with no intervention.
   C. A system where the central bank pegs the currency within a pre‑announced narrow band.
   D. A flexible system where the exchange rate is largely market‑determined but the central bank intervenes to reduce excessive volatility.
2. India’s NEER/REER basket was expanded from 36 to 40 currencies for the base year 2015–16. The broader basket now covers approximately what percentage of India’s trade?
   A. 60 %
   B. 72 %
   C. 88 %
   D. 96 %
3. Which component accounts for the largest share of India’s foreign exchange reserves?
   A. Gold reserves
   B. Special Drawing Rights
   C. Foreign Currency Assets
   D. Reserve position in the IMF
4. In India the two‑step rupee devaluation of 18–19 % occurred in which year?
   A. 1975
   B. 1991
   C. 2004
   D. 2013
5. An increase in the Real Effective Exchange Rate (REER) generally implies that:
   A. Domestic goods have become cheaper relative to foreign goods, boosting exports.
   B. Domestic goods have become more expensive relative to foreign goods, potentially hurting exports.
   C. The nominal exchange rate has depreciated but domestic inflation has fallen.
   D. The central bank has devalued the currency under a fixed regime.

Answer Key: 1–D; 2–C; 3–C; 4–B; 5–B.

Frequently Asked Questions (FAQs)

What is a managed floating exchange rate regime?

A managed floating regime is an exchange rate system where the value of the currency is largely determined by market forces but the central bank intervenes from time to time to smooth extreme fluctuations. Interventions aim to prevent undue volatility, build reserves or influence expectations.

How does the RBI intervene in the forex market?

The RBI uses several instruments. It can buy or sell US dollars in the spot market, enter into forward or non‑deliverable forward contracts, execute foreign exchange swaps and operate through state‑owned banks. It supplements these actions with sterilisation tools—OMOs, MSS bonds, repo/reverse repo operations and CRR/SLR adjustments—to neutralise the liquidity impact.

Why does the RBI monitor the REER and NEER?

The NEER provides a snapshot of the rupee’s nominal value relative to a basket of currencies, while the REER adjusts for inflation differentials and therefore reflects external competitiveness. A rising REER indicates that Indian goods are becoming costlier relative to competitors. Policymakers monitor REER to decide whether interventions or policy adjustments are needed to maintain export competitiveness.

What are the main components of India’s forex reserves?

India’s reserves consist of foreign currency assets (US dollars, euros and other major currencies), gold holdings, Special Drawing Rights allocated by the IMF and the reserve tranche with the IMF. Together these assets provide a buffer against external shocks and enable the RBI to intervene when needed.

How adequate are India’s foreign exchange reserves?

With reserves near US$700 billion in 2025, India has one of the world’s largest buffers. The reserves cover roughly 11–12 months of imports and almost all of India’s short‑term external debt. This level is considered comfortable, though the adequacy also depends on factors like capital flow volatility and the size of future external obligations.

What is the Market Stabilisation Scheme (MSS)?

The MSS is a sterilisation tool introduced in 2004. Under this scheme the government issues special securities known as Market Stabilisation Bonds. The proceeds are held in a separate account with the RBI and used solely to absorb surplus liquidity caused by large capital inflows, ensuring that monetary policy remains aligned with the inflation target.

Why can persistent intervention be controversial?

Frequent intervention may keep the currency at an artificially high level, making exports less competitive. It can also distort market signals and invite speculative bets on the central bank’s line of defence. On the other hand, too little intervention could allow disorderly market behaviour that destabilises the economy. Finding the right balance is a key policy challenge.

How is devaluation different from depreciation?

Devaluation is a deliberate policy decision to lower the value of a currency under a fixed or pegged regime; it often accompanies broader macroeconomic reforms. Depreciation refers to a market‑driven decline in the value of a currency under a floating regime. Both make exports cheaper and imports more expensive, but the circumstances and policy mechanisms differ.