Telugu Vallaku Boothu Kathalu

An analysis of the complexities, challenges and vulnerabilities faced by EMEs in the conduct of exchange rate policy and managing volatilities in foreign exchange market reveal that the choice of a particular exchange rate regime alone cannot meet all the requirements. The emerging consensus is that for successful conduct of exchange rate policy, it is essential for countries to pursue sound and credible macroeconomic policies so as to avoid the build-up of major macro imbalances in the economy. Second, it is essential for EMEs to improve the flexibility of their product and factor markets in order to cope and adjust to shocks arising from the volatility of currency markets and swings in the terms of trade in world product markets. Third, it is crucial for EMEs to develop and strengthen their financial systems in order to enhance their resilience to shocks. In addition, a sound and efficient banking system together with deep and liquid capital market contributes to the efficient intermediation of financial flows. This could help prevent the emergence of vulnerabilities in the financial system by minimising unsound lending practices that lead to the build-up of excessive leveraging in the corporate sector and exposure to foreign currency borrowings. Fourth, countries would need to build regulatory and supervisory capabilities to keep pace with financial innovations and the emergence of new financial institutions’ activities, and new products and services, which have complicated the conduct of exchange rate policy. Fifth, policy makers need to promote greater disclosures and transparency.

Economic literature suggests that, at an aggregated level, the adoption of more flexible exchange rate regimes in Emerging Market (EM) countries has been associated with greater monetary policy independence. EM countries with exchange rate anchors are generally associated with pegged regimes. Here, the exchange rate serves as the nominal anchor or intermediate target of monetary policy. Around 27 per cent of the EM countries followed exchange rate anchors at the end of April 2006 (Table). When the exchange rate is directly targeted in order to achieve price stability, intervention operations are unsterilised with inter-bank interest rates adjusting fully. In Singapore, while pursuing a target band for the exchange rate is the major monetary policy instrument, the central bank’s decision on whether to sterilise intervention is made with reference to conditions in the domestic markets. In other regimes, where the exchange rate is not the 1monetary policy anchor, any liquidity impact of intervention that would cause a change in monetary conditions is generally avoided. Most foreign exchange operations are sterilised. Interventions may also be used in coordination with changes in monetary policy, giving the latter a greater room for manoeuvre. For example, where a change in monetary policy is unexpected,surprising the market can erode confidence or destabilise the market. Intervention may help minimise the costs of surprising financial markets, allowing monetary policy greater capacity to move ahead of market expectations.

Globally, operations in the foreign exchange market started in a major way after the breakdown of the Bretton Woods system in 1971, which also marked the beginning of floating exchange rate regimes in several countries. Over the years, the foreign exchange market has emerged as the largest market in the world. The decade of the 1990s witnessed a perceptible policy shift in many emerging markets towards reorientation of their financial markets interms of new products and instruments, development of institutional and market infrastructure and realignment of regulatory structure consistent with the liberalised operational framework. The changing contours were mirrored in a rapid expansion of foreign exchange market in terms of participants, transaction volumes, decline in transaction costs and more efficient mechanisms of risk transfer.The origin of the foreign exchange market in India could be traced to the year 1978 when banks in India were permitted to undertake intra-day trade in foreign exchange. However, it was in the 1990s that the Indian foreign exchange market witnessed far reaching changes along with the shifts in the currency regime in India. The exchange rate of the rupee, that was pegged earlier was floated partially in March 1992 and fully in March 1993 following the recommendations of the Report of the High Level Committee on Balance of Payments. The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility.