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The IUP Journal of Applied Economics
Macroeconomic Regimes and Foreign Exchange Rate Volatility in India
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This paper analyzes the asymmetric volatility of foreign exchange rates with respect to the Indian rupee by identifying associated macroeconomic regimes in India. The paper aims to analyze the volatility spillovers and other relationships of the Indian rupee (INR) with respect to the US dollar (USD), Canadian dollar (CAD), British pound (GBP), Swiss franc (CHF) Japanese yen (YEN) and the euro (EUR) for the period 1973-2012. The study makes use of GARCH family models. The results show that the daily exchange rates of all the currencies considered exhibit volatility persistence and conditional autocorrelation. It is also found that the impact of exchange rate innovations on the conditional variance of the foreign exchange return series varies across the macroeconomic regimes.

 
 
 

Between 1950 and 1973 the INR was linked to the British pound. However, due to the devaluation of the British pound against the INR in 1966 and 1973, the ties between the two currencies were broken. India established a floating exchange rate regime linking the rupee to a ‘basket of currencies’ of the major Indian trading partners, which mainly consisted of the Japanese yen, the West German mark and the US dollar. In March 1992, a dual system was created under which the effective rate would govern only certain import payments, 40% of export and invisible receipts and official grants and IMF transactions. All other dealings would come under an interbank free rate determined by supply and demand in the interbank market. In 1993, the liberalized exchange rate management system was replaced by the unified exchange rate system, and a system of market determined exchange rate was adopted. The rate system was unified at the Interbank free rate and the rupee was fully convertible. All foreign exchange transactions would be conducted by authorized dealers at market-determined rates.

Since independence, Indian exchange rate policy has evolved in tandem with global developments and the gradual opening up of the economy as part of the broader strategy of macroeconomic reforms initiated in the early 1990s. It has moved from a par value system to a basket-peg and then to a managed float exchange rate system. Since March 1993, India has been operating with a managed flexible regime, where the objective is not to achieve any explicit or implicit target for the exchange rate but to contain volatility by ensuring orderly market conditions. During the phase of unexpected market behavior authorities managed actively so as to avoid disruptive market corrections in the regime and engaged passively so as to avoid nominal corrections in the phases of normal market conditions.

However, with the gradual removal of restrictions on many capital account transactions, particularly in the past few years, the exchange rate regime in India has also been described as a bounded float (Gokarn, 2012). If volatility in the exchange rate increases, appropriate tools, including those in the domain of capital account management, are used in India. Within these overall boundaries, the exchange rate is determined by daily variations in demand and supply. The Reserve Bank’s policy approach does not involve strong intervention in the currency market to achieve a specific rate target. However, in excessively volatile market conditions, smoothing interventions are carried out that help to keep markets orderly and prevent large jumps that can induce further spirals. Therefore, the objective of exchange rate management is to find a balance between the short-term risk of the Indian rupee spiraling downwards and the medium-term risk of a loss of confidence in meeting external obligations. In this paper, four macroeconomic regimes are chosen to test the asymmetric volatility of the Indian rupee: (i) the nationalization of financial institutions from 1970 to 1987; (ii) the era of liberalization from 1988 to 1999; (iii) the highly competitive period from 2000 to 2007; and (iv) the global financial crisis from 2008 to 2012.

 
 
 

Applied Economics Jouranl, Foreign Exchange Rate Volatility ,Asymmetric Volatility of Foreign Exchange rates,Associated macroeconomic regimes in India,