Evolution of exchange rate mechanism in India

The Indian forex market owes its origin to the important step that RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange. As a consequence, the stipulation of maintaining "square" or "near square" position was to be complied with only at the close of business each day. During the period 1975-1992, the exchange rate of rupee was officially determined by the RBI in terms of a weighted basket of currencies of India’s major trading partners and there were significant restrictions on the current account transactions.


The initiation of economic reforms in July 1991 saw significant two-step downward adjustment in the exchange rate of the rupee on July 1 and 3, 1991 with a view to placing it at an appropriate level in line with the inflation differential to maintain the competitiveness of exports. Subsequently, following the recommendations of the High Level Committee on Balance of Payments (Chairman:Dr C. Rangarajan) the Liberalized Exchange Rate Management System(LERMS) involving dual exchange rate mechanism was instituted in March 1992, which was followed by the ultimate convergence of the dual rates effective from March 1, 1993(christened modified LERMS). The unification of the exchange rate of the rupee marks the beginning of the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It is also an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

The appointment of an Expert Group on Foreign Exchange (popularly known as Sodhani Committee) in November 1994 is a landmark in the design of foreign exchange market in India. The Group studied the market in great detail and came up with far reaching recommendations to develop, deepen and widen the forex market. In the process of development of forex markets, banks have been accorded significant initiative and freedom to operate in the market. To quote a few important measures relating to market development and liberalization, banks were allowed freedom to fix their trading limits, permitted to borrow and invest funds in the overseas markets up to specified limits, accorded freedom to determine interest rates on FCNR deposits within ceilings and allowed to use derivative products for asset-liability management purposes. Similarly, corporates were given flexibility to book forward cover based on past turnover and allowed to use a variety of instruments like interest rates and currency swaps, caps/collars and forward rate agreements in the international forex market. Rupee-foreign currency swap market for hedging longer -term exposure has developed substantially in the last few years.

Courtesy from the RBI (Reserve Bank of India)