Looking at the weak fundamentals and the fiscal mess that India is in it cannot afford to commit the same mistake as that of the East Asian and Latin American countries. Hence, it is very essential that the monetary authorities choose a regime studying carefully the volatility of the capital inflows and outflows that would influence the very nature of the regime.

Cautious approach to follow
Today there exists a very strong positive correlation between the macro economic indicators and the exchange rate. At the theoretical level an ambitious relationship can be established between the exchange rate regime and macro economic performance of the country. Looking at the high level of fiscal deficit, with external trade picking up only recently and with the government faced with several unexpected calamities like drought and war, it is only an indication that there would be a further drain in the country’s kitty with no substantial amount of revenues flowing in what with capital inflows practically drying up.

Appropriate exchange rate
What is an appropriate exchange rate ? With world economies getting globalised it is very difficult to predict whether fixed rate or pegged exchange rates are a better option. Inflation differentials, external trade practices have all been changing in the present and comparision with differentials in economies becomes a difficult task. But an exchange rate that takes into account the prevailing inflation with exchange rate in the background is so far considered to be an appropriate form of judging ones external value of the currency. There are several differences in world growth rates and differences in macro economic performance across exchange rate regime are rather nebulous as exchange rate regime itself could be endogenous.

To make a choice between fixed exchange rate or a flexible exchange rate could also be a difficult option as there is some amount of predictable depreciation which currency agents could take full advantage of and go in for excessive unhedged foreign currency loans which in the short-term could be damaging to medium and and long run stability of the economy.

Fixed exchange rates are suitable to small open economies which have a high degree of commodity diversification as they can reconcile internal and external balances more efficiently than flexible exchange rates. Diversification makes a country less vulnerable to shocks as such a country does not require frequent changes in relative prices via the exchange rate. Countries that have few commodities have to depend on flexible exchange rates so as to effectively respond to changes in world prices spreading thereby the spillover effect to other sectors of the economy.

Lessons to learn
Today where economies are more complex in their workings and are more integrated with world markets openness of the capital account could be a significant factor in choice of exchange rate regimes. The level of forex reserves in comparision to a country’s short-term liabilities could also be an influencing factor in determining a country’s exchange rate. Today a comfortable level of reserves is very necessary for a country to protect its exchange rate level. If there is a fall in the reserves then the country should have a very effective monetary policy wherein the interest rate is allowed to increase in case there is downward pressure on on the domestic currency.

Today India has an open financial system. So, going from the Asian crisis it is appropriate to have a complete flexible exchange rate and currency board systems as appropriate alternative approaches to exchange rate policy in an open financial system. However, today the Indian financial markets are still volatile and not fully developed to withstand currency pressures. So, currency board systems are generally recommended as transitional arrangements for countries lacking credibility. If India should avoid a similar type of an Asian crisis it should move on to more flexibility though not necessarily a free float.

India should first strengthen its financial system , check fiscal deficit and then frame a monetary policy that aims at low inflation which are the prerequisites for CAC. Choice of an exchange rate regime is a very complex issue and depends on specific circumstances to individual countries. That is, the structure of the economy, its inflationary history, the degree of vulnerability to shocks, the extent of trade diversification, the degree of capital account liberalisation and exposure to global capital markets.

Long-term view required
Every economy moves through transitional shocks and it is only the ability of the country to withstand speculative attacks and financial shocks that can prove the appropriate exchange rate for the country. It is thus very important for a country to strengthen its macro economic policies and financial sector reforms before choosing a appropriate exchange rate regime. As the economy advances, the central bank of the country should also be empowered with sufficient autonomy powers and adequate instruments to regulate capital flows in relation to the economy’s absorptive capacity. To wade off speculators the central bank should not ideally support any particular exchange rate nominal or real.