For many years, while India has claimed that there is a “market determined exch-ange rate”, in reality the exchange rate has been distorted by RBI’s large-scale trading. As is well known in the field of macroeconomics, when a central bank tries to target the exchange rate, this leads to a loss of autonomy of monetary policy. The pursuit of exch-ange rate targets in 2006 and 2007 led to loose monetary policy, which helped generate the inflation crises of 2007 and 2008.

As the Mistry and Rajan reports have emphasised, the way forward for India lies in getting RBI out of currency trading. While some policy-makers like Commerce Minister Kamal Nath believe that the exchange rate must be a tool of government policy, such pressures need to be resisted. The exchange rate is a price, just like any other price, and the best way to determine a price is through the market. Once RBI is out of the currency market, it will have the sovereign ability to determine monetary policy based on India’s needs. Monetary policy can then respond to domestic conditions, instead of being hijacked by currency policy. The recent volatility of the rupee will have made agents more comfortable with a rupee that moves sharply, rather than one kept under a tight rein by RBI.

Towards the end of Y.V. Reddy’s tenure as governor of RBI, some preliminary signs of increased exchange rate flexibility became visible. Sadly, this was not accompanied by a policy statement ann-ouncing the onset of a new monetary policy regime. In these weeks of global financial turbulence, Governor Subbarao has done well to refrain from trying to deliver “stability” of the exchange rate. The exchange rate has moved significantly, and everyone who is adversely affected by this risk is able to use the NSE currency futures market in order to eliminate this risk. Subbarao now needs to do two things. First, he needs to stay the course, of allowing a genuinely market determined exchange rate even in the face of criticism from the exporter lobby. Second, he needs to unveil a new world of transparency at RBI, by releasing an official document about what India’s exchange rate regime and monetary policy framework is. This would take out the guesswork and give the market confidence about what is being done.