Safety Band To Ward Off Volatility In Exchange Rate
The Tarapore committee has recommended that the Reserve Bank of India (RBI) should have a monitoring exchange rate band (MERB) of plus or minus five per cent around the neutral real effective exchange rate (REER).
It has advised the central bank to generally intervene as and when the REER is outside the band. However, the RBI could use its own discretion to intervene even within the band to obviate speculative forces and unwarranted volatility.
The committee has expressed the view that a move towards capital account convertibility would logically ensure that the forward premia in the forex market reflect interest rate differentials between overseas and domestic markets. It has also recommended that as part of exchange rate management greater attention should be focused on ensuring that the forward exchange markets reflect interest rate differentials.
The committee has also suggested that the RBI should undertake a periodic review of the neutral REER which could be changed as warranted by fundamentals.
It has stressed that the credibility of the exchange rate policy would be vital in the context of capital account convertibility and said that a transparent exchange rate policy is of utmost importance. In this regard it has said that the neutral REER i.e., the base period should be announced, the REER Monitoring Band should be declared, the REER should be published on a weekly basis with the same time lag as the publication of the reserves and changes in the neutral REER should be made public.
The exchange rate regime proposed by the committee is expected to provide greater transparency. This would greatly enhance the efficacy capital account convertibility of the exchange rate policy by encouraging orderly market behaviour.
A Monitoring Band, built around the neutral REER could be expected to provide an environment to the market participants for anchoring their expectations. Also, an element of discretion in intervention by the RBI would be necessary.
Finally, the central bank is expected to use its best judgement in the evolving situation and operate its exchange rate policy as warranted by these circumstances. The policy pursued
with respect to exchange rate management will change once capital account convertibility is ushered in.