The textbook case for a free float rests on three premises. First, price adjusts to clear the market through a self-correcting mechanism: A cheaper rupee should promote exports and discourage imports. Second, resources get allocated efficiently. Third, it prevents moral hazard — the belief among traders and importers that the central bank will always step in. These do not work when capital flows dominate trade.
In many countries, leaving exchange rates entirely to market forces has caused too much instability. Some prominent cases where a free float proved costly include Brazil in 1999 following its crawling peg collapse, Argentina in 2001-02 after abandoning its currency board-like arrangement, and Russia in 2014-15, when sanctions and the oil-price crash drove a sharp rouble depreciation. That is why most central banks, even in advanced economies, do not leave the exchange rate free. The gap between theory and practice is reflected in the International Monetary Fund’s classification: Only 16 per cent of its member countries were “free floating” as of 2023. Most use managed floats, pegs, or bands.
India’s current account deficit (CAD) is modest, but portfolio flows and oil price volatility mean the rupee is driven more by sentiment and positioning than by exports and imports. Leaving the exchange rate to market forces would be too risky for India for several reasons. One, high dependence on imported oil and commodities means that a sharp rupee depreciation passes through quickly to inflation: A 10 per cent depreciation adds about 70 basis points. Two, onshore forex markets lack depth and liquidity. With foreign institutional investors able to pull billions in a week —$3.4 billion a week on average over the last eight weeks — the rate cannot be left entirely to the market. The rupee can overshoot fundamentals. Three, the biggest risk is self-fulfilling expectations amid rising commodity prices and large capital outflows. Importers rush to cover, exporters delay repatriation, and speculators short the rupee expecting a further fall. The expectation of weakness creates further weakness.
After West Asia tensions flared in late February, the dollar index rose on safe-haven demand. Speculation and short-positioning exerted pressure on the rupee through March, with the currency weakening past 95 against the dollar by March 30. Volatility increased, with price moves disconnected from underlying trade and investment flows. In such conditions, a free float would not discover a fair price. In late March, the RBI tightened banks’ net open position limits and barred them from offering rupee non-deliverable forward (NDF) contracts to clients to curb speculation and restore orderly market conditions.
While the exchange rate needs to be managed, it is equally important to address some structural issues. First, the onshore hedging market needs to be deepened. The daily turnover in USD/INR NDF of about $100-150 billion is much larger than that in the onshore forward market, though due to some idiosyncratic factors. The NDF market exists because India restricts full capital account convertibility, but global investors still need to hedge rupee exposure. When onshore access is limited or expensive, risk is then hedged offshore. A deeper onshore rupee derivatives market with easy non-resident access will help narrow the pricing gap between the two markets. Second, the RBI needs to explore how to simplify genuine hedge verification while keeping speculation in check.
Third, we need to revisit the foreign direct investment (FDI) policy to promote stable FDI over volatile foreign portfolio investment (FPI) for two reasons: (i) oil prices have surged recently, driven by the war in West Asia and damage to key energy infrastructure. Even if the war ends and prices decline, they are unlikely to fall to pre-war levels. Given India’s heavy oil import dependence, this will keep straining the current account deficit; (ii) portfolio flows, which were stable for long, have become volatile in recent years. These flows depend on global risk-return assessments and interest rate differentials, not just domestic fundamentals. Recent outflows reflect this. Given this experience, we should not count on volatile portfolio flows when it comes to financing a structural CAD in our calculus. Fourth, efforts need to be intensified to internationalise the rupee, which will help reduce such offshore pressures.
In sum, a free float is good in theory. For a country with India’s capital flow profile, it cannot be practised. Markets tend to overshoot and expectations become self-fulfilling — a phenomenon amplified by offshore NDFs. While the rupee needs to be managed, we need to strengthen market microstructure to make it deeper and more liquid. Deeper onshore derivatives and easier access to onshore hedging will help contain volatility and reduce NDF arbitrage and the need for intervention.
The author is senior fellow, Centre for Social and Economic Progress, New Delhi
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