Exports and remittances in foreign currencies by non-resident Indians (NRIs) have historically constituted a large majority of foreign currency reserves of India. Post-colonial Fabian socialist policies – which mostly closed off the Indian market to investment by foreigners – also restricted the Indian currency, the rupee, to a fixed (1947-1977), a basket peg (1978-1992), and a dual exchange rate system (1992-1993), in this order of historical evolution, until 1993.
Beginning in 1991, economic reforms in response to the balance of payments crisis saw the Indian exchange rate regime also evolve into an unified exchange rate system by March 1993. The unification of the exchange rate of the Indian rupee was an important step towards full convertibility on all current account transactions which was finally achieved in August 1994 when India accepted obligations under Article VIII of the Articles of Agreement of the International Monetary Fund (IMF). Upon extensive consultations with experts and market participants, the Reserve Bank of India (RBI) gradually implemented wide-ranging reforms in the second half of the 1990s to remove market distortions and deepen the foreign exchange market.
The focus of the reforms has been to move away from the micromanagement of foreign exchange transactions to the macro-management of foreign exchange flows. Because the RBI at times actively intervenes to “correct” the exchange rate, India can be considered to be a managed float regime rather than an independently floating exchange rate system. To become an independently floating currency, the controls on the capital account must fully be lifted just as they were lifted on the current account: India’s capital account, which consists of foreign direct investment (FDI) and foreign institutional investment (FII), must become fully convertible.
India is currently the seventh largest economy by nominal gross domestic product (GDP) and on a purchasing power parity (PPP) basis it is the third largest economy in the world. The trilemma does not hold for large economies. India is growing rapidly and is by no means a small economy but even if the trilemma were to apply to India it can retain control over its monetary policy and have open capital markets and move to an independently floating exchange rate regime.
Most importantly the growing up of India from the status of a lower middle income country to a wealthy nation will depend upon India emulating the United States for the growth of its domestic market and Germany (despite the strong euro) for the growth of its export market to be able to weather the vicissitudes of the global economy for sustaining – by mitigating the risks of free financial flows across borders – an independently floating currency.
While removing controls on the capital account, India can improve its international economic standing further by gradually beginning to use its own currency in global trade by entering into currency swap arrangements with its major trading partners – India must begin to pay for its imports in rupees rather than in dollars or in other major currencies. The internationalization of the Indian rupee, including for investment in rupees by Indian firms in foreign markets, will make the rupee a reserve currency in international trade thus minimizing the need for maintaining large foreign exchange reserves.