Words and deeds in the Indian exchange rate

by Rajeswari Sengupta and Ajay Shah.

The most important price in any economy is the exchange rate. In India's case, this is the price of the Indian rupee against the US dollar. By default, the exchange rate is controlled by market forces. The policy stance of the government, towards the exchange rate, is termed 'the exchange rate regime'. This is one of the most consequential economic policy choices.

In most advanced economies, the answer is straightforward: the exchange rate is set by financial markets, and the government stays out. In India, it is more complicated. The RBI regularly intervenes in the foreign exchange market. India's exchange rate regime needs to be deciphered from the data using statistical tools.

At any point in time, to understand the Indian economy, knowing the present exchange rate regime is central. Looking back at economic history, knowing the dates and characteristics of the changing exchange rate regime is central.

Inferring the true exchange rate regime from the data

We now have mature tools for deciphering the exchange rate regime using exchange rate data, without requiring information about the actions taken by the government. This runs in two steps: the first is a sweet linear regression called 'the exchange rate regression' and the second is the econometrics of structural change through which structural breaks in the regression coefficients and the residual standard deviation are detected. This idea for structural breaks in linear regression models where the residual standard deviation can also change is taken from Zeileis, Shah and Patnaik (2010) and implemented in the R package fxregime which now has numerous applications into fields well beyond exchange rate regimes and structural change.

In this article we will first rev up this tool chain for the Indian rupee, offering measures of the present exchange rate regime and of the history of Indian macroeconomic policy. We will offer ready access to reproducible research so that everyone can perform these calculations. We will then turn to a comparison against RBI and IMF statements about the Indian exchange rate regime.

Reading the data: six distinct regimes since 2000

The exchange rate regression estimates how much of the movement in the rupee is explained by movements in the world's major floating currencies - the US dollar, the euro, the British pound, and the Japanese yen. The greater the role of these foreign currencies in explaining the rupee's movement, the less independently the rupee is floating. Alongside this, we get the residual standard deviation: the extent to which the movements of the rupee reflect none of the above. The dates of structural breaks mark the boundaries between different exchange rate regimes.

We apply this method to weekly exchange rate data from the BIS from January 2000 to December 2025, and it shows six distinct exchange rate regimes. This gives us an updated version of the knowledge in Patnaik and Sengupta (2022) and Pandey, Patnaik and Sengupta (2024).

Figure 1: USD/INR exchange rate with structural breaks.

Figure 2: Annualised volatility of USD/INR (6 month rolling window) with structural breaks.

The six periods are as follows:

Regime 1 (January 2000 - March 2004): This was a tight peg to the dollar. The rupee moved very little independently. The annualised INR-USD volatility averaged just 2.2%.

Regime 2 (March 2004 - March 2007): This was a move towards greater flexibility. The rupee was moderately pegged to a basket of currencies. The volatility rose to 4.1%.

Regime 3 (April 2007 - December 2013): This was the most flexible period in the 25 years under examination. This was the era when India came closest to a genuinely market-determined exchange rate. The USD/INR volatility was 8.8%. There were many months in this period where RBI trading on the currency market was 0. This gives us an interesting conjecture: If the rupee were to float, it would have an annualised vol of about 9%.

Regime 4 (January 2014 - September 2023): This was a retreat to greater currency management. This was the longest single regime in our sample - nearly a decade. The INR-USD volatility fell back to 5%, and the RBI's interventions in the foreign exchange market grew steadily. It is ironic that inflation targeting came into India in February 2015, with the signing of the Monetary Policy Framework Agreement. This was roughly the same time that rupee flexibility was in retreat.

Regime 5 (October 2023 - December 2024): A remarkable de-facto peg; the lowest volatility in 25 years. For this 15-month period, INR-USD volatility was just 1.5%: the lowest in our 25-year sample, lower even than Regime 1 which reflected the macroeconomics knowledge of long ago. The rupee barely moved against the dollar, even as other emerging market currencies fluctuated.

Regime 6 (December 2024 - December 2025): Finally, we got a partial retreat from the peg. Volatility has risen to around 4.4%, comparable to Regime 2.

What the RBI says

In 1993, India officially moved towards a "market-determined exchange rate". The RBI website states that its "exchange rate policy focuses on ensuring orderly conditions in the foreign exchange market" - implying that it intervenes only to prevent excessive volatility, not to target any particular level of the rupee.

The empirical evidence, however, shows that the Indian economy experienced six different exchange rate regimes without any changes in official statements, announcements, or rationale.

What the IMF says

The International Monetary Fund, which classifies every member country's exchange rate regime every year, had long described India's regime as "floating", noting that the rupee is "largely market determined" and that the RBI intervenes only to manage "excessive volatility". The IMF classification does not see the six regimes that the data reports.

Figure 3: USD/INR exchange rate with regime classification from IMF AREAER.

The econometrics of structural change shows the recent nearly-fixed exchange rate regime as running from October 2023 -December 2024. This event was so large and remarkable that the IMF picked it up. In its 2023 Annual Report on Exchange Arrangements and Exchange Restrictions (released in December 2024), the IMF reclassified India's de-facto exchange rate regime retroactively:

"Since December 2022, the exchange rate stabilized within a 2% band against the US dollar, with one realignment in August 2023. Therefore, the de facto exchange rate arrangement was reclassified retroactively to 'stabilized' from 'floating', effective December 6, 2022."

The structural change econometrics picks up different dates compared with these statements. The statistical techniques precise dates for structural breaks down to the week, in contrast to the IMF classification, which is updated annually.

The centrality of the exchange rate regime in the Impossible Trinity

The Impossible Trinity is a foundational concept in economics. It states that a country can achieve at most two of the following three objectives simultaneously: an open capital account (allowing money to flow freely in and out of the country), a fixed or managed exchange rate, and an independent monetary policy. It is impossible to have all three at once.

India adopted inflation targeting in February 2015, which means it chose to have autonomy in domestic monetary policy with the legal mandate to keep CPI inflation at 4%. India also has a substantially open capital account after three decades of gradual liberalisation. According to the Trilemma, these two choices leave no room for a managed exchange rate. India cannot simultaneously target 4% inflation, maintain an open capital account, and stabilise the rupee against the dollar.

Yet the data show that from late 2022 to late 2024, that is what the RBI attempted to do. In this period, India's nominal anchor - what the monetary system was supposed to be anchored to - quietly shifted from the inflation target to the exchange rate. In effect, RBI's legal mandate under IT was temporarily displaced by an unannounced exchange rate objective. These attempts induce many difficulties; financial restrictions impeded economic growth, and inflation was excessively volatile owing to the pursuit of extraneous objectives.

Macroeconomic stability requires credibility of monetary policy. Under inflation targeting, the authorities must say what they will do, and then do what they just said. Even if all the right things are done immediately, it would take decades for private persons to learn to trust that there is a stable framework of macroeconomic policy.

It is easy to do these calculations

We have made this analysis a self-contained Google Colab notebook, which can be used by you to do runs or classroom teaching.

The authors thank Rounak for excellent research assistance with the data and analysis, and Anjali Sharma for valuable discussions and comments.

References

Radhika Pandey, Ila Patnaik and Rajeswari Sengupta (2024) "The journey of inflation targeting in India," Indira Gandhi Institute of Development Research, Mumbai Working Papers 2024-022, Indira Gandhi Institute of Development Research, Mumbai, India.

Patnaik, Ila and Rajeswari Sengupta (2022) "Analyzing India's Exchange Rate Regime," India Policy Forum, National Council of Applied Economic Research, vol. 18(1), pages 53-85.

Zeileis, Achim, Ajay Shah and Ila Patnaik (2010) "Testing, monitoring, and dating structural changes in exchange rate regimes", Computational Statistics & Data Analysis, Volume 54, Issue 6.

The authors are researchers at IGIDR, Bombay and XKDR Forum, Bombay, respectively.