Managed Floating - What is Managed Floating Exchange Rate System?

To understand the concept of a managed floating exchange rate system, you have to understand what exchange rates are and how they function. An exchange rate regime is adopted by the top bank of any sovereign country to ideate, establish and operate a functioning exchange rate of its currency against foreign currency.

Most often, political, fiscal and social issues determine a country’s exchange rate. 

In India, the exchange rate regimen is governed by the Reserve Bank of India (RBI), often called the ‘Banker of Banks’. There are several types of exchange rate regimes, including managed float, free float, and a flexible exchange rate.

India follows a managed floating rate system. It gives a lot of independence to the market forces, provides data to regulators and stabilises India’s economy. Starting in 1991, when India’s economic policy underwent a renovation, and the markets opened to global companies, this regime has helped the country get back on its feet.

At first glance, a managed float system may not seem useful. However, economists and policy-makers have observed that since India needs to import certain essential items like crude oil, it is important for a Central Bank to maintain a tight leash on exchange rates.

That Central Bank is the RBI.

Before you Delve Deeper into the Topic, here is a DIY Task for you: Research on the last 4 Governors on the Internet. Look at their track records and their methods of management. 

Managed Floating Exchange Rate Definition

In simple terms, a managed floating exchange rate is a system where currencies fluctuate daily but the regulatory authorities, including the government and the Reserve bank of India, may step in to control and stabilise the value of the currency.

If these bodies do not step in, there is bound to be an ‘economic shock’ to the country. As you know, India is a developing country with precise economic requirements. The GDP has been growing at a steady pace, and INR’s strength has increased over the last couple of years.

A managed floating exchange rate is occasionally called a ‘dirty float’ as opposed to a ‘clean float’ where central banks do not intervene.

According to numbers made public by the Reserve Bank of India, more than 40% of all countries use some sort of a managed floating regime. Without the guiding hand of Governments and their respective Central Banks, countries including Algeria, Argentina, Croatia, Egypt, Romania, Singapore and Ukraine would face rising foreign exchange costs.

It can be safely said that a managed float is a hybrid control system. It is neither a free-float nor a flexible float exchange rate.

Why Does India have a Floating Exchange Rate System?

The single most important rationale behind this lies in its history. You must remember that before 1991, India was not a globalised economy. Government offices were underperforming and suffering huge losses; there was rampant unemployment, and private enterprises were practically non-existent.

The table below lists the chronology of events since Independence.

Year(s)

Important events

1947-71

The ‘Par Value’ system that governed exchange rates was in place. The Pound Sterling was selected as an ‘intervention currency’. The Indian Rupee’s external par value was tied to gold reserves.

1971

The Bretton-Woods system finally broke down, and most of its signatories exited. This system had been agreed upon in 1944 by 44 Allied nations. The International Monetary Fund (IMF) was also a result of the Bretton-Woods system. Its main aim was to provide directions on monetary policies to each country after the war. By 1971, this agreement was deemed obsolete. In December 1971, the INR was directly linked to the Pound Sterling.

1990-91

The Indian economy was facing a severe crisis in the balance of payments (BoP). India had limited foreign exchange, and it would not last long. A new economic policy was introduced by the then-Finance Minister, Dr Manmohan Singh. Loans were taken from the IMF.

July 1991

The pegged, or fixed, the exchange rate system was removed. The exchange rates were adjusted downward twice- once by 9% and once by 11%. These steps were essential to ensure that precious foreign exchange reserves were not depleted.

March 1992

The then-Government finally decided to let market forces decide exchange rates. A transition system – termed Liberalised Exchange Rate Management System or LERMS, was set in place. This LERMS was a dual exchange rate regime.

March 1993

One year later, these dual rates ceased to exist – they were converged. The exchange rate was directly linked to prevailing market rates. It is this system that continues to this day.

 

Tasks for Advanced Commerce Students: Research about the Bretton-Woods Agreement and who the parties were. Noted economists and great thinkers like John Keynes and Harry White were present at the summit held in New Hampshire’s famous Mount Washington Hotel.

Find out why it broke down after 1971. You will also notice a return to similar lines of thinking after the 2008-09 global economic crisis.

Objectives of a Managed Floating System

Developing countries with high GDP growth rates usually prefer a managed floating exchange. Since there are bound to be geopolitical events beyond their control, such countries – including India- have placed a great deal of emphasis on this hybrid system.

Here are the four main objectives of a dirty float.

  1. To Reduce or Pause Exchange Rate Volatility: At times, the exchange rate of the US Dollar may go up against the INR. India will then have to pay more to buy crude oil and other essential commodities from the international market. The Rs 70/USD is considered a ‘psychologically significant mark’. If this is breached, both the Govt and the RBI will step in for corrective measures.

  2. To preserve Adequate Forex Reserves: The BoP crisis of 1991 has not been forgotten. If such a scenario ever happened again, there would be enormous harm to India’s economy. A managed float ensures that India’s reserves have enough Foreign Exchange that can be sold at fair market prices during crises.

  3. To Curb Speculative Activities: Speculation in foreign exchange and stock markets is not new. In fact, without speculation, such complex systems would not work. However, certain mala fide elements often carry out a series of rapid and successive speculations by buying or selling Forex in large volumes to make a quick profit. A managed floating exchange prevents such practices and ensures balance.

  4. To Develop a Robust Forex Market: Despite the ‘Make in India’ and ‘Stand Up India’ schemes, the country still has to import a sizable range of products from overseas. To ensure fair competition and maintain adequate BoP, a managed floating exchange rate is necessary.

Advantages of a Managed Floating Regime

There are several merits of a managed float. Some crucial ones are:

  1. A much stronger and resilient monetary policy. Since the Central Bank and the Government work in tandem, there are little chances of differences in opinion at the very top. In India, the RBI has its own Monetary Planning Committee (MPC), formed under the RBI Act of 1934. This committee can alter interest rates if there are extenuating circumstances.

Once such discretionary measures are exercised, banks can alternatively pour in or squeeze out liquidity by giving loans. 

  1. The domestic economy is hardly impacted by the actions taken under a managed floating regime. It must be remembered that such a regime allows a high amount of autonomy to market forces to correct themselves, and the economy by extension. If this does not happen, the central agencies step in to make amends. 

This 2-layered protection system had shielded India well in the 2008-09 crisis.

Disadvantages of a Managed Floating Regime

There are some demerits of a managed floating exchange rate system too. These are:

  1. Competitive devaluations of currencies are the fallout of a managed regime. In a globalised world, more countries than ever before are vying for businesses and big enterprises to establish facilities in their nations. This competition has often led to intentional devaluation. Such phenomenons are often observed in South American countries.

  2. Countries with a managed floating exchange often tend to have weaker financial systems. That is because the Central Banks and Governments have to be careful when drafting budgets and providing stimuli to slowing sectors. In India, there have been several complaints of weak fiscal policies. Various governments have been accused of not laying out a counter-cyclical budget.

For advanced students, it will be interesting to note that fixed and managed regimes share some disadvantages. It is partly due to the ability that countries with fixed exchange regimes can knowingly devalue their currency.

For more topics related to senior secondary Commerce stream, you can make use of Vedantu’s study materials. Also, you can participate in our live interactive classes to gain a more profound understanding of challenging topics. You can refer to our learning programmes to improve your self-study sessions. 


FAQ (Frequently Asked Questions)

1. What is the Floating Exchange Rate?

Ans. A floating exchange rate is a fiscal policy adopted by certain countries where their currency’s value is allowed to fluctuate in line with prevailing market forces.

2. What is a Managed Floating Rate?

Ans. A system where a country’s Central Bank and its Government may step in to correct its currency’s exchange value is considered to have a managed floating rate. It is also known as a ‘dirty float’.

3. Is a Managed Float Better than a Fixed Float?

Ans. The answer depends on the country’s macroeconomic situations and currency strength. There is no blanket consensus on this either way.