thus, enlargement of the current account deficit beyond the present level is sustainable. volatility 8. the reserve bank has been intervening in both the spot and forward markets to prevent undue fluctuations. in the context of large capital flows ( inflows as well as outflows ) within a short period, it may not be possible to prevent movements in the exchange rate away from the fundamentals. hence, the management of rate fluctuations becomes passive, i. e., one of preventing undue appreciation in the context of large inflows and providing a supply of dollars in the market to prevent sharp depreciation. but, the correction, if any, has to be gradual and not sudden. level of reserves 9. adequacy of reserves is, as i mentioned, an important consideration. the level of foreign exchange reserves rose to us $ 29. 8 billion by august 1, 1997 - equivalent to seven months of imports. in the context of the changing interface with the external sector and the importance of the capital account, we have to evaluate reserve adequacy in terms of both conventional indicators and non - conventional norms. the present level of foreign exchange reserves is equivalent to about 30 months of debt service payments and 5. 7 months of payments for import and debt service taken together. in the context of mobile capital flows, it may be useful to assess the level of reserves in terms of the volume of short - term debt which can be covered by reserves. at the end of march 1997, the ratio of short - term debt to the level of reserves amounted to a little over 25 per cent, compared to about 100 per cent for indonesia, 50 per cent for argentina, and 25 per cent for malaysia. in fact, the level of reserves exceeds the total stock of short - term debt and portfolio flows which, taken together, constitute little less than 75 per cent of the level of reserves. the present level of external reserves is a source of comfort as it provides a measure of insulation against unforeseen external shocks or shocks created by domestic supply shortages. besides, it helps to meet the precautionary motive and satisfy the need for liquidity, which in itself instils confidence in the indian economy among international investors and financial markets. such confidence has also a bearing on the extent and of course cost of external borrowings. as the economy becomes more open, external shocks need a cushion which reserves alone can provide. the volatility of some of the

mr. reddy reports on the dilemmas of exchange rate management in india inaugural address by the deputy governor of the reserve bank of india, dr. y. v. reddy, at the xith national assembly forex association of india held in goa on 15 / 8 / 97. i am thankful to the organisers of the xith national assembly of the forex association of india for giving me an opportunity to share with you the dilemmas that we face in foreign exchange management. the fifty years since independence have seen significant changes in our exchange rate regime. the exchange rate policy has evolved from the rupee being pegged to the pound sterling until 1975, pegged to an undisclosed currency basket until 1992 and after a year's experience with dual exchange rate system to a market - related system by march 1993. this has helped to bring about flexibility in exchange rate management. a couple of years ago, my predecessor, distinguished dr. s. s. tarapore, addressed this assembly on some of the burning issues of foreign exchange markets. last year, my colleague, mrs. usha thorat gave an authentic and analytical account of the recent developments in forex markets and on the role of authorised dealers ( ads ) in forex markets. today, i will address the dilemmas that we, as policy makers, face in the conduct of exchange rate policy. international parity 2. i will briefly, as a backdrop, revisit the four parity conditions, that you are familiar with. first, the purchasing power parity ( ppp ) which links the spot exchange rate and inflation. secondly, the international fisher relation which links interest rates and inflation. thirdly, the foreign exchange expectations which link forward exchange rates and expected future spot exchange rates. fourthly, the interest rate parity, which links spot exchange rates, forward exchange rates and interest rates. the four parity relations could be combined in several ways to throw light on the four critical variables that are often used in exchange rate management policies, viz., the interest rate differential, the inflation differential, the forward discount / premium, and the exchange rate movement. the theories built around the parity relations help us to understand the foreign exchange markets better, but, they rarely give us ready - made solutions to the problems that arise in day - to - day, say, minute - to - minute operations in the exchange markets. 3. what could be the explanation for such a phenomenon? in the real world, expectations cannot be