The Reserve Bank of India will continue to manage exchange rate volatility even when the rate becomes more flexible, as it has significant employment, output and distributional consequences.
As India moves towards fuller capital account convertibility, at best only two out of the three objectives of an independent monetary policy - open capital account and exchange rate regime - would be feasible, said RBI.
However, the impact of foregoing the rate objective would be significantly different for the reserve currency countries and emerging market economies, such as India, said RBI.
In the reserve currency countries, which specialise in technology-intensive products, the degree of exchange rate pass-through is low, enabling exporters and importers to ignore temporary shocks and set stable product prices to maintain monopolistic positions, despite large currency fluctuations.
The well-developed financial markets in these countries can also absorb the risk associated with exchange rate fluctuations with minimal impact on the real sector.
On the other hand, for most developing countries, which specialise in labour-intensive and low and intermediate technology products, profit margins for these products in highly competitive markets are very thin and are vulnerable to pricing power by retail chains.
The foreign exchange market is also likely to see a significant rise in volumes and liquidity in the spot and derivative segments as the country moves towards a fuller capital account convertibility in the coming years and gets increasingly integrated with the global economy.
Inflows into India are likely to continue considering its stable macroeconomic conditions and positive growth outlook and, therefore, the foreign exchange market will have to prepare itself to deal with large capital inflows, according to the RBI.
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