Unit 4
Foreign exchange market
Meaning
The foreign exchange Market is a market where the buyers and sellers are involved within the sale and purchase of foreign currencies. In other words, a market where the currencies of various countries are bought and sold is named a foreign exchange market. The structure of the foreign exchange market constitutes central banks, commercial banks, brokers, exporters and importers, immigrants, investors, tourists. These are the main players of the foreign market.
Currencies are always traded in pairs, therefore the "value" of 1 of the currencies in that pair is relative to the worth of the opposite. This determines what proportion of country A's currency country B can purchase, and the other way around. Establishing this relationship (price) for the global markets is that the main function of the foreign exchange market. This also greatly enhances liquidity in all other financial markets, which is essential to overall stability. The foreign exchange market is an over-the-counter (OTC) marketplace that determines the rate of exchange for global currencies. It is, by far, the most important financial market in the world and is comprised of a worldwide network of monetary centers that transact 24 hours daily, closing only on the weekends. Currencies are always traded in pairs, therefore the "value" of 1 of the currencies therein pair is relative to the value of the opposite.
The following are the key points:
a) The foreign exchange (also referred to as FX or forex) market is a global marketplace for exchanging national currencies against each other .
b) Because of the worldwide reach of trade, commerce, and finance, forex markets tend to be the most important and most liquid asset markets within the world.
c) Currencies trade against one another as exchange rate pairs. for instance, EUR/USD.
d) Forex markets exist as spot (cash) markets also as derivatives markets offering forwards, futures, options, and currency swaps.
e) Market participants use forex to hedge against international currency and rate of interest risk, to speculate on geopolitical events, and to diversify portfolios, among several other reasons.
The main participants in the foreign exchange market are (i) retail clients (i) commercial banks (iii) foreign exchange dealers, (iv) foreign exchange brokers and other authorised agents. The central banks too participate in this market as per its policy decisions. Let us briefly explain the main participants in the foreign exchange market. Retail Clients: These comprise people, international investors, multinational corporations and others who need foreign exchange. Retail clients deal through commercial banks and authorised agents.
Commercial Banks: They carry out buy and sell orders from their retail clients and of their own account. They deal with other commercial banks and also through foreign exchange brokers.
Foreign Exchange Dealers: Banks, investment firms and brokers function as dealers.
- A foreign exchange dealer is a firm or individual that buys foreign exchange from one party and sells to another party in order to earn profit. The spread between bid (buy) and ask (sell) price, that is, the difference between buy and sell price (spread) earns him a profit.
- A dealer is often a commercial company or bank, or another entity like an investment management firm. Foreign exchange dealers can also be brokers and agents working for these entities. They also carry out speculation or/and retail trading.
- A forex dealer handles foreign exchange investment opportunities by exchanging one currency for another.
- A foreign exchange dealer's work is exciting as well as risky. To be a dealer one should have enough knowledge of forex market, of mathematics and economics, analytical skill and quick decision making abilities.
Foreign Exchange Brokers: Each foreign exchange market centre has some authorised brokers. Brokers act as intermediaries between buyers and sellers, mainly the banks. Commercial banks prefer the brokers as banks could obtain the most favourable quotations from them.
They are the currency sellers or currency retailers. They constitute a small percentage among the dealers, that is, around 2 percent. Their importance is increasing as more and more individuals enter the foreign exchange trading. These small traders who also get in speculation to earn profit, require the help of brokers.
Central Banks: Under the floating exchange rate the central bank of a country normally does not interfere in the exchange market. Since 1973 however most of the central banks frequently intervened to buy and sell their currencies in an attempt to influence the rate at which their currencies are traded. Being the monetary authority of the country, Central Bank of each country is the custodian of foreign exchange reserves which it uses to balance the balance of payments. In the process it draws down its foreign exchange reserves or adds to them.
a) The above groups are the sources from where demand and supply forces generate which in turn help determine the foreign exchange rate.
b) The foreign exchange market is broadly divided into (i) wholesale and (ii) retail market.
c) The wholesale market is also called the interbank market. Commercial banks, business corporations and central banks are the main participants in this segment of the market. The size of transaction in the market is very large. The dealers here are highly professional and are the primary price makers. It is big players like multinational banks that exert a lot of influence in the market and are mainly responsible for determining the exchange rate.
d) In the retail market travellers, tourists and people who are in need of foreign exchange for permitted small transactions, exchange one currency for another. The retail market is a secondary price maker.
e) Brokers act as middlemen between the price makers. They provide information to the banks about the prices at which there are buyers and sellers of a pair of currencies. Most of the banks except the major ones deal through brokers who purchase and sell on behalf of others. i Brokers possess more information and better knowledge of market.
f) The price takers in the foreign exchange market are those who buy the foreign exchange which they require and sell what they earn at the price determined by the primary price makers.
INDIAN FOREIGN EXCHANGE MARKET
It is made up of three tiers. In the first, the dealings take place between Reserve Bank of India and Authorised dealers (ADs) comprising mainly commercial banks. In the second tier the ADs deal with each other and in the third the ADs deal with their corporate customers. The retail market mainly caters to the tourists. In this segment there are money changers who deal in foreign currencies.
1. Transfer Function: the essential and the most visible function of exchange market is the transfer of funds (foreign currency) from one country to a different for the settlement of payments. It basically includes the conversion of 1 currency to another, wherein the role of FOREX is to transfer the purchasing power from one country to another.
For example, If the exporter of India imports goods from the USA and the payment is to be made in dollars, then the conversion of the rupee to the dollar are going to be facilitated by FOREX. The transfer function is performed through a use of credit instruments, like bank drafts, bills of foreign exchange, and telephone transfers.
2. Credit Function: FOREX provides a short-term credit to the importers so on facilitate the smooth flow of products and services from country to country. An importer can use credit to finance the foreign purchases. like an Indian company wants to get the machinery from the USA, pays for the purchase by issuing a bill of exchange within the exchange market, essentially with a three-month maturity.
3. Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange risks. The parties to the exchange are often scared of the fluctuations in the exchange rates, i.e., the worth of 1 currency in terms of another. The change in the rate of exchange may end in a gain or loss to the party concerned.
Thus, because of this reason the FOREX provides the services for hedging the anticipated or actual claims/liabilities in exchange for the forward contracts. A forward contract is typically a three-month contract to buy or sell the exchange for another currency at a fixed date within the future at a price agreed upon today. Thus, no money is exchanged at the time of the contract.
There are several dealers within the foreign exchange markets, the foremost important amongst them are the banks. The banks have their branches in several countries through which the exchange is facilitated; such service of a bank is named as Exchange Banks.
Foreign exchange market helps cover the risk involved in foreign exchange transactions. Exporters, importers, investors and others who deal in foreign exchange, try to protect themselves from the fluctuating foreign exchange rate, particularly from the possible loss resulting from frequent changes in foreign exchange rate. Foreign exchange market also provides opportunities to earn profit through operation of the arbitrage system. For this purpose we require to understand the concepts and operation of spot and forward exchange rate and arbitrage.
A. Arbitrage
Arbitrage is a process through which abitrageurs (usually banks) who intend to make a riskless profit out of discrepancies between interest rate and the forward discount and forward premium. Arbitrageurs enter into arbitrage, that is, to purchase of an asset in a low price market and its riskless sale in a higher price market. This process leads to equalization of prices of an asset in all the segments of the market. Difference in prices if at all, is not more than transport or transaction cost.
Arbitrageurs will take advantage of the different exchange rates prevailing in various foreign exchange markets due to interest rate differentials. Let us explain this with an example - suppose=$ exchange rate prevailing in India is Rs.75 = 1$ and in USA Rs.73= 1$. People will purchase dollars in USA and sell it in India earning ai profit of Rs.2 per dollar. In the process, increasing demand for dollars in USA will push up the prices to Rs.74 and more supply of dollar will bring down the price of dollar in India to Rs.74. Arbitrage, therefore helps equalize the exchange rate in different markets. Arbitrage can be internal or international.
- Internal Arbitrage
Arbitrage is possible within the country or within the local market where two banks offer two different bids and asking rates. Let usi illustrate this with an example. Following are the quotes of bank A and bank B.
A B
INR/$ 75.50/75.60 75.40/75.45
The rates are close to each other. Yet a firm or even a dealer may take the advantage of the situation. A dealer can purchase $1,00,000 from bank B and sell it to bank A at 75.50, thus making 0.05 paise profit on a dollar, earning a sum of Rs. 5,000-00. The profit earned is without any risk and blocking capital.
Due to the development of communication system the dealers will exploit the situation to their advantage. The difference in rate however, will soon disappear due to the operation of market forces Heavy demand experienced by bank B will push its selling (asking) price and increased supply of dollars coming to bank A will bring down its buying (bidding) price. The arbitrage opportunity thus will disappear very fast.
If the arbitrage margin is very small, the firms or dealers will not get into arbitrage operation as the execution of the transaction is not very simple and the trouble and cost involved is not worth the small amount of profit.
- International Arbitrage
When only two currencies and two countries are involved in arbitrage it is called two-point arbitrage. When three currencies and three monetary authorities are involved, we have triangular or three-point arbitrage. Triangular arbitrage operates in similar way to that of two-point arbitrage. It increases the demand for cheaper currency and increases supply of dearer currencies. Thus eliminating differences in exchange rates in different centres and in turn unifying all the monetary centres into a single foreign exchange market.
Interest rates and arbitrage: There is a relationship between interest rate and rate of inflation. According to Irving Fisher, a country's nominal interest rate (i) is the sum of required real rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). This can be stated as
i=r + I
If the real rate of interest in a country is 5 percent and annual inflation is 5 percent, the nominal interest rate will be 10 percent. This relationship is called 'Fisher Effect', according to which, a strong relationship seems to exist between inflation rates and interest rates If the real interest rates between the countries differ then arbitrage takes place. For example, if the real interest rate in India is 6 percent and in USA 4 percent then money will flow to India to take the advantage of the difference in real interest rate. The process will lead to an increase in money supply in India leading to a lower real interest rate and shortage of dollars in USA and consequently an increase in real interest rate. According to the purchasing power parity (PPP) theory there is a link between inflation and exchange rates and as the interest rates reflect expectations about inflation, it follows that there must also be a link between interest rate and exchange rate. Such a link is known as International Fisher Effect. It states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries.
If India's nominal rate of interest is higher than USA's with the expectation of higher rate of inflation, the value of Rupee against dollar should fall by that interest rate differential in future.
For example, if the interest rate in India is 10 percent and in USA 6 percent, reflecting 4 percent higher expected inflation in India, we would expect the value of Rupee to depreciate by 4 percent against the US dollar.
Interest arbitrage may be uncovered or covered.
- UNCOVERED ARBITRAGE
In this system, arbitrageurs would take the risk to earn profit by investing in a high interest bearing risk free securities in a foreign market. His earnings would be according to his calculations provided the currency of the foreign market where he invested does not depreciate. If the depreciation is equal to the difference in interest rate, the investor would not incur loss. However, if the depreciation is more than interest rate differential, then the arbitrageur will incur loss. For example, if a trader from U.S.A. invests in risk free Indian security to earn 4 percent more than what he gets at home- for a period of 90 days or 3 months, his profits will be 1 percent. This isi on the assumption of exchange rate remaining the same. If Indian rupee depreciates more than 1 percent during this period the U.S.A. dealer will lose, whereas, if the Indian rupee appreciates, his earnings will be more than what he estimated at the time of investment. Here the investor does not cover foreign exchange risk through forward contract; hence it is called Uncovered Arbitrage.
B. Hedging
Hedgers are agents (usually firms) who enter the forward exchange market to protect themselves against the risk arising out of exchange rate fluctuations. Hedging undertaken by hedgers refers to an operation to protect themselves against the risk arising out of exchange rate changes. To understand the risk, let us assume an Indian importer who imports goods from U.S.A. worth $50,000, has to make the payments in three months’ time. The spot rate at the moment is 70 = $1 which requires 35,00,000. Due to uncertainty of the market, if the importer fears a depreciation of rupee, he will have to pay more than Rs. 70 = $1 three months hence. Therefore, he may enter into buying dollar forward today, through an agreement with commercial banks or authorised agents.
If he enters into an agreement to purchase at the rate of Rs. 70.25, he does so as he fears the depreciation of rupee. After three months he requires to pay an additional Rs. 12,500 more. If the spot rate is more than 70.25 after 3 months, then the hedgers stand to gain. If it turns out to be only Rs. 69.00 or less than that, hedgers are the losers. The advantage of forward market which provides this facility makes the importers sure of the money that he has to pay for obtaining $ 50,000.
Hedging helps the firms cover the risk arising out of changes in exchange rates. It is specially essential for those firms which have large amounts receivables or commitments to pay in foreign currencies.
C. Speculation
Speculators are agents who speculate, that is, purchase and sell foreign exchange with the intention of making a profit by taking the advantage of changes in exchange rates. They participate in the forward exchange market by entering into forward exchange deal. They do so on the basis of their own calculation of the difference between the forward rate and the spot rate that may prevail on a future date. For example, if a speculator enters to sell a dollar at
75.00 after three months with expectations of the dollar becoming r cheap and the spot rate after three months is74= 1$, the speculator purchases the dollar for spot rate (Rs. 74) and sells for the agreed forward rate (Rs. 75), thus making a profit of 1 per dollar. He may Incur loss if the spot rate crosses 76.
Speculators, however, try to minimise their loss by entering into Spot and forward arrangements simultaneously (swaps). For example, let us say, the US $ is quoted as follows:
Spot 75= $1
6months forward 75.50 = 1$
If the speculator anticipates that the US $ may go up to Rs. 76.00, he will take a long position and buy US $at 75.50, six months forward If his calculations turn out to be true, he will sell his US dollars at 76.00 and earn profit of 0.50 per dollar.
Suppose the speculator anticipates a decrease in the value of the US $to Rs. 74.50, then he will take a short position2 in dollar by selling them 6 months forward. If expectations turn out to be true, that is the spot rate after six months turns out to be 74.50, he will make a profit Rs. 1.00 per dollar (purchasing on the spot and selling at the agreed forward rate of Rs. 75.50). If the spot rates go up to 76, then he will incur a loss 0.50 per dollar.
The forward exchange rate is determined by the interaction of hedgers, arbitrageurs and speculators.
Speculators are in the market for the purpose of earning profit, their activities may lead to destabilisation of foreign exchange market. i a fixed exchange rate system, the scope for speculation is limited yet one could speculate on government's move on possible devaluation and enter into forward contracts. Depending on the size of foreign exchange deal entered on the speculation move the market may feel the impact.
INTRODUCTION
International trade requires exchange of currencies between multiple trading partners. In order have a better understanding of international trade, it is necessary to be familiar with the international payments system. What should be the value of one currency in terms of another has always been a challenging queston for economists and policymakers.
A country's currency is used not only by its residents but also by foreign residents who wish to purchase the country's goods and services. This brings us to the concept of exchange rate between different currencies. The rate of exchange of a currency is its price in terms of another currency, or a group of other currencies. The rate of exchange of a currency is a measure of its external value that measures its purchasing power in terms of foreign goods and services. It is an important variable through which a country's interdependence with the global economy can be measured and evaluated.
EQUILIBRIUM EXCHANGE RATE
The concept of equilibrium exchange rate is similar to the equilibrium price of a commodity. Like the price of a commodity, the value of a foreign currency, in terms of the domestic currency, 1s determined by the interaction of the demand for and the supply of the foreign currency in the home market.
The rate of exchange of a currency is said to be in equilibrium if there is no excess supply of order and for it in the foreign exchange market, and therefore there is no tendency for the exchange rate to change. In other words, it is the rate at which the demand for a foreign currency is equal to its supply at a given point of time. Over a period of time, the equilibrium rate will change only when there is a change in either demand or supply, or both. The concept of equilibrium rate of exchange is relevant only when market forces are allowed to operate freely in the foreign exchange market.
The demand for and supply of foreign exchange influences the determination of exchange and vice versa. The equilibrium exchange rate, expressed as the value of a foreign currency in terms of the domestic currency, is determined by the demand for and supply of the foreign currency. Let us now examine the factors that Influence the demand for and supply of a foreign exchange in a country.
DEMAND FOR FOREIGN EXCHANGE
The demand for foreign exchange in a country is determined by a complex set of factors that are influenced by the country's level of development, growth rate, international trade and government policies. Some of the important factors that generate demand for foreign exchange are:
1. Import of goods: This is the most important factor generating demand for foreign exchange in a country. Most countries import goods to meet domestic demand and to take advantage of cost differences with other countries. Countries trade in capital, intermediate and consumer goods. With the lowering of trade barriers in the last few decades, there has been very significant increase in import of goods, particularly by emerging economies, resulting in increased demand for foreign exchange. The price of imports and the demand for foreign exchange are inversely related. Elasticity of demand for imports has a significant impact on the demand for foreign exchange for this purpose. If the demand for a country's major merchandise imports is price and income inelastic then the demand for foreign exchange is likely to be consistently high.
2. Import of services: Along with goods, countries import services. Import of services by many countries has increased manifolds after the creation of the WTO and the development of communication technology. Services that are imported by nations include tourism, transport, banking and insurance, communication, education, professional services.
3. Unilateral payments: These are payments from one country to another that do not correspond to the purchase of any good, service or asset. These include donations, gifts, repatriations (returning of incomes like profits, dividends, interest to investing and creditor countries), remittances sent by foreign workers working in the reporting country, foreign aid and assistance given by the government of a country to other countries.
4. Export of capital: Capital leaves a country in various forms resulting in demand for foreign exchange. Repayment of debts purchase of assets by residents and government in foreign countries, investments in financial assets in foreign countries, foreign direct investments and lending to foreign nationals, all generate demand for foreign exchange.
5. Future expectations: Since almost everywhere, the foreign exchange rates are market determined, they change with changes in demand and supply. Hedgers demand foreign currencies in order to protect themselves from risk arising out of exchange rate fluctuations, while speculators demand foreign exchange to make profit by selling the currencies at a higher rate in the future. Both these activities generate demand for foreign exchange on the basis of future expectations.
The total demand for foreign exchange is inversely related to its price, that is, the exchange rate.
The demand curve like an ordinary demand curve is sloping downwards from left to right and shows an inverse relationship between the price of foreign exchange in domestic currency and the demand for it.
SUPPLY OF FOREIGN EXCHANGE
Foreign currencies enter a country through exports of goods and services, capital inflows, unilateral receipts, all together generates Supply of foreign exchange in the domestic exchange market. Some of the important factors that generate supply for foreign exchange are:
1. Export of goods: Merchandise or goods exports constitute a major source of supply of foreign exchange. Supply of foreign exchange is influenced by the volume of exports and the prices of the exported goods. The elasticity of demand for and supply of a country s exports significantly influence the foreign exchange earned from exports. If the demand for a country's major exports is relatively inelastic in foreign countries, then the supply of foreign exchange from merchandise exports will be large. Example, oil exporting countries. If demand for exports is relatively elastic, then with a fall in price of exports, there will be significant rise in foreign exchange earnings and supply of foreign exchange in the country will be large.
2. Export of services: With increase in trade in services, many countries have been earning large part of their foreign exchanges from this source. India is a significant example in this regard. Exports of services are a major factor generating supply of foreign exchange in the exchange markets.
3. Unilateral receipts: These include receipts from one country to another without corresponding sale of any good, service or asset. These include donations, gifts, aid received by the residents and the government, as well as receipts of repatriations of incomes like profits, dividends and interest from abroad, and remittances sent by nationals working in foreign countries.
4. Import of capital: Capital inflows into a country generate supply of foreign exchange. Such inflows take due to external borrowings, foreign direct investments and foreign portfolio investments. There has been significant increase in foreign capital flows from developed to emerging economies in the process of the current phase of globalization. Such movement of capital cause frequent changes in the exchange rates. Import of capital is highly influenced by government policies.
5. Future expectations: Just like demand for foreign exchange supply of foreign exchange is also influenced by future expectations. When speculators begin to sell foreign currencies in order to make profits, the supply of foreign exchange rises, lowering the value of the foreign currency. Speculation is motivated by future price expectation the total supply of foreign exchange is directly related to its price, that is, the exchange rate.
Supply from all these sources add up to the aggregate supply of foreign exchange. The total supply, like the supply of any other commodity, is directly related to the price i.e. the foreign exchange rate. The diagram above shows the relationship between rate of foreign exchange and its supply. The supply curve of foreign exchange like any other supply curve, slopes upwards.
DETERMINATION OF EQUILIBRIUM EXCHANGE RATE
In figure 12.3 the equilibrium rate is determined at E, where demand and supply curves for foreign exchange intersect. OR is the equilibrium exchange rate when demand for the foreign exchange is equal to its supply. OR¹, and OR² are not the equilibrium exchange rates. At OR², D > S i.e. R²M > R²N. Similarly, at OR¹ S> D i.e. R¹Q> R¹P. Exchange rate R¹ and R² are not stable or equilibrium exchange rates. At the R¹ and R² exchange rates there will be pressure on the prevailing rate to move towards the equilibrium exchange rate i.e. towards point E.
From the above analysis it is understood that exchange rate, like any other price is determined by demand and supply forces in the foreign exchange market. Any change in demand and supply will result in a change in the exchange rate.
The exchange rate determined by the market forces would change as these forces change in the market. The primary price makers buy (bid) or sell (ask) the currencies in the market and the rates continuously change in a free market depending on demand and supply.
The primary dealers quote two-way prices and are ready to deal on either side, that is, to buy and sell. A bank quotes its rate in the following manner.
INR/USD 70.50bid/70.75 ask
The above quote expresses the units of rupee (INR) the dealer is ready to pay (70.50) while buying the dollar that is his bid (buying price for one US dollar (USD). The ask (selling) price (70.75) is one at which he is willing to sell one dollar for those who want to purchase it. In the transaction there is a spread between bid and ask price enabling the dealer earn a profit of Rs. 0.25 on a transaction of one dollar.
CHANGES IN EXCHANGE RATE
The equilibrium exchange rate is determined by the intersection of demand for and supply of foreign exchange. At this point the demand is equal to supply. However, the demand and supply curves may shift either to the right or to the left indicating an increase or decrease in demand and supply. Accordingly, the rate of exchange would also change. Figure 12.4 explains the above mentioned changes.
Shifts in demand and supply curves have brought a change in the foreign exchange rate, that is, rupees offered per dollar. When supply of dollar increased, dollar became cheap bringing down the exchange rate per dollar, that is from R to R⁰. The equilibrium exchange rate went up from R to R¹ when the demand curve shifted to the right from D to D¹ indicating an increase in demand for dollars. The shifts in demand and supply of foreign exchange (dollars) are the result Of changes in underlying factors that affect demand and supply. At R⁰ rupee is stronger, that is, less rupees are offered per dollar.
Whereas at R¹ rupee has become weaker or depreciated, that is, more rupees are required to purchase one dollar.
SPOT AND FORWARD EXCHANGE
- Spot Exchange Rate
In foreign exchange market two types of exchange rate operation take place. They are spot exchange rate and forward exchange rate.
Spot exchange rate is the current exchange rate between the two currencies. It is determined by the market forces i.e. demand for and supply ot foreign exchange. It is the rate at which immediate delivery of foreign exchange has to be made. In reality, specially for large transactions, there is a two day time lag between the spot purchase or sale and the actual delivery. The time lag is allowed for paperwork, verification and clearing of payments.
The basic principle of the spot exchange rate is that it can be analysed like any other price with the help of demand and supply forces. The exchange rate of the dollar is determined by the intersection of demand for and supply of dollars in the foreign exchange market The demand for dollar is derived from the country's demand or imports which are paid in dollars and the supply is derived from the country's exports which are sold in dollars.
The exchange rate determined by the market forces would change as these forces undergo changes. The primary price makers buy (bid or sell (ask) the currencies in the market and the rates continuously change in a free market depending on demand and supply.
The primary dealers quote two-way prices and are ready to deal on either side, that is, to buy and sell. A bank quotes its rate in the following manner:
INR/USD 75.50 bid /75.75 ask
The above quote expresses the units of rupee (INR) the dealer s ready to pay (75.50) while buying the dollar that is his bid (buying price for one US dollar (USD). Rupees 75.75 is the ask (selling) price at which he is willing to sell one dollar for those who want to purchase the dollar. In the transaction there is a spread between bid and ask price enabling the dealer earn a profit of Rs. 0.25 on a transaction of one dollar.
- Spot Rate and Spot Date
Spot rate refers to the current exchange rate which may change many times during the day. Spot date, on the other hand refers to the delivery date of the currency. It is the settlement date when the actual exchange of currencies take place. As per the international practices, delivery of currency of the spot transaction takes place on the second working day after the day of settlement. Accordingly, for a spot deal stuck on Wednesday, delivery will take place on Friday, subject to the condition that both Thursday and Friday are working days. It is necessary that the date of currency delivery must be certain. Any uncertainty in this regard will cause not only inconvenience but even loss.
- Size and Nature
Spot exchange rates are determined in a gigantic global interbank foreign exchange market. The market operates at a lightning speed and in a vast amount of money. The money moves between the banks quickly and in a large amounts making the interbank foreign exchange market the largest financial market.
The international foreign exchange market is an arrangement where the large commercial banks and foreign exchange brokers participate. They are linked together by telephone, telex and satellite communications network called the Society for Worldwide International Financial Telecommunications (SWIFT). The communication system based in Brussels (Belgium), links banks and brokers in every financial centre. 'The constant link and the speed of communication enable the system to react to all the events which have an impact on the exchange rate. All these characteristics make foreign exchange market just as efficient as a conventional stock exchange market housed under one roof.
Most of the transactions among banks in the international foreign exchange market are spot transactions which account for more than
two-thirds of all business transacted in the foreign exchange market In theory, a spot transaction is one in which the exchange of currencies takes place immediately, but in reality spot transactions are settled on the second working day. The spot dealing between an individual like a tourist and bank / money changer is settled by exchanging the currencies on the spot.
The spot exchange rate is determined by the demand and supply of foreign exchange through primary dealers. Currencies of different countries are designated by ISO code. Following are the codes of some of the selected currencies.
USD: US Dollar
EURO: EURO
JPY: Japanese Yen
INR: Indian Rupee
AUD: Australian Dollar
GBP: British Pound
- Forward Exchange Rate
When forward exchange rate is determined in the foreign exchange market the purchase and sale of foreign exchange is agreed upon currently for delivery and payment at a fixed date in the future. These contracts usually have maturities of 30, 60 or 90 days. There are transactions for 180 and 360 days also.
Forward exchange rate differs from spot exchange rate as the former may either be at a premium or discount. Importers who require to make a payment, say, after 90 days will enter into an agreement to purchase foreign currency (S) at a plus or minus rate than the spot rate. If spot $ rate is 75 =1$, the forward exchange rate may be76= 1$ or Rs. 75 = 1. It will be Rs. 76, if the market expects the exchange rate to increase or Rs. 74, if the rate is expected to decline.
The quotation for forward exchange rate can be in two different Ways. It can be expressed in terms of the amount of local currency at which a dealer will buy and sell a unit of foreign currency. This is termed as the outright rate. The forward rate can also be quoted in terms of points, called the forward points. These points are added to the spot rate if the foreign currency is traded at a premium. The forward points are subtracted from the price, if the trading is expected to be at a discount. The rate decided in this manner is called the outright forward rate which is the forward rate adjusted for forward points, which reflect interest rate differentials between two currencies.
To explain with an example, let us say that the spot exchange rate of t Rs. and $ is
INR / USD 75.50 bid / 75.70 ask
The forward exchange rate after 180 days can be quoted through points
Spot Rate
75.50 bid / 75.70 ask
Forward rate (points) - Six months’ swap
25-20
Since the points are in ascending order, the points to be added, which means exchange rate is at a premium.
The forward rate after 180 days will be
75.70 bid / 75.95 ask
If the forward rate is going to be at discount then the points will stated in descending order, that is
Spot Rate
75.50 bid / 75.70 ask
Forward Rate (points) - Six months’ swap
25 -20
Hence the forward rate will be calculated by subtracting the points, hence the forward rate will be
75.25 bid / 75.50 ask
The basic question required to be answered is, why anyone should wish to agree into a contract to buy or sell foreign exchange at some future time, and how the spot and forward markets are linked? The link between the spot and forward exchange rate comes from the actions of three groups of economic agents who use the markets: arbitrageurs, hedgers and speculators. Interaction between these tree groups determine the forward exchange rate. One of the conditions that must hold in the forward exchange market is that, for every forward purchase there must be a forward sale of the currency Forward rates frequently differ from prevailing spot rate. If a currency is worth less in the future than the present, then the forward rate will be at a discount and an opposite situation will have a premium on the forward exchange rate.
FACTORS RESPONSIBLE FOR CHANGE IN EXCHANGE RATE
1. Inflation: Relative inflation rates of the two countries influence the exchange rate. Between India and USA; let us say, the exchange rate is 70=1 US $ in a given year. In the subsequent year if the rate of inflation is higher in India than USA, Indian goods and services will be costlier compared to USA, where inflation rate is lower. There will be less demand for Indian goods and services from USA, thus reducing the supply of dollars, whereas USA s rate of inflation being low, there will be more demand from India for USA's goods and services. The situation results in more demand for dollars and at the same l time less supply. Increased demand with the given supply or decrease in supply of dollars, make the dollar costlier. In Figure 12.4 the exchange rate has gone up from R to R let us say from 70 to 72. An opposite scenario would make the dollar cheaper.
2. Interest Rates: A higher rate of interest in India will attract foreign money to India to take advantage of interest differentials. Larger inflow of, say, dollar or euro would increase their supply and make them cheaper against the rupee However, it should be noted that investors consider the differential in real interest rate, that is nominal rate of interest minus rate of inflation.
3. Economic Growth: Higher economic growth rate attracts foreign capital to that country. China which enjoyed higher economic growth attracted more foreign investment than others. India which enjoys a better growth rate than many other countries has experienced its rupee appreciating in recent years, from Rs.48.395 in 2002-43 to Rs.44.411 in October 2010. However, in June 2013, exchange rate per US $ crossed Rs.60.00. On August 28, 2013 rupee-dollar exchange rate was Rs.68.85 - 1 US$ which reflected weak economic situation of India. Subsequently exchange rate settled around 65 - $1. At present (December 2020) the exchange rate has crossed Rs.73 = $1. Similarly, countries with poor economic performance experience foreign capital moving out thus making the domestic currency weaker.
4. Political and Other Factors: Political instability coupled with poor economic performance along with other factors like social unrest make people demand less of that country's currency Whereas those countries which enjoy a positive economic social and political environment find their currencies are more in demand.
The above discussed factors influence the demand and supply of a particular country's currency, thus rendering it strong or weak. Besides these factors, future expectations by the market participants about foreign exchange market/ rate, leading to speculation would also bring in a change in exchange rate.
The purchasing power parity internationally, between 1875 and 1914, the gold standard monetary system was used to determine the exchange rates between different currencies. Under this system, the government of a country allowed its currency to be freely converted into fixed amounts of gold. Theoretically, the exchange rate determination was explained with the help of the Mint Parity Theory. After the WW I, gold parities and free movements of gold stopped and the gold standard was replaced by the paper currency standard. The mint par of exchange lost significance in the exchange market. Hence, to explain this phenomenon and the problem of determination of the equilibrium rate of exchange between inconvertible paper currencies, the Purchasing Power Parity Theory was developed by Gustav Cassel.
The Purchasing Power Parity (PPP) theory explains the determination of long-term equilibrium exchange rates based on relative price levels of two countries. The concept of PPP originated with the School of Salamanca in the 16th century and was found in the writings of David Ricardo, However, the concept was developed into a theory by Gustav Cassel in 1918. The PPP theory is based on the Law of One Price, which says in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.
The basic idea underlying the PPP theory is that foreign exchange is demanded by the nationals of a country because it has the power to command goods (purchasing power) in the foreign country. When the domestic currency of a nation is exchanged for foreign currency, the domestic purchasing power is exchanged for foreign purchasing power. Therefore, the main factor determining the exchange rate is the relative purchasing power of the two currencies. Thus, the equilibrium rate of exchange should be such that the exchange of currencies would involve the exchange of equal amounts of purchasing power. Hence, it is the parity of the purchasing powers of the currencies which determines the exchange The theory states that, the rate of exchange between too currencies will be in equilibrium when it equals the ratio of price levels in their too countries expressed in terms of their respective currencies. The rate of exchange between the currencies of too countries is determined by their relative price levels.
The PPP theory is based on the following assumptions:
(a) There are no trade barriers between countries
(b) The price index for each of the two countries must comprise the same basket of goods.
(c) The concerned goods in the two countries must be identical in every respect.
(d) All the prices should be indexed to the same. year.
(e) The Law of One Price prevails. That is, identical goods should sell for the same price in two different countries at the same time.
The theory has two versions:
(a) Absolute version
(b) Relative version
THE ABSOLUTE VERSION
According to the absolute version of the PPP theory, the identical basket of goods in too different countries must sell for the same price when expressed in the same currency. In other words, the exchange rate between the currencies of two different countries is decided by their respective purchasing power.
For example, if a basket of commodities is sold at Rs.140 in India and the basket of identical commodities sell at $ 2 in the USA, then the exchange rate, expressed as price of S 1 in terms of rupees, will be 140 = $ 2 or 70 = $1.
The exchange rate is equal to the ratio of the price index of the basket of commodities in the home market to the price index of the basket of commodities in the foreign market. It can be expressed as:
R= P/P*
Where,
R= exchange rate defined as domestic currency units per unit of foreign currency
P= price index of a basket of goods expressed in the home country expressed in domestic currency (say India and the rupe respectively)
P*= price index of an identical basket of goods in a foreign country expressed in the foreign currency (say the USA and the dollar respectively)
Taking the earlier example, we can express the rate of exchange as
R = 140/2
=70
$1 = Rs.70
From this explanation it follows that the primary factor determining the exchange rate between two currencies is the relative purchasing power of the two currencies in their respective domestic markets. Therefore, changes in the price levels in either or both the countries will affect the exchange rate.
If there is inflation in India, with no price change in the USA, then the rupee will depreciate against the dollar.
Let us say, that now the basket of commodities in India costs 150 instead of 140. With no price change in the USA, the new exchange rate will be
R = 150/2
= 75
$1 = Rs.75
It will now require more rupees to purchase one unit of dollar. If price level in India falls, with no change in the price level in the USA, the rupee will appreciate in terms of the dollar.
On the other hand, if there is a price rise in the USA, with no price change in India, then the rupee will appreciate in term of the dollar.
Let us say, that after one year the basket of commodities in the USA costs $ 3 instead of $2. With no price change in India, the new i exchange rate will be
R = 150/3
= 50
$1 = Rs.50
Criticism
1. The absolute version measures the absolute levels of internal prices. It is widely accepted that the purchasing power of money cannot be measured in absolute terms.
2. The goods produced and demanded in the two different countries cannot be of the same kind and quality and therefore cannot be compared in terms of their prices.
3. The selection of the basket of commodities may not be done objectively. It is difficult to decide which goods to include and which not to.
4. There are several difficulties involved in compilation of price index numbers.
5. According to the theory, there is a functional relationship between the purchasing powers of the currencies of two countries and their exchange rate. In reality there is no such direct and precise link between the two. There are many factors apart from the purchasing power of currencies, such as tariff, speculation, capital flows, non-tariff barriers which significantly affect the rate of exchange.
6. Capital account transactions are not taken in account while determining the exchange rate.
THE RELATIVE VERSION
In the relative version, the method of calculating the current equilibrium exchange rate is different from that used in the absolute version. The relative version of PPP theory is propounded by Cassel as a means for measuring changes in equilibrium exchange rate. As compared to the absolute version, it brings out the relationship between changes in internal purchasing power and the changes in exchange rates.
The relative version of PPP theory states that changes in the equilibrium rate of exchange between two currencies will be governed by the changes in the ratio of their respective purchasing
power. Here some past exchange rate is assumed to be the equilibrium exchange rate, and is adopted as the base rate. Any change in the internal purchasing power can be measured by changes in the indices of domestic prices of the countries concerned. Since, according to the PPP theory, the exchange rate between the domestic and foreign currencies is determined by internal purchasing power, any change in internal purchasing power will cause the earlier equilibrium exchange rate to change. According to the relative version, the exchange rate will adjust by the amount of inflation differential between the two countries.
The primary focus of the relative version is the comparison between the past (base rate) equilibrium exchange rate with the current equilibrium exchange. The theory concludes that the change between the two equilibrium rates is primarily due to changes in the internal purchasing power of the two currencies over a period of time.
The current equilibrium rate is calculated by taking into account the shifts in price levels in the two countries.
R1 = R0 × (Ph1/Ph0 ÷ Pf1/Pf0)
Where
R1 = the current equilibrium exchange rate as the price of the foreign currency in terms of the domestic currency
R0 = the equilibrium exchange rate in the base period
Ph1 = price index in the home country in the current year
Ph0 = price index in the home country in the base year
Pf1 = price index in the foreign country in the current year
Pf0 = price index in the foreign country in the base year
Example
Let us assume that the exchange rate as the price of the foreign currency (dollar) in terms of domestic currency (rupee) in the bas year 2011 was vear $1 =60. Let us also assume that in the base year the price indices in both the countries were 100. In the year 2018, the price in the home country (India) has risen to 180 and that in the foreign country (USA) has risen to 150. Then
R1 = R0 × (Ph1/Ph0 ÷ Pf1/Pf0)
R1 =60 × (180/100 ÷ 150/100)
=60 × (180/100 x 100/150)
=60 ×1.2
=72
The current exchange rate of $1 =72 indicates a change from the base year exchange rate of year S1 =60. This change, according to the relative version of the PPP theory, is due to the inflation in the two countries concerned. The exchange rate changes between two periods are attributed to the internal inflation rates in the countries. Thus, the comparative inflation rates in the two countries will I determine by how much the exchange rate will change between the two time periods.
Criticism
1. This version of the theory suffers from the same drawback as the absolute version in that it assumes free trade.
2. According to the relative version, there must be a known equilibrium exchange rate in the base year. But in reality, it is difficult to ascertain the particular rate which actually prevailed between the currencies as the equilibrium rate.
3. The new or current rate would represent the equilibrium rate at purchasing power parity only it economic conditions have remained unchanged between the two periods being considered. This, in reality is not possible.
4. The theory takes into consideration only those goods that are internationally traded between countries. Whereas, price indices are calculated on the basis of both internationally traded and domestically traded commodities.
5. The theory assumes that, the baskets of commodities are similar in both countries. This assumption is not feasible as geographical specialisation is the basis of international trade. Different trading countries may not produce similar products.
7. Prices of all commodities do not change uniformly. Under such conditions, no simple comparison can be made between the price changes in different countries.
8. The theory doesn't specify which type of price index should be considered, that is, wholesale or consumer price index. Besides, it is practically not possible to compare price indices of different countries as they may be calculated using different methodology. Comparing them may not give us the true purchasing power parity.
9. The theory does not take into account the effect of capital account transactions on the determination of exchange rates and only focuses on current account transaction. In reality movement of capital makes significant impact on exchange rates.
10. The theory assumes that changes in price levels could bring about changes in exchange rates not vice versa. In reality empirical evidence has shown that exchange has an impact on the general internal price level. An appreciation in the value of the foreign currency makes imports more expensive and if such imports are necessities with inelastic demand, like crude oil then they can result in inflation in the home country.
Though the two versions of the PPP theory suffer from several drawbacks, the theory continues to remain the only explanation of long term changes in exchange rates and has been used as a basis for framing trade policies.
The world has experienced two major exchange rate systems since the 19th century, broadly called Fixed and Floating exchange rate and different variants of these two systems.
Fixed exchange rate system was operating under gold standard and Bretton Woods (IMF) gold exchange rate system.
Between the two world wars, the attempts by some countries to restore gold standard proved unsuccessful. There was virtually a chaos as each country adopted a system as per its requirement. By and large it was a type of floating exchange rate. From 1947 another variant of fixed exchange rate system was established under the supervision of International Monetary Fund (IMF). The IMF/Bretton Woods system collapsed in the early 1970s and thereafter flexible exchange rate system came into operation. The system that came into existence in 1970s and thereafter was not a freely floating exchange rate system but in many countries it was managed by their central banks, hence it is known as Managed Flexible Exchange Rate.
We in this chapter, first try to understand different exchange rate systems. Thereafter we discuss the role of the Central Bank in managing foreign exchange rate management and finally we attempt to understand the managing flexible exchange rate prevailing in India.
FIXED EXCHANGE RATE SYSTEM
A. Gold Standard
Gold standard operated from around 1880 to the beginning of World War I in 1914. Attempts to restore it after World War I were not successful and completely failed in 1931 during the Great Depression. Under the gold standard, currency was either in gold or fully convertible in gold at the central bank of the country.
MINT PAR OF EXCHANGE
Exchange rate between two currencies under the gold standard was determined by the gold contents of the respective currencies of two countries. The system is called Mint Par of Exchange. Suppose India and England are under gold standard, with Indian rupee of 0.001 gms of gold content and England's pound of 0.10 gms of gold, the exchange between Indian rupee and English pound is 0.10/0.001 = 100 that is, £E 1= 100.
OR
If in India price of one gram of gold is Rs.2500 = 00 and in England it is £ 25, then
The value of one £ is= Rs.100
Thus the exchange rate is 1£ = Rs.100
or Rs.1= 1 Pence
The above exchange rate is based on gold contents of the respective currencies.
The exchange rate here is fixed but may vary upto a point called gold point. Gold point is equal to the cost of shipping gold worth Ts.100 or £1. Gold point is further sub-divided as (a) gold export point, the cost of exporting gold worth Rs.100 (b) gold import point, the cost of importing gold worth Rs.100 or £1, that is Rs5.
If the cost of export is Rs.5, then the exchange rate can increase upto Rs.105 = £1. If the exchange rate increases beyond Rs.105 then it is advantageous to exchange Rs.100 against 0.10 gms gold with the RBI, export it to England and obtain one British pound for Rs.105 (100+shipping cost Rs.5). Expenses incurred to ship the gold is termed gold export point.
Similarly, if less than Rs.95 are offered for a British pound, it is worthwhile to import gold by spending Rs.5 per 0.10 gms of gold and exchange it for Rs.100 with Indian Central Bank. The exchange rate between £ and Rs therefore cannot fluctuate beyond £1 = 105(export point) and £1=Rs.95 (import point). Fluctuation in exchange rate under gold standard is limited to Gold Points.
Shipment of gold in and out of an economy leads to surplus and deficit in the balance of payments of that country. Since gold movement between the countries is limited by the size of the gold availability, the countries under gold standard are expected to follow certain rules under the system (Rules of the Game) which leads to automatic adjustment of disequilibrium in the balance of payments. This automatic mechanism is called Price-Specie Flow Mechanism.
Under this system a surplus country which receives gold will have its money supply increased resulting in an increase in price level and decline in exports. Similarly, a deficit country experiences a decline in price level due to loss of gold. This in turn will lead to increase in exports of a deficit country due to decline in price level. The process of price-specie flow mechanism, thus leads to automatic correction in the disequilibrium of the nations' balance of payments under gold standard.
B. Gold Exchange /IMF/ Dollar Standard
International Monetary Fund was established in 1944 under Bretton Woods conference (New Hampshire, USA) where 44 countries including USA and UK attended. It established a fixed exchange rate system through gold exchange standard. IMF started operating on March 1, 1947, with 30 members. As on 1st March, 2017, 189 countries are the members of IMF.
Under the IMF (Bretton Woods system) the US dollar was accepted as an international reserve currency. The United States assured the IMF members to convert their official dollars into gold at a fixed rate of $ 35 per ounce of gold. Members were asked to declare par value of their currency in terms of gold and in turn in US dollar. The exchange rate thus established was allowed to fluctuate ± 1 percent.
It is a fixed exchange rate system under the IMF termed as gold exchange standard as the member countries could convert their dollar holding into gold at the rate $35=1 ounce of gold, as promised by U.S.A. It is also called dollar standard as dollar became a vehicle currency, that is, international convertible currency. Member countries currencies were pegged to the USA dollar which in turn pegged to gold.
The system worked sufficiently well through 1950s. During 1960s, the Bretton Woods (IMF) system increasingly came under stress. The USA accumulated huge deficits because of its heavy expenditure under Marshall plan for the reconstruction of European countries. These countries accumulated dollars as they were confident about USA's assurance to redeem dollars into gold. USA's deficits increased further due to the Vietnam war (1959-1975) and also due to huge
expenditure incurred in Japan in post-world war II period. As a result, by 1970, foreign official dollar holdings were more than $40 billion, as against USAs gold holdings of $ 11 billion.
Countries like West Germany and Japan refused USA's request to revalue their currencies. The development of Euro currency market further weakened the dollar. The huge deficit in balance of payment of the USA made the other industrial countries expect devaluation of dollar. Such uncertain situations led to the massive flight of capital from USA, compelling president Nixon to suspend the convertibility of the dollar into gold on 15 August 1971.
OTHER FORMS OF FIXED EXCHANGE RATE SYSTEM
Besides the gold standard (1880-1914) and IMF dollar standard (19g 1971), there are some other variants of fixed or pegged exchange rate system that have been tried by different countries. Seventeen members of the European community have accepted a common currency - EURO (January 1, 1999) -grouping themselves as Euro-zone or Euro-land. The exchange rate between the Euro and individual member countries is fixed. Euro is allowed to float against dollar and other external currencies. It is called Dollarization or Euroization.
Currency Board Arrangements (CBAs): It is another fixed exchange rate system. CBAs have been in operation in many countries sun as Hong Kong (since 1983), Argentina (1991-2001), Estonia (since 1992), Lithuania (since 1994), Bulgaria (since 1997), Bosnia and Herozogovina (since 1997).
Under this system, a nation rigidly fixes the exchange rate of its currency to a foreign currency. It is similar to gold standard, where the nation's currency is backed by 100 percent reserve. This type arrangement is usually made by a country when it is in a de financial crisis and as way to fight inflation.
Dollarization: Under this system a country adopts another nations currency as its own legal tender. The system or process is usually called dollarization. The benefits of this arrangement are similar to those arising from Currency Board Arrangement. Peurto Rico, US, Virgin island and Panama are under this system since 1904. Ecuador in 2000), El Salvador (in 2001) and Guatemala (in 2001) are the other countries that adopted this system. These countries have accepted S dollar as their domestic currency.
FLOATING EXCHANGE RATE SYSTEM
Floating exchange or flexible exchange rate system has its different variants. They have emerged after the collapse of fixed exchange or dollar exchange rate system in 1973.
1. Free or Clean Float
Free float exchange rate system is one, under which the exchange rate is determined in the market by the forces of demand and supply without any government intervention. It is also termed as Clean Float.
2. Dirty Float
Dirty float exchange rate system takes place when the government intervenes deliberately to influence the exchange rate, specially to depreciate the currency, to increase exports to solve balance of payment problems. Such a situation arises when rules of intervention are not spelled out precisely.
Crawling Peg: This system allows the par values to change by small preannounced amounts or percentages at frequent and specified l intervals of one or two months till the equilibrium rate is reached. For example, it a country's currency requires to devalue by 10 percent, it would be devalued by 2 percent at a time, once a month I or in two months instead of 10 percent at a time.
3. Free Float v/s Managed Float
The countries that adopted a flexible exchange rate have either allowed their currency to have a free float in the market or retained certain control over it in order to manage the exchange rate as per I the national interest. Thus we have countries with free float but intervention may take place in a rare emergency situation. Others have a floating system managed by the monetary authorities making the system a managed float.
4. Managed Float
Most of the countries have now opted for flexible exchange rate. Developing countries which were under IMF followed the Bretton. woods system till 1971. Thereafter they too, like the advanced countries gave up the dollar exchange rate and allowed the market forces to determine the exchange rate. However to minimise the disadvantages of floating exchange rate, most of the developing countries have gone for a managed float or managed flexible exchange rate.
ROLE OF CENTRAL BANK
Under the gold standard, the central bank supplies the currencies in the form of gold coins or fully convertible in gold. Exchange rate is determined on the basis of gold contents of the respective currencies, as explained above. Central bank is expected to sell and purchase gold or the currency. Since currency is fully backed by gold, it would not be difficult for the central bank under gold standard to undertake the operation of purchasing and selling gold or currency and maintain the exchange rate within the gold points. Under the gold standard, the respective central banks are expected to observe the 'rules of the game' and allow the price-specie mechanism' to operate in order to have automatic adjustment of disequilibrium in the balance of payment.
- Central Banks in the present system of floating or managed floating system can influence the exchange by bringing a change in demand and supply.
- Influence Demand and Supply: Central banks may purchase or sell foreign exchange in the forex market to influence demand and supply of foreign exchange hence have an impact on exchange rate. Such intervention can be undertaken in all foreign exchange regimes or systems. Purchasing foreign exchange will prevent undue depreciation. Similarly selling foreign exchange will check the appreciation of the domestic currency.
- Change in Rate of Interest: Higher interest will attract foreign financial investors which in turn will increase the supply. Such an exercise will check the depreciation of domestic currency. For example, an increase in supply of dollars will bring down the price of dollar in terms of rupee.
- At present (2018) an increase in the rate of interest in USA by Federal Reserve System has encouraged the outflow of dollars from India and other emerging economies. Reduced supply ot dollars has increased the price of dollar in terms of domestic currency. Foreign exchange will move out from the economies where earnings are low, to the countries in which earnings are better because of higher interest rate.
- Central banks, however, have the limitations for using the rate of interest to influence the rate of exchange, as the changes in the rate of interest have their impact on macro-variables of the domestic economy. Inflation and development are the two major macro variables; a central bank is mainly concerned with.
- Restriction on the Use of Foreign Exchange: Central banks may introduce certain foreign exchange control methods such as licence, restriction on quantity or multiple exchange rate and thereby influence or check the demand for foreign exchange. Exchange control however, are discouraged by IMF and also by the WTO under the liberalised global economic system.
ROLE OF CENTRAL BANK UNDER MANAGED FLOAT
Under the managed float, the government or monetary authority (RBI in India) intervenes to bring about the required stability in the exchange rate (to manage the flexible exchange rate). Exchange market intervention is defined as a sale or purchase of foreign currency by monetary authorities with the aim of changing the exchange rate of their own currency vis-a-vis one or more currencies. In the seventies of the last century, an overwhelming number of countries which switched to a flexible regime have followed a managed exchange rate system. In most of these countries central banks intervene in the foreign exchange markets to minimise the fluctuation in exchange rate. In case of the developing countries where the foreign exchange markets are thin and narrow, central banks' "leaning against wind" intervention policy is to check erratic fluctuation in the exchange rate of its currency.
The important reasons for Central Bank's intervention to manage the exchange rate are:
1. Ability to produce a more appropriate rate: The government or monetary authorities may be in a better position to gather all the relevant information than the market. The market may have the wrong perception and may find it difficult to use the information to determine the appropriate rate of exchange. The authorities are in a better position than the market in predicting the future course of policies and their implications tor the exchange rate. For example, if there is an expected increase in money supply, the authorities would know the extent of it and accordingly plan the intervention to influence the exchange rate In the absence of intervention, the market may indulge in speculation due to its inability to have accurate information.
2. To mitigate costs of overvalued or undervalued exchange rates: Exchange rates which deviate from the real exchange rates (in relation to purchasing power parity) lead to distortion in resource allocation between the domestic and external sectors Undervaluation leads to inflationary pressure, while overvaluation brings in higher rates of unemployment. Change in the exchange rate in either direction brings in uncertainty and affects investment decisions. The disturbances in economic activities caused by changes in the exchange rate can thus be kept under control if the authorities intervene and bring in the necessary changes in the exchange rate.
3. To smoothen the economic adjustment process: A persistent surplus or deficit in the balance of payments lead to changes it the exchange rate to correct the disequilibrium. If the changes are larger, then the consequent disturbances in the domestic economic activities require adjustments in employment, price levels etc. If adjustments required are of higher magnitude, it becomes painful in its effects. Intervention can reduce such disturbances and the effects. An economy may be caught in a vicious circle of depreciation leading to price and wage rises which in turn leads to further depreciation i.e. depreciation wage-price spiral. Intervention by the authorities may slow down or avoid the spiral.
a) Intervention is also preferred by many economists to other methods i of protection or correction like tariffs, subsidies, exchange rate controls etc. Most of these methods have the tendency to becomes permanent and cause more damage to the economy by producing wrong exchange rate.
b) Many countries have taken precautions to check the negative effects of flexible exchange rate by not allowing convertibility in the capital account. At the same time by adopting managed flexible exchange rate, they attempt to have the advantages associated with both flexible and fixed exchange rate systems.
c) Under managed flexible exchange rate, the monetary authority (Central Bank) requires to intervene to prevent foreign exchange rate from extreme fluctuations. The Central Banks (RBI in India) intervention are of two types: (i) Unsterilized and (ii) Sterilized.
d) Under the unsterilized intervention, the central bank purchases or sells foreign exchange (currency) in order to maintain the desired level of exchange rate. For this purpose, a central bank requires to maintain enough reserves of foreign exchange.
e) Foreign exchange transaction of a Central Bank (RBI), through purchase and sale of foreign currency (dollars / euros) leads to the increase or decrease in the supply of domestic currency. Accordingly, it may increase or decrease the level of inflation. When the Central Bank (RBI) attempts to insulate or neutralize the effects of foreign exchange market intervention through use of monetary policy instruments it is called sterilized intervention.
f) Purchase of foreign currency, in order to prevent the appreciation of domestic currency, results in an increase in the quantity of domestic currency. This can be neutralized by the sale of government securities through open market operations, which reduces the money in circulation. Central Bank can also make use of Cash Reserve Ration (CRR) when an increase in CRR reduces the ability of commercial banks to create credit, thus reducing money supply. Similarly, sale of foreign currency brings down the quantity of money in circulation.
To counter-check this effect, that is, to inject more money in circulation, the Central Bank can make use of open market operation whereby it resorts to purchase of government securities. Also at the same time, CRR can be reduced to enable commercial banks advance more loans to the public.
The foreign exchange market intervention by the Central Bank to maintain a desirable or appropriate rate of exchange is inevitable under the managed float exchange rate regime. By doing so it tries to achieve the objectives of its intervention as stated above.
EXCHANGE RATE SYSTEM OF INDIA
EXCHANGE RATE SYSTEM (1947-1991)
After independence, as a member of IMF, India followed Bretton Woods system. It was a fixed exchange rate system which was also known as IMF or Dollar Standard. The Indian Rupee was pegged to the pound sterling on account of historical link with Briton. After the breakdown of Bretton Woods system in the early 1970s, mostof the countries moved towards a system of managed flexible exchange rate system. Indian rupee was delinked from the pound sterling in September 1975.
The exchange rate system, thereafter was determined with reference to the daily exchange rate movements of an undisclosed basket of currencies of India's major trading partners. As the system did not reflect fully the market dynamics and the developments in the exchange rate of competing countries, the external value of rupee was allowed to be determined by market forces in a phased manner.
CHANGES SINCE 1991
In 1991, as a part of the macroeconomic stabilisation measures undertaken, the rupee was devalued in two stages in order to boost exports and overcome the severe foreign exchange crisis facing their economy. With this, India moved away from the prevailing exchange rate regime and entered a new one. In the new exchange rate regime, i the RBI was no longer the controller of the foreign exchange market but became a regulator-cum-facilitator. As India began the process of opening up the economy to the global market, it was necessary that the foreign exchange market was liberalised and at the same time measures were taken to see that it was not vulnerable to volatility and uncertainty.
The broad objectives of RBI's exchange rate management post-1991are:
1. To reduce volatility in exchange rates.
2. To ensuring that the market correction of exchange rates is effected in an orderly and gradual manner.
3. To help maintain an adequate level of foreign exchange reserves.
4. To help prevent the destabilisation of the foreign exchange market due to speculative activities.
RBI's management of the foreign exchange market since 1991 can be analysed as follows:
1. Dual Exchange Rate System in 1991: The severe balance of payments crisis and other financial difficulties forced the government to devalue the rupee twice in July 1991 against a basket of currencies to the extent of 20%. A system of dual exchange rate was introduced through EXIM scrip scheme which gave the importers the right for import entitlements equivalent to 30-40% of export earnings.
2. Liberalized Exchange Rate Management System (LERMS): LERMS was introduced with effect from 1 March 1992. Under LERMS, exporters and recipients of remittances from abroad could sell the bulk (60%) of their foreign exchange receipts at market determined rates, the rest would have to be surrendered at the RBI determined rate. Similarly, those who needed to purchase foreign exchange for imports of goods and services and travelling abroad, could do so at market determined rates from authorised dealers, subject to their transactions being eligible under the liberalized exchange control system. This brought about partial convertibility of the rupee in the current account. Currency convertibility means that currency of a country can be freely exchanged for a foreign currency at a market determined rate. The rate is determined by the forces of demand for and supply of the foreign currency.
3. Full Convertibility of the Rupee in the Current Account: Full convertibility on current account was introduced with effect from August 20, 1994. The current account of the balance of payments includes imports and exports of merchandise and services as well as movement of incomes between the reporting country and the rest of the world. Accordingly, in 1994, several provisions like remittances for service, education, basic travel, gift remittances, donation, and provisions of the Exchange Earners Foreign Currency Account (EEFCA) were relaxed. In 1997, the RBI further liberalised the existing regulations in regard to payments for various kinds of services.
4. Partial Convertibility on the Capital Account: The capital account of the balance of payments includes all capital movements between the reporting country and the rest of the world. These include borrowings and lending, inflow and outflow of investments. Convertibility in the capital account means that a foreign investor can convert foreign currency into the Indian rupee and invest in any asset in India without any restrictions and a domestic investor can convert the rupee into foreign currency and invest in any asset abroad without any restriction. India has introduced partial capital account convertibility, which means foreign currency conversion for the purpose of capital account transactions are generally restricted by the RBl except in the case of FDI in certain sectors and NRI deposits, while all other forms of capital account conversion require RBI s approval. At present, there are limits on investment by foreign financial investors and also caps on FDI ceiling in many sectors. Full convertibility on the capital account may cause huge capital outflow or inflow and may bring in conditions of instability. Therefore, it is being avoided presently.
A unified market determined exchange rate was introduced for all transactions in the current account in 1993. A full float, wherein all foreign exchange received through all transactions in current and capital accounts would be exchanged at a market determined rate, i was being considered by the government. But certain international development like the East Asian currency crisis had made their government reconsider this move. We now have a system of managed flexible exchange system wherein, the RBI intervenes in the spot and forward foreign exchange market on selective basis.
RBI'S INTERVENTION
RBI intervenes as and when necessary to maintain orderly condition and curb excessive volatility in the foreign exchange market. Recently the RBI intervened in the forex market to check the volatility in the forex market caused through an increase in USA's Federal Reserve's interest rate and increase in price of crude oil.
Direct and Indirect Intervention: RBI has developed mechanisms for both direct and indirect intervention in the foreign exchange market to prevent volatility. Direct intervention is done by purchase and sale of US S in the spot and forward markets. To prevent the rupee from depreciating, the RBl sells US $ (increasing the supply of US S) and to prevent the rupee rom appreciating, it buys US S increasing the demand for US $). RBI also intervenes indirectly by regulatory action. In recent years, the RBI has relaxed caps on the interest rates for foreign currency non-resident deposits in (FCNR) in order to attract more US $ in these deposits.
Since the adoption of managed float in 1990, the RBI has intervened in foreign exchange market whenever necessary to check the volatility in the external value of the rupee. Since 2011, till date exchange rate has depreciated from 60 to 74. The rupee also appreciated frequently, though marginally, during this period. Whenever the change is in a wide range, the RBI has sold US S to check the volatility. As per the press report, the rupee has appreciated to 73.64 per dollar. RBI intervened in a limited way saying that their tide was too strong for the central bank to swim against.
Central banks require sufficient amount of foreign exchange (forex) reserves to intervene in the market. India has a forex reserves about $487 (September 2020) billion US dollars which according to the finance ministry, is sufficient to intervene if necessary, in the foreign exchange market. At present (December 2020) forex reserves are about $ 500 billion.
On August 20, 1994, full convertibility of the rupee in the current account was introduced.
Reference-
1. Business Economics P.N Chopra
2. Business Economics by H.L Ahuja