a detail study of foreign exchange market in india

8/10/2019 a detail study of foreign exchange market in india

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CHAPTER-1

INTRODUCTION OF FOREIGN EXCHANGE MARKET

1.1

MEANING AND DEFINITION

A foreign exchange market refers to buying foreign currencies with domestic currencies

and selling foreign currencies for domestic currencies. Thus it is a market in which the

claims to foreign moneys are bought and sold for domestic currency. Exporters sell

foreign currencies for domestic currencies and importers buy foreign currencies with

domestic currencies.

According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions

and individuals who buy and sell foreign exchange which may be defined as foreign

money or any liquid claim on foreign money". Foreign Exchange transactions result in

inflow and outflow of foreign exchange.

1.2 IMPORTANCE OF FOREIGN EXCHANGE MARKET

The foreign exchange market is a crucial international market and is the worlds most

respected financial institution. On a daily basis, the Forex exchange trades with

approximately two trillion U.S Dollars.

Forex trade has facilitated international trade among countries. When your business is

dealing with investors from another country, you need to acquire their currency to trade.

Transfer of purchasing is facilitated through foreign exchange among countries. You are

able to acquire capital that will enhance you purchasing power when dealing with

another country, Importance of Foreign Exchange Markets.

Forex markets have a credit provision and this goes a long way in enhancing the growth

of foreign trade. Most investors dealing with international trade depend on the credit

facilities that are advanced to them by Forex markets. The advanced credit is used to

purchase imports from other countries. It is easier to get credit from Forex markets

because they have enormous capital reserves that are in liquid form.


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access that make up the foreign exchange market are determined by the size of the "line"

(the amount of money with which they are trading). The top-tier interbank market

accounts for 39% of all transactions. From there, smaller banks, followed by large

multi-national corporations (which need to hedge risk and pay employees in different

countries), large hedge funds, and even some of the retailmarket makers.According to

Galati and Melvin, Pension funds, insurance companies, mutual funds, and other

institutional investors have played an increasingly important role in financial markets in

general, and in FX markets in particular, since the early 2000s. (2004) In addition, he

notes, Hedge funds have grown markedly over the 20012004 period in terms of both

number and overall size.Central banks also participate in the foreign exchange market

to align currencies to their economic needs.

VARIOUS FOREIGN EXCHANGE MARKET PARTICIPANTS

(1) BANKS

The interbank market caters for both the majority of commercial turnover and large

amounts of speculative trading every day. A large bank may trade billions of dollars

daily. Some of this trading is undertaken on behalf of customers, but much is conducted

by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating

interbank trading and matching anonymous counterparts for small fees. Today,

however, much of this business has moved on to more efficient electronic systems, such

as EBS, Reuters Dealing 3000 Matching, the Chicago Mercantile Exchange, Bloomberg

and Trade Book. The broker squawk box lets traders listen in on ongoing interbank

trading and is heard in most trading rooms, but turnover is noticeably smaller than just a

few years ago.

(2) COMMERCIAL COMPANIES

An important part of this market comes from the financial activities of companies

seeking foreign exchange to pay for goods or services. Commercial companies often

trade fairly small amounts compared to those of banks or speculators, and their trades

often have little short term impact on market rates. Nevertheless, trade flows are an

important factor in the long-term direction of a currency's exchange rate. Some
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multinational companies can have an unpredictable impact when very large positions

are covered due to exposures that are not widely known by other market participants.

(3) CENTRAL BANKS

National central banks play an important role in the foreign exchange markets. They try

to control the money supply, inflation, and/or interest rates and often have official or

unofficial target rates for their currencies. They can use their often substantial foreign

exchange reserves, to stabilize the market.

Milton Friedman argued that the best stabilization strategy would be for central banks to

buy when the exchange rate is too low, and to sell when the rate is too high - that is, to

trade for a profit.

Nevertheless, central banks do not go bankrupt if they make large losses, like other

traders would, and there is no convincing evidence that they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to stabilize

a currency, but aggressive intervention might be used several times each year in

countries with a dirty float currency regime. Central banks do not always achieve their

objectives, however. The combined resources of the market can easily overwhelm any

central bank. Several scenarios of this nature were seen in the 1992-93 ERM collapse,

and in more recent times in South East Asia.

(4) INVESTMENT MANAGEMENT FIRMS

Investment Management firms (who typically manage large accounts on behalf of

customers such as pension funds, endowments etc.) use the Foreign exchange market to

facilitate transactions in foreign securities. For example, an investment manager with an

international equity portfolio will need to buy and sell foreign currencies in the spot

market in order to pay for purchases of foreign equities. Since the forex transactions are

secondary to the actual investment decision, they are not seen as speculative or aimed at

profit-maximization.

Some investment management firms also have more speculative specialist currency

overlay units, which manage clients' currency exposures with the aim of generating


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profits as well as limiting risk. The number of this type of specialist is quite small, their

large assets under management (AUM) can lead to large trades.

(5) HEDGE FUNDS

Hedge funds, such as George Soros's Quantum fund have gained a reputation for

aggressive currency speculation since 1990. They control billions of dollars of equity

and may borrow billions more, and thus may overwhelm intervention by central banks

to support almost any currency, if the economic fundamentals are in the hedge funds'

favor.

(6) NON-BANK FOREIGN EXCHANGE COMPANIES

Non-bank foreign exchange companies offer currency exchange and international

payments to private individuals and companies. These are also known as foreign

exchange brokers but are distinct in that they do not offer speculative trading but rather

currency exchange with payments (i.e., there is usually a physical delivery of currency

to a bank account).

It is estimated that in the UK, 14% of currency transfers payments are made via Foreign

Exchange Companies. These companies' selling point is usually that they will offer

better exchange rates or cheaper payments than the customer's bank. These companies

differ from Money Transfer/Remittance Companies in that they generally offer higher-

value services.

(7) MONEY TRANSFER/REMITTANCE COMPANIES AND BUREAUX DE

CHANGE

Money transfer companies/remittance companies perform high-volume low-value

transfers generally by economic migrants back to their home country. In 2007, theAite

Group estimated that there were $369 billion of remittances (an increase of 8% on the

previous year). The four largest markets (India, China, Mexico and the Philippines)

receive $95 billion. The largest and best known provider isWestern Union with 345,000

agents globally followed byUAE Exchange.
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Bureaux de change or currency transfer companies provide low value foreign exchange

services for travelers. These are typically located at airports and stations or at tourist

locations and allow physical notes to be exchanged from one currency to another. They

access the foreign exchange markets via banks or non-bank foreign exchange

companies.

(8) RETAIL FOREX BROKERS

Retail forex brokers or market makers handle a minute fraction of the total volume of

the foreign exchange market. According to CNN, one retail broker estimates retail

volume at $25-50 billion daily, which is about 2% of the whole market. CNN also

quotes an official of the National Futures Association "Retail forex trading hasincreased dramatically over the past few years. Unfortunately, the amount of forex fraud

has also increased dramatically."

All firms offering foreign exchange trading online are either market makers or facilitate

the placing of trades with market makers.In the retail forex industry market makers

often have two separate trading desks- one that actually trades foreign exchange (which

determines the firm's own net position in the market, serving as both a proprietary

trading desk and a means of offsetting client trades on the interbank market) and oneused for off-exchange trading with retail customers (called the "dealing desk" or

"trading desk").Many retail FX market makers claim to "offset" clients' trades on the

interbank market (that is, with other larger market makers), e.g. after buying from the

client, they sell to a bank. Nevertheless, the large majority of retail currency speculators

are novices and who lose money, so that the market makers would be giving up large

profits by offsetting.

Offsetting does occur, but only when the market maker judges its clients' net position as

being very risky. The dealing desk operates much like the currency exchange counter at

a bank. Interbank exchange rates, which are displayed at the dealing desk, are adjusted

to incorporate spreads (so that the market maker will make a profit) before they are

displayed to retail customers. Prices shown by the market maker do not neccesarily

reflect interbank market rates. Arbitrage opportunities may exist, but retail market

makers are efficient at removing arbitrageurs from their systems or limiting their trades.
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A limited number of retail forex brokers offer consumers direct access to the interbank

forex market. But most do not because of the limited number of clearing banks willing

to process small orders. More importantly, the dealing desk model can be far more

profitable, as a large portion of retail traders' losses are directly turned into market

maker profits.

While the income of a market maker that offsets trades or a broker that facilitates

transactions is limited to transaction fees (commissions), dealing desk brokers can

generate income in a variety of ways because they not only control the trading process,

they also control pricing which they can skew at any time to maximize profits.

The rules of the game in trading FX are highly disadvantageous for retail speculators.

Most retail speculators in FX lack trading experience and and capital (account

minimums at some firms are as low as 250-500 USD). Large minimum position sizes,

which on most retail platforms ranges from $10,000 to $100,000, force small traders to

take imprudently large positions using extremely high leverage.

In the US, "it is unlawful to offer foreign currency futures and option contracts to retail

customers unless the offeror is a regulated financial entity" according to the Commodity

Futures Trading Commission.Legitimate retail brokers serving traders in the U.S. are

most often registered with the CFTC as "futures commission merchants" (FCMs) and

are members of the National Futures Association (NFA).Potential clients can check the

broker's FCM status atthe NFA.Retail forex brokers are much less regulated than stock

brokers and there is no protection similar to that from the Securities Investor Protection

Corporation. The CFTC has noted an increase in forex scams.
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CHAPTER-2

FACTORS AFFECTING FOREIGN EXCHANGE RATE

2.1 FACTOR AFFECTING FOREIGN EXCHANGE RATE

Currency changes affect you, whether you are actively trading in the foreign exchange

market, planning your next vacation, shopping online for goods from another country

or just buying food and staples imported from abroad.

Like any commodity, the value of a currency rises and falls in response to the forces of

supply and demand. Everyone needs to spend, and consumer spending directly affects

the money supply (and vice versa). The supply and demand of a countrys money is

reflected in its foreign exchange rate.

When a countrys economy falters, consumer spending declines and trading sentiment

for its currency turns sour, leading to a decline in that countrys currency against other

currencies with stronger economies. On the other hand, a booming economy will lift the

value of its currency, if there is no government intervention to restrain it.

Consumer spending is influenced by a number of factors: the price of goods and

services (inflation), employment, interest rates, government initiatives, and so on. Here

are some economic factors you can follow to identify economic trends and their effect

on currencies.

1. ECONOMIC FACTORS

The state of a countrys economy determines its currency value. A growing economy is

generally the foundation for a stable currency that is valued highly in comparison with

others. Any factors which impact the growth of the economy, either positively or

negatively also affect currency prices. For example, during inflation, currency values

typically fall. Inflation reduces the purchasing power of money so that less can be

bought for each unit of money.

There are many economic indicators that need to be considered before making a forex

trade decision. These indictors represent various aspects of the economy. As the general

economic condition influences the currency value, these indicators are very useful in

determining how the currency prices will fare given the current economic conditions.


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GDP The Gross Domestic product of a country measures the industrial growth and

production. This figure is agood indicator of how active the economy is. A steady GDP

is the indication of a healthy, growing economy. Currency values are likely to rise when

such circumstances prevail.

Purchasing Power Parity PPP measures the comparative power of a currency to

purchase goods and services in a country. Consider two countries, A and B. 100 units of

currency of A are equal to 1 unit of currency of B as per prevailing exchange rates in the

market. PPP aims to measure the purchasing power of As currency with respect to Bs

currency.

What can be bought for 100 units of local currency in country A should be available for

1 unit of local currency in country B. Then the countries are at par as far as purchasing

power is concerned. If the countries are not evenly matched with respect to PPP and one

currency has greater purchasing power than the other then it has a higher value in the

forex market.

Interest Rate Parity "Benchmark"interest rates from central banks influence the

retail rates financial institutions charge customers to borrow money. For instance, if the

economy is under-performing, central banks may lower interest rates to make it cheaper

to borrow; this often boosts consumer spending, which may help expand the economy.

To slow the rate of inflation in an overheated economy, central banks raise the

benchmark so borrowing is more expensive.

Interest rates are of particular concern to investors seeking a balance between yield

returns and safety of funds. When interest rates go up, so do yields for assetsdenominated in that currency; this leads to increased demand by investors and causes an

increase in the value of the currency in question. If interest rates go down, this may lead

to a flight from that currency to another. The interest rates prevalent in both countries

must also be comparable so that investments yield similar returns. The ability of a

countrys currency to multiply in this way ultimately determines its own value. This is

why interest rate parity is also an important factor in determining currency prices.
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Employment LevelsEmployment levels determine the productivity of a nation. This

is an indicator of future growth in the economy. A high level of employment means that

most of the countrys population is engaged in contributing to economic growth. A good

employment rate is a sign of a healthy economy and forms the basis for more

investments.

This, in turn, increases the currency value. A low employment rate shows that fewer

people are contributing to the economy. Production of goods and services is being

carried out by a smaller proportion of the population, although consumption is at the

same level. Currency value will be subdued when employment levels are low.

Consumer Spending The amount of money which the people of a country are

spending gives an idea of what they think about the economy. If spending is low and

saving is high, then it shows that people fear an economic downturn. This indicates that

the currency value may fall in future.

Increased consumer spending shows that people are confident of their future earnings

and investment yields. Consumer spending is also an indicator of the purchasing power

of the average citizen and the standard of living. A prosperous economy is one where

consumer spending is at a sustainable level. Such an economy is likely to have a stable

currency with a high value

2. GOVERNMENT POLICIES

The government constantly assesses the economy and takes actions. Government

policies are created and implemented to encourage prevailing economic conditions

during a positive trend and to correct the imbalance if the economy is not doing well.

Most economic policies fall under two categories fiscal policies and monetarypolicies. Fiscal policies are those which outline the spending of the government. The

annual budget is a part of the fiscal policy. It determines the areas where the government

will be spending money. Government spending boosts the prospects of industries and

segments of the economy.

Monetary policies are those which influence the various components of the countrys

financial fabric to improve or sustain the economy. The central bank of a country

implements the governments policies by using various investment strategies in the

markets.


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Given the huge amount of funds the central bank can control, any action by the bank has

a huge impact on the market. An inflationary trend can be curbed, falling prices can be

shored and many other economic imbalances can be set right by central banks though

their market activities.

Both monetary and fiscal policies affect currency prices, though the impact of monetary

policies is almost immediate.

3. NATURAL FACTORS

A natural disaster like floods, famine or drought in a country will have a negative

impact on its currency value. The flow of money within the countys boundaries is

restricted severely under adverse circumstances like these.

The general public is more cautious in spending and there is likely to be a dramatic

reduction in the overall amount of funds which are being used for investments. High

risk investments like forex do not find many takers during these times. Government

spending is also reduced because of huge expenditure in relief measures. Any excess

funds are diverted toward rehabilitation programs because the governments focus is on

getting the country back on its feet.

4. INTERNATIONAL TRADE

Countries trade with each other to buy and sell products and services. As with any

transaction, this too requires an exchange of money. In fact, the level of international

trade is a good indicator of demand for a countrys currency. When countries with

different currencies trade, the deal influences the value of currencies for both of them.

Such international trade is a permanent feature of any economy with goods and services

being bought and sold from many different countries at any given point in time. When

imports are higher than exports, the economy is said to have a trade deficit and whenexports are higher than imports, there is a trade surplus. Governments publish the

balance of trade figures showing this status every month.

A government has to pay for its purchases or imports and it receives money for its

exports. In a trade deficit situation, it will be spending more of the domestic currency to

buy foreign currency to fund the purchases. In this case, the domestic currency will fall

in value in comparison with the foreign one. When exports exceed imports, there is a

trade surplus which also translates into a higher domestic currency value. The status of

this equation is given by the capital flow of a country.


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Both capital flow and balance of trade are combined into the balance of payments

statistics, which are released by the government. Three components make up the balance

of payments of a country:

Current accountMeasures the goods bought and sold in international trade.

Capital account Measures the acquisition of disposal of assets that are non-

financial in nature.

Financial accountMeasures the cross-border flow of money.

The balance of payments statistics play an important role in determining currency value

of any country. This is one of the most important factors that a forex trader must

consider when he makes investment decisions, especially long term ones.

5. CENTRAL BANK ACTIONS

With interest rates in several major economies already very low (and set to stay that way

for the time being), central bank and government officials are now resorting to other,

less commonly used measures to directly intervene in the market and influence

economic growth.

For example, quantitative easing is being used to increase the money supply within an

economy. It involves the purchase ofgovernment bonds and other assets from financial

institutions to provide the banking system with additional liquidity. Quantitative easing

is considered a last resort when the more typical responselowering interest rates

fails to boost the economy. It comes with some risk: increasing the supply of a currency

could result in a devaluation of the currency.

6. CAPITAL MARKET

The global capital markets are perhaps the most visible indicators of an economy's

health. Stock and bond markets are the most noticeable markets in the world. With

constant media coverage and up-to-the-second information on the dealings of

corporations, institutions and government entities, there is not much public information

that the capital markets miss. A wide rally or sell-off of securities originating from one

country or another should be a clear signal that the future outlook (short term or long

term) for that economy has changed in investors' eyes.

A rally in oil prices would likely lead to the appreciation of the loonie relative to other

currencies. Commodity traders, like forex traders, rely heavily on economic data for
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their trades, so in many cases, the same economic data will have a direct affect on both

markets. (For more on this correlation, see How to Trade Currency and Commodity

Correlations.)

Moreover, the bond markets are critical to what is happening in the forex market, since

both fixed income securities and currencies are rely heavily on interest rates.

Movements in Treasuries are a first level factor in movements in currencies, meaning

that a change in yields will directly affect currency values. Because of how closely tied

the two markets are, it is important to understand how bonds - and government bonds

especially - are valued in order to excel as a forex trader.

7. MARKET SENTIMENT

Market sentiments play an important role in determining currency values. These directly

influence demand and supply within the market. During times of global economic

unrest, values will increase for stronger currencies which are linked to countries viewed

as stable.

A country whose inflation levels are high will be viewed as a poor prospect for forex

trading because future economic growth is likely to be hampered by high prices.

Investors perception of an economy and interpretation of various economic indicators

determine the overall market sentiment for a currency.

8. POLITICAL FACTORS

Politics often determines the direction which an economy will take. Political unrest

brings a lot of uncertainty about the future and subdues both economic growth and

currency value. An upcoming election or war may give rise to a cautious investment

approach, reducing the capital flow into a country.

Achange in leadership also often subdues the price movement of a currency in the forexmarket. Until the new leaderships political views, monetary and fiscal policies and

views on international trade become clear, the markets do not show a clear trend in the

currencys value.

A country that is considered politically unstable will not be a favored trading partner.

This will affect its forex trade and the value of its currency in this market. On the other

hand, a progressive political leader and a stable leadership pave the way for increased

investments as investor confidence becomes strong.
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CHAPTER-3

REGULATION AND MANAGEMENT OF FOREIGN EXCHANGE

IN INDIA

1. DEALING IN FOREIGN EXCHANGE

FEMApermits only authorised person to deal in foreign exchange or foreign security.

Such an authorised person, under the Act, means authorised dealer,money changer, off-

shore banking unit or any other person for the time being authorised by Reserve Bank.

The Act thus prohibits any person who:-

Deal in or transfer any foreign exchange or foreign security to any person not

being an authorized person.

Make any payment to or for the credit of any person resident outside India in any

manner;

Receive otherwise through an authorized person, any payment by order or on

behalf of any person resident outside India in any manner;

Enter into any financial transaction in India as consideration for or in association

with acquisition or creation or transfer of a right to acquire, any asset outside

India by any person is resident in India which acquire, hold, own, possess or

transfer any foreign exchange, foreign security or any immovable property

situated outside India.

2. HOLDING OF FOREIGN EXCHANGE

Save otherwise provided in this Act, no person resident in India shall acquire, hold,

own, possess or transfer any foreign exchange, foreign security or any immovable

property situated outside India.

3. CURRENT ACCOUNT TRANSACTIONS

Any person may sell or draw foreign exchange to or from an authorized person if such

sale or drawl is a current account transaction: Provided that the Central Government
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may, in public interest and in consultation with the Reserve Bank, impose such

reasonable restrictions for current account transactions as may be prescribed.

4. CAPITAL ACCOUNT TRANSACTIONS

(1) Subject to the provisions of sub-section (2), any person may sell or draw foreign

exchange to or from an authorized person for a capital account transaction.

(2)The Reserve Bank may, in consultation with the Central Government, specify-

(a) any class or classes of capital account transactions which are permissible,

(b) the limit up to which foreign exchange shall be admissible for such transactions:

Provided that the Reserve Bank shall not impose any restriction on the drawl of foreign

exchange for payments due on account of amortization of loans or for depreciation of

direct investments in the ordinary courts of business.

(3) Without prejudice to the generality of the provisions of sub-section (2), the Reserve

Bank may, by regulations, prohibit, restrict or regulate the following-

(a) transfer or issue of any foreign security by a person resident in India;

(b) transfer or issue of any security by a person resident outside India;

(c) transfer or issue of any security or foreign security by any branch, office or agency

in India of a person resident outside India;

(d) any borrowing or lending in rupees in whatever form or by whatever name called;

(e) any borrowing or lending in rupees in whatever form or by whatever name called

between a person resident in India and a person resident outside India;

(f) deposits between persons resident in India and persons resident outside India;

(g) export, import or holding of currency or currency notes;(h) transfer of immovable property outside India, other than a lease not exceeding five

years, by a person resident in India;

(i) acquisition or transfer of immovable property in India, other than a lease not

exceeding five years, by a person resident outside India;

(j) giving of a guarantee or surety in respect of any debt, obligation or other liability

incurred-

(i) by a person resident in India and owed to a person resident outside India; or

(ii)by a person resident outside India.


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(4) A person resident in India may hold, own, transfer or invest in foreign currency,

foreign security or any immovable property situated outside India if such currency,

security or property was acquired, held or owned by such person when he was resident

outside India or inherited from a person who was resident outside India.

(5) A person resident outside India may hold, own, transfer or invest in Indian currency,

security or any immovable property situated in India if such currency, security or

property was acquired, held or owned by such person when he was resident in India or

inherited from a person who was resident in India.

(6) Without prejudice to the provisions of this section, the Reserve Bank may, by

regulation, prohibit, restrict, or regulate establishment in India of a branch, office or

other place of business by a person resident outside India, for carrying on any activity

relating to such branch, office or other place of business.

5. EXPORT OF GOODS AND SERVICES

(1) Every exporter of goods shall-

(a) furnish to the Reserve Bank or to such other authority a declaration in such form and

in such manner as may be specified, containing true and correct material particulars,

including the amount representing the full export value or, if the full export value of the

goods is not ascertainable at the time of export, the value which the exporter, having

regard to the prevailing market conditions, expects to receive on the sale of the goods in

a market outside India

(b) furnish to the Reserve Bank such other information as may be required by theReserve Bank for the purpose of ensuring the realization of the export proceeds by such

exporter.

(2) The Reserve Bank may, for the purpose of ensuring that the full export value of the

goods or such reduced value of the goods as the Reserve Bank determines, having

regard to the prevailing market conditions, is received without any delay, direct any

exporter to comply with such requirements as it deems fit.


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3.2REGULATION OF CROSS BORDER CURRENCY FLOWS

A feature of the economy that is intricately related with the exchange rate regime

followed is the freedom of cross-border capital flows. This relationship comes from the

so-called impossible trinity or trilemma of international finance, which essentially

states that a country may have any two but not all of the following three things a fixed

exchange rate, free flow of capital across its borders and autonomy in its monetary

policy. Since liberalization, India has been having close to a de facto peg to the dollar

and simultaneously has been liberalizing its foreign currency flow regime.

Close on the heels of the adoption of market determined exchange rate (within limits) in

1993 came current account convertibility in 1994. In 1997, the Tarapore committee, on

Capital Account Convertibility, defined the concept as the freedom to convert local

financial assets into foreign financial assets and vice versa at market determined rates of

exchange and laid down fiscal consolidation, a mandated inflation target and

strengthening of the financial system as its three main preconditions.

Meanwhile capital flows have been gradually liberalized, allowing, on the inflow side,

foreign direct and portfolio investments, and tapping foreign capital markets by Indian

companies as well as considerably better remittance privileges for individuals; and on

the outflow side, international expansion of domestic companies. In 2000, the infamous

Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign

Exchange Management Act (FEMA) that gave participants in the foreign exchange

market a much greater leeway.

The ultimate goal of capital account convertibility now seems to be within the

governments sights and efforts are on to chalk out the roadmap for the last leg, though

it is not expected to be accomplished before 2009. Expectedly, the wisdom of the move

has been hotly debated. Advocates of convertibility cite the consumption smoothing

benefits of global funds flow and point out that it actually improves macroeconomic

discipline because of external monitoring by the global financial markets. Convertibility

can spur domestic investment and growth because of easier and cheaper financing. Itcan also contribute to greater efficiency in the banking and financial systems. On the


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other hand, skeptics like Williamson (2006), for instance, points out that India is yet to

fulfill at least one of the three major preconditions to Capital Account Convertibility set

out by the Tarapore committee, viz. fiscal discipline, with a public sector deficit of 7.6%

of the GDP and the ratio of public debt to GDP of over 83% in 2005-06. In any case, the

argument goes, the benefits of convertibility do not necessarily outweigh the risks and

cross-border short-term bank loans usually the last item to be liberalized are the

most volatile. It is generally held that it was, in fact, the lack of convertibility that

protected India from contamination during the Asian contagion in 1997-98.


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CHAPTER-5

FOREIGN EXCHANGE MARKET IN DEVELOPI9NG

COUNTRIES

A. INDIA

5.1 EVOLUTION AND HISTORY OF INDIAN FOREIGN

EXCHANGE MARKET

The evolution of Indias foreign exchange market may be viewed in linewith the shifts

in Indias exchange rate policies over the last few decades. With the breakdown of the

Bretton Woods System in 1971 and the floatation of major currencies, the conduct of

exchange rate policy posed a serious challenge to all central banks world-wide as

currency fluctuations opened up tremendous opportunities for market players to trade in

currencies in a borderless market. In order to overcome the weaknesses associated with

a single currency peg and to ensure stability of the exchange rate, the rupee, with effect

from September 1975, was pegged to a basket of currencies. The impetus to trading in

the foreign exchange market in India since 1978 when banks in India were allowed to

undertake intra-day trading in foreign exchange. The exchange rate of the rupee was

officially determined by the Reserve Bank in terms of a weighted basket of currencies of

Indias major trading partners and the exchange rate regime was characterized by daily

announcement by the Reserve Bank of its buying and selling rates to the Authorized

Dealers (ADs) for undertaking merchant transactions. The spread between the buying

and the selling rates was 0.5 percent and the market began to trade actively within this

range and the foreign exchange market in India till the early 1990s, remained highly

regulated with restrictions on external transactions, barriers to entry, low liquidity and

high transaction costs. The exchange rate during this period was managed mainly for

facilitating Indias imports and the strict control on foreign exchange transactions

through the Foreign Exchange Regulations Act (FERA) had resulted in one of the

largest and most efficient parallel markets for foreign exchange in the world, i.e., the

hawala (unofficial) market.


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The Post-Reform Period (1992 onwards) phase was marked by wide ranging reform

measures aimed at widening and deepening the foreign exchange market and

liberalization of exchange control regimes. It was recognized that trade policies,

exchange rate policies and industrial policies should form part of an integrated policy

framework to improve the overall productivity, competitiveness and efficiency of the

economic system, in general, and the external sector, in particular. As a stabilization

measure, a two step downward exchange rate adjustment in July 1991 effectively

brought to close the regime of a pegged exchange rate.

Following the recommendations of Rangarajans High Level Committee on Balance of

Payments, to move towards the market-determined exchange rate, the Liberalized

Exchange Rate Management System (LERMS) was introduced in March 1992, was

essentially a transitional mechanism and a downward adjustment in the official

exchange rate and ultimate convergence of the dual rates was made effective and a

market-determined exchange rate regime was replaced by a unified exchange rate

system in March 1993, whereby all foreign exchange receipts could be converted at

market determined exchange rates. On unification of the exchange rates, the nominal

exchange rate of the rupee against both the US dollars also against a basket of

currencies got adjusted lower. Thus, the unification of the exchange rate of the Indian

rupee was an important step towards current account convertibility, which was finally

achieved in August 1994, when India accepted obligations under Article VIII of the

Articles of Agreement of the IMF.

With the rupee becoming fully convertible on all current account transaction, risk

bearing capacity of banks increased and foreign exchange trading volumes startedraising. This was supplemented by wide ranging reforms undertaken by the reserve bank

in conjunction with the government to remove market distortion and deepen the foreign

exchange market. Several initiatives aimed at dismantling control and providing an

enabling environment to all entities engaging in foreign exchange transaction have been

undertaken since the mid1990s. The focus has been on developing the institutional

framework and increasing the instruments for effective functioning, enhancing

transparency and liberalizing the conduct of foreign exchange business so as to move

away from micro management of foreign exchange transaction to macro management of


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and nonresident Indian investors were permitted to repatriate not only their profits but

also their capital for foreign exchange in India. Indian exporters are enjoying the

freedom to use their export earnings as they find it suitable. However, transfer of capital

abroad by Indian nationals is only allowed in particular circumstances, such as

emigration. Foreign exchange in India is automatically made accessible for imports for

which import licenses are widely issued.

Indian authorities are able to manage the exchange rate easily, only because foreign

exchange transactions in India are so securely controlled. From 1975 to 1992 the rupee

was coupled to a trade-weighted basket of currencies. In February 1992, the Indian

government started to make the rupee convertible, and in March 1993 a single floating

exchange rate in the market of foreign exchange in India was implemented. In July

1995, Rs 31.81 was worth US$1, as compared to Rs 7.86 in 1980, Rs 12.37 in 1985, and

Rs17.50 in 1990.

Since the onset of liberalization, foreign exchange markets in India have witnessed

explosive growth in trading capacity. The importance of the exchange rate of foreign

exchange in India for the Indian economy has also been far greater than ever before.

While the Indian government has clearly adopted a flexible exchange rate regime, in

practice the rupee is one of most resourceful trackers of the US dollar.

Predictions of capital flow-driven currency crisis have held India back from capital

account convertibility, as stated by experts. The rupee`s deviations from Covered

Interest Parity as compared to the dollar) display relatively long-lived swings. An

inevitable side effect of the foreign exchange rate policy in India has been the

ballooning of foreign exchange reserves to over a hundred billion dollars. In an

unparalleled move, the government is considering to use part of these reserves tosponsor infrastructure investments in the country.

The foreign exchange market India is growing very rapidly, since the annual turnover of

the market is more than $400 billion. This foreign exchange transaction in India does

not include the inter-bank transactions. According to the record of foreign exchange in

India, RBI released these transactions. The average monthly turnover in the merchant

segment was $40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the

same period. The average total monthly turnover in the sector of foreign exchange in


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India was about $174.7 billion for the same period. The transactions are made on spot

and also on forward basis, which include currency swaps and interest rate swaps.

The Indian foreign exchange market is made up of the buyers, sellers, market mediators

and the monetary authority of India. The main center of foreign exchange in India is

Mumbai, the commercial capital of the country. There are several other centers for

foreign exchange transactions in India including the major cities of Kolkata, New Delhi,

Chennai, Bangalore, Pondicherry and Cochin. With the development of technologies, all

the foreign exchange markets of India work collectively and in much easier process.

Read more indiaforex.com

Foreign Exchange Dealers Association is a voluntary association that also provides

some help in regulating the market. The Authorized Dealers and the attributed brokers

are qualified to participate in the foreign Exchange markets of India. When the foreign

exchange trade is going on between Authorized Dealers and RBI or between the

Authorized Dealers and the overseas banks, the brokers usually do not have any role to

play. Besides the Authorized Dealers and brokers, there are some others who are

provided with the limited rights to accept the foreign currency or travelers` cheque, they

are the authorized moneychangers, travel agents, certain hotels and government shops.

The IDBI and Exim bank are also permitted at specific times to hold foreign currency.

The Foreign Exchange Market in India is a flourishing ground of profit and higher

initiatives are taken by the central government in order to strengthen the foundation.

5.3 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)

When a business enterprise imports goods from other countries, exports its products to

them or makes investments abroad, it deals in foreign exchange. Foreign exchangemeans 'foreign currency' and includes:- (i) deposits, credits and balances payable in any

foreign currency; (ii) drafts, travellers cheques, letters of credit or bills of exchange,

expressed or drawn in Indian currency but payable in any foreign currency; and (iii)

drafts, travellers cheques, letters of credit or bills of exchange drawn by banks,

institutions or persons outside India, but payable in Indian currency.

In India, all transactions that include foreign exchange were regulated byForeign

Exchange Regulations Act (FERA),1973. The main objective of FERA was
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B)CHINA

5.4 EVOLUTION AND HISTORY OF FOREIGN EXCHANGE

MANAGEMENT IN CHINA

In November 1993 the Third Plenum of the Fourteenth CPC Central Committee

approved a comprehensive reform strategy in which foreign exchange management

reforms were highlighted as a key element for a market -oriented economy. A market-

based unified floating exchange regime and RMB convertibility were seen as the

ultimate goals of the exchange reform. A Foreign Exchange Surrender and Purchase

system (FESPS) was put in place. Firms were to surrender their foreign exchange

earnings from current account transactions and purchase foreign exchange from a

Foreign Exchange Designated Bank (FEDB) when a payment in foreign currency was

needed. The RMB thereby achieved so-called conditional convertibility under the

current account. In 1996 foreign-funded enterprises were included in the system and

China officially announced its acceptance of Article VIII of the IMF Articles of

Agreement.

In recent years, quotas for enterprises holding their foreign exchange earnings under thecurrent account have been raised several times; enterprises with authentic trade

activities have been allowed to purchase foreign exchange in advance to pay foreign

counterparties; enterprises' foreign exchange accounts under the current account have

been managed on a recording basis; and foreign exchange purchase and payment

procedures for trade in services have been simplified. Since 2007, annual foreign

exchange purchases and sales quotas for individuals have been set at US$ 50,000 to

meet their needs for holding and using foreign exchange.

In sequencing the liberalization of the capital account, China has followed an FDI first

policy. After 1994, significant progress was made in opening up to FDI. More regions

were opened to foreign investment, and ownership requirements for FDI in most

industries were relaxed. The authority to approve FDI projects was assigned to local

governments. From 1995, Foreign-Funded Enterprises (FFEs) could engage in State-

Owned Enterprise (SOE) reform by purchasing equity or injecting capital.


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Except for FDI, all capital account transactions were to be approved by the Peoples

Bank of China (PBC). The receipts from capital account transactions, including external

borrowing, IPO and bond issuance, had to be deposited in a specified account and used

for specified expenditures. Conversion of receipts into RMB was generally not allowed.

In December 2001 China joined the World Trade Organization (WTO). This event

marked a new era for Chinas external sector liberalization. In addition to tariff cuts,

China promised to eliminate over the next few years most restrictions on foreign entry

and ownership, as well as most forms of discrimination against foreign firms. A large

number of key services were to be opened up to foreign competition, including

important business services, courier services, wholesale trade, franchising, tourism

services, rail and road transport, and freight forwarding services. In many other services,

substantial foreign entry was to be allowed, including in telecommunications,

audiovisual services, construction, retail trade, insurance, banking, securities, and

maritime transport.

Since Chinas accession to the WTO, significantprogress has been made. In the banking

sector, more cities have been opened to foreign banks to conduct business in RMB;

China has also made a breakthrough in capital market liberalization. Since 2001,

domestic investors, including individual residents, have been allowed to invest their

own foreign exchange in B-shares. Starting from 2002, Qualified Foreign Institutional

Investors (QFII) have been allowed to invest in the domestic capital market. Since 2004,

insurance companies have been allowed to use their own foreign exchange to invest in

the international capital market. In 2005, the first foreign company was listed on the

Shanghai Stock Exchange, and in the same year, domestic firms were allowed to set up

special purpose corporations abroad to facilitate overseas listing, mergers andacquisitions.

Since China joined the WTO, the country has experienced a sharp increase in both

current account surplus and capital inflows. By end-2007, the foreign exchange reserves

had increased to USD 1,528.2 billion. The rapid build -up of foreign exchange reserves

has complicated monetary policy and increased pressure for RMB appreciation.

In response to these developments, the authorities have taken measures to promote


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balanced capital inflows and outflows. The measures include: (i) enhancing the

verification of export receipts to stop disguised capital inflows; (ii) expanding the right

of firms to hold foreign exchange earnings abroad or in bank accounts; the

qualifications for domestic firms retaining foreign exchange in a bank account were

lowered and the ceiling on the account was raised several times during the period; and

(iii) imposing limits on FFEs and foreign banks external borrowing, etc.

In 2003, the provisional regulation on external debt further limited capital inflows. The

long-term external debt quota was extended to foreign banks in China. In 2005, import

payments overdue six months or amounting to over USD 200,000 had to be registered

as external debt. Ceilings were imposed on the scale of the external debt of foreigninvested companies. Measures introduced to facilitate capital outflows included: (i) in

October 2002, a pilot programme was launched in six coastal provinces to allow

provincial authorities to approve firms purchase of foreign exchange for overseas

investment; this policy was eventually extended nationwide in 2005; (ii) the ceilings on

residents carrying of foreign exchange in cash across the border and on residents

purchase of foreign exchange for purposes of tourism and overseas study were raised

several times and, in 2004, the restriction on transferring assets overseas was further

relaxed; (iii) the ceiling on firms settlement account balance was abandoned; and (iv) in

2007, overseas financial investments were expanded by broadening the commercial

banks overseas investment instruments and including trust and investment companies

to develop Qualified Domestic Institutional Investors (QDII) businesses.

For a long time China has been implementing relatively strict foreign exchange

administration system due to shortage of foreign exchange resources, insufficiency of

macro control capability, imperfection of market system. Since China took on the

innovative opening-up policy in 1978, China forms a foreign exchange administration

profile--RMB (Chinese Yuan) is convertible for current account items, while partially

convertible for capital account step by step.


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Chinas foreign exchange reform can be divided into three periods:

Exchange regime during the planned economy (1949-1978). A highly centered,

planningsystem was implemented in the planned economy environment. Bank of China

was the only specialized bank involving in foreign exchange business. All foreign

exchange receipts were obliged to surrender to the state, any purchase of foreign

exchange should be included in the state plan. The nation never incurred foreign

borrowings or allowed foreign direct investment.

Exchange regime during the transitional period (1979-1993). (1) The State

Administration of Foreign Exchange, which is authorized for charging foreign exchange

control matters under the leadership of the Peoples Bank of China, was established. (2)

The enterprises were permitted to retain a portion of their foreign exchange earnings. (3)

Foreign exchange swap center was set up and developed. (4) The RMB exchange rate

regime was reformed. (5) Various financial institutions were allowed to involve in

foreign exchange business. (6) Restrictions on domestic individuals foreign exchange

receipts were relaxed. (7) The foreign exchange certificate was introduced in order to

encourage foreign exchange inflows and sales for RMB from oversea Chinese residents.

Exchange regime after 1994. (1) In 1994, China realized RMB conditionally

convertible under current account transactions. (2) The dual exchange rate regime of the

RMB was unified into a single managed floating exchange rate on the basis of market

demand and supply. (3) A system of purchasing and surrendering foreign exchange

through designated foreign exchange banks was formed. (4) A nationwide, unified and

standard inter - bank foreign exchange market, i.e. China Foreign Exchange Trade

System (CFETS) was established. (5) Domestic enterprises that meeting someconditions was allowed to open settlement foreign exchange account to keep export

receipts within the upper limit set by SAFE.

On December 1st, 1996, China officially accepted the obligations of Article VIII of the

IMF Articles of Agreement and made the RMB fully convertible for current account

transactions


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5.5 PRESENT FOREIGN EXCHANGE MARKET IN CHINA AND

ITS GROWTH

When people talk about convertibility, they normally think that China is one of the few

countries still with strict capital control. But if we go into this issue in more detail, we

will find that at present Chinas capital account is partially convertible. Corresponding

to the 43 items of the seven categories under capital account transactions set up by the

IMF, some of the items have always be treated as fully or basically convertible ; some

of them are still strictly or totally prohibited. When evaluating the extension of Chinas

capital account opening-up, some international organizations, including the BIS,

conclude that the RMB has become convertible to a substantial extent for capital

account transactions. In conclusion, China is already on its way to capital account

convertibility.

First of all, FDI flows are encouraged. The only measure applied is authenticity test.

The priority area for FDI has enlarged from manufacturing sector to high technology

and infrastructures. At present, China fulfills its commitment to access to WTO, foreign

investments are also allowed in financial services, insurance, securities and other

specialist service areas. In the future, China support the foreign investors to take part in

the restructuring and reform of state-owned enterprises and commercial banks by way of

merger and acquisition.

Secondly, portfolio investment liberalization has been conducted in a cautious manner

in order to stay away from associated shocks. Foreign investors are allowed to invest in

B-shares and foreign currency-denominated bonds issued domestically and H-shares

and N-shares issued on overseas markets except for RMB-denominated equities and

bonds on the domestic markets. According to the WTO commitments, there is

possibility to set up Chinese and foreign joint venture securities companies. However,

their trading activities are limited to primary market underwriting and fiduciary trading

on the secondary market. In addition, priority trading is not allowed.

Thirdly, external debts are strictly controlled and China are working towards centralized

administration on foreign debts. Short-term foreign debts are monitored by theiroutstanding amounts whereas medium and long-tem foreign debts are controlled by the


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pre-determined quota. The borrowers are also subject to qualification examination. In

principal, international borrowings of domestic enterprises are subject to permission

from the administrative agencies and have to be carried out through qualified financial

institutions. The exceptions are that foreign-invested enterprises have the discretion to

borrow internationally to make up the difference between their registered capital and

paid-in capital. The international borrowings of foreign banks and short-term trade

finance within three months have been included in the foreign debt statistics.


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CHAPTER -6

6.1 CONCLUSION


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6.2 ABBREVIATIONS

1. FEMA : FOREIGN EXCHANGE MANAGEMENT ACT

2.

FERA : FOREIGN EXCHANGE REGULATION ACT

3. PBC : PEOPLES BANK OF CHINA

4. WTO : WORLD TRADE ORGANISATION

5. CFETS : CHINA FOREIGN EXCHANGE TRADE SYSTEM

6. QDII : QUALIFIED DOMESTIC INSTITUTIONAL INVESTORS

7. QFII : QUALIFIED FOREIGN INSTITUTIONAL INVESTORS

8. CPC : COMMUNIST PARTY OF CHINA

9.

FFES : FOREIGN FUNDED ENTERPRISES

10.SOE : STATE OWNED ENTERPRISES

11.FEDB : FOREIGN EXCHANGE DESIGNATED BANK

12.FESPS : FOREIGN EXCHANGE SURRENDER AND PURCHASE

SYSTEM

13.RMB : RENMINBI


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6.3 REFERENCES

Documents

a detail study of foreign exchange market in india