Exchange rate policy of indiaSangeeta Mondal

Roll No. 12GBO-semester II

What is exchange rate?

Definition

Rate at which one currency may be converted into another

Converting one currency to another, eg, travel purpose to some foreign land, investing in foreign exchange market.

Different exchange rate systems

Floating exchange rates

Managed floating exchange rates

Fixed exchange rate system (pegged exchange rate)

REER (Real effective exchange rate )

It is used to determine an individual country's currency value relative to the other major currencies in the index, as adjusted for the effects of inflationIn 2004, RBI replaced its five-country indices of nominal effective exchange rate (NEER) and real effective exchange rate (REER) with new six-currency indices. It is also revising its 36 country indices.

NEER (Nominal effective exchange rate)It represents the relative value of a home country's currency compared to the other major currencies being traded. A higher NEER coefficient (above 1) means that the home country's currency will usually be worth more than an imported currency A lower coefficient (below 1) means that the home currency will usually be worth less than the imported currency. The NEER also represents the approximate relative price a consumer will pay for an imported good

Fixed exchange rateA fixed, or pegged, rate is a rate the government sets and maintains as the official exchange rate.

A set price is determined against a major world currency (usually the U.S. dollar)

In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged

Advantages Fixed rates should eliminate destabilising speculation Reduced risk in international trade – By maintaining a

fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate

Introduces discipline in economic management - the burden of adjustment to equilibrium is thrown onto the domestic economy, governments have a built-in incentive not to follow inflationary policies since unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive.

Disadvantages…No automatic balance of payments adjustment – with a fixed rate, the problem would have to be solved by a reduction in the level of aggregate demand. As demand drops people consume less imports and also the price level falls making you more competitive. Large holdings of foreign exchange reserves requiredIt is not a long term solution if the underlying economy is weak. International disagreement might be created when a country sets its exchange rate on a too low level

Floating exchange rateCurrency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies

Clean floating– the central bank stands aside completely and allows the exchange rate to be freely determined in the forex market – official reserve transactions are zero

Managed floating-the central bank intervenes to buy or sell foreign currencies periodically in an attempt to influence the exchange rates

Advantages…Disequilibrium in balance of payment is auto stabilized

No need to maintain large forex reserve

It gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands

Disadvantages…

Volatility in the markets

Speculation

Economics vocabulary Devaluation – the price of foreign currencies under a

fixed exchange rate regime is increased by official action Revaluation - the price of foreign currencies under a

fixed exchange rate regime is decreased by official action

Depreciation – is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system

Appreciation - under a floating rate system, price of foreign currencies decreases because of market adjustment

HistoryBefore 1991…

Indian rupee had followed the initial devaluation with Sterling in 1949 and was maintained at the same per value for the next 16 years.In 1966 the rupee was devaluated by 57.5% to Rs.7.50 per again US dollar.In 1975 India delinked from sterling and pegged. With in 2.25 % until January 1980.

Foreign exchange regulation act 1973

To regulate dealings in foreign exchange and securitiesTo regulate the transaction indirectly affecting foreign exchangeTo regulate import and export of currency and bullionTo regulate employment of foreign nationalsTo regulate foreign companiesTo regulate acquisition, holding etc of immovable property in India by non-residents

The process of steady depreciation of rupee began in 1980s from 7.96 to 18.07.

IMF’s assistance of 5million SDR during Indira Gandhi’s regime.

Policy before LPG…Exchange rate was highly over-valued.

Strict exchange controls applied to not just capital

account but also current account transactions

Foreign investment was subject to stringent restrictions

Foreign investment amounted to a paltry $100-200 million

annually

1991 crisis…Indian economy underwent a severe balance-of-payments

crisis

By the summer of 1991, India's foreign exchange reserves

covered less than two weeks of imports.

High rate of inflation

Fleeing non-resident deposits

Declining production and a serious likelihood of an

unprecedented external payments default by India.

The 1991 Balance of Payments crisis forced India to procure a $1.8 billion IMF loan.

The economic reforms were thus introduced because of the IMF conditionalities and not because of any sudden change of economic philosophy by the Government. The fiscal tightening and devaluation of the rupee by nearly 25% adequately reduced the current accountdeficit.

Post LPG… RBI's announced depreciation of the rupee, in two instalments — on July 1 and 3, 1991.

The value of the rupee declined by 18-19 % against major currencies to improve the competitiveness of Indian exports.

In march 1992 the LERMS (Liberalized Exchange Rate Management System )involving dual exchange rate was introduced

LERMSAll foreign exchange receipts on current account transactions (exports, remittances, etc.) were required to be surrendered to the Authorized Dealers (ADs) in full. The rate of exchange for conversion of 60 per cent of the proceeds of these transactions was the market rate quoted by the ADs Remaining 40 per cent of the proceeds were converted at the Reserve Bank’s official rateThe ADs, in turn, were required to surrender these 40 per cent of their purchase of foreign currencies to the Reserve Bank

The dual exchange rate system was replaced by a unified exchange rate system in March 1993, whereby all foreign exchange receipts could be converted at market determined exchange rates. With the rupee becoming fully convertible on all current account transactions, the risk-bearing capacity of banks increased and foreign exchange trading volumes started rising.

FERA to FEMA1st June 2000, FERA was repealed to FEMA(Foreign exchange management act.)FERA had a controversial 27 year stint during which Indian Corporate world found themselves at the mercy of the Enforcement Directorate. Offense under FERA was a criminal offence liable to imprisonment, whereas FEMA seeks to make offenses relating to foreign exchange civil offences.Money laundering and the hawala (unofficial) market.

What is convertibility?The freedom to convert one currency into other internationally accepted currency

CAC

Capital Account Convertibility (CAC) means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange

It refers to the removal of restraints on international flows on a country's capital account, enabling full currency convertibility and opening of the financial system

Now and then…

In 1991, India pawned 67 tons of gold to tide over a balance of payments crisis.

18 years later, the Reserve Bank of India has bought thrice that amount of gold from the IMF to diversify its assets

In a nuttshell

We emulated the Russian school of thoughtThe collapse of the Soviet Union and its economyPhenomenal success of China since the opening of its economy to foreign trade and investment in 1978The crisis of 1991Opening up of Indian economy.

The road ahead…

Capital account convertibility???