EXCHAGE RATE SYSTEM

EXCHAGE RATE SYSTEM

 

The exchange rate of any currency is determined by the supply and demand for the country’s currency in the international foreign exchange market.

  • For example, the value of Indian rupee with respect to the dollar is determined by the demand of dollar against the Indian rupee. If the demand for dollar increases, its value increases, and dollar appreciate while Indian rupee depreciates with respect to the dollar.
  • The price of one currency in terms of the other currency is called exchange rate. E.g. $1 = ₹ 70. Meaning, it costs ₹ 70 to buy one dollar.
  • This is also called Nominal Exchange Rate because it does not take into consideration inflation or purchasing power in the respective countries.
  • Foreign Exchange Market is a place where currencies are exchanged is called. Their dealers are called Authorized (Forex) Dealers (AD). They can be banks or non-banks. They have to get registered with RBI under the Foreign Exchange Management Act (FEMA).
  • These dealers keep separate prices for buying and selling, to make profit in between e.g. ICICI: $1 Dollar buying price ₹ 67.95 and $1 selling price is ₹ 72.76.
  • Such currency transaction service is also subjected to GST, however the rate depends on the quantum of currency exchanged. (e.g. upto ₹ 10 lakh exchanged in foreign currency then only about ₹ 3000 of that 10 lakh will be taxable in GST → 18% of 3000 → ₹ 540 GST Tax.)

 

American Economist James Tobin had suggested 0.1% to 0.5% Tobin Tax on currency exchange transactions to discourage the speculative trading and volatility in the International Financial Market, but on that logic if ₹ 10 lakhs exchanged then 0.1-0.5% = ₹1,000 to 5,000 should be levied as ‘tax’, but since GST amount is much lower, so in reality it can’t be labelled as ‘Tobin Tax’.

Objectives Of Exchange Rate Management In India

  • To ensure that the economic fundamentals of the Indian economy are correctly reflected in the external value of Indian rupee.
  • To reduce the volatility in exchange rates for ensuring that changes in the exchange rates take place in a smooth and orderly manner.
  • To maintain a sufficient level of foreign exchange reserves to deal with any external currency shocks.
  • To help in the elimination of market constraints for ensuring the growth of a healthy foreign exchange market.
  • To help in the prevention of the emergence of any destabilizing and speculative activities in the foreign exchange market.

The exchange rate system in India has undergone a systematic change since Independence. From the system of the pegged exchange rate to the present form of market determined exchange rate after liberalisation in 1993.

 

Factors Affecting The Exchange Rate Of India

  • Intervention of The Reserve Bank of India:
    • During high volatility in the exchange rate, RBI intervenes to prevent the exchange rate going out of control.
    • For example, the RBI sells dollars when Indian rupee depreciates too much, while it purchases dollars when the Indian rupee appreciates beyond a certain level.

 

  • Inflation rate:
    • The increase in inflation rate can increase the demand for foreign currency which can negatively impact the exchange rate of the national currency.
    • For example, an increase in the inflation level of petroleum oil can increase the demand for foreign currency leading to the depreciation of Indian rupee.

 

  • Interest rate:
    • Interest rates on government securities and bonds, corporate securities etc affect the outflow and inflow of foreign currency.
    • If the interest rates on government bonds are higher compared to other country forex markets, it can increase the inflow of foreign currency, while lower interest rates can lead to the outflow of foreign currency. This affects the exchange rate of Indian rupee,.

 

  • Exports and imports:
    • Exports and imports affect exchange rate as exports earn of foreign currency while imports require payments in foreign currency.
    • Thus, if the overall exports increases, the national currency appreciates, while increases in imports leads to the depreciation of the national currency.
    • Apart from above, the Indian foreign exchange market is also affected by factors such as the receipts in the accounts of exports in invisibles in the current account, inflow in the capital account such as FDI, external commercial borrowings, foreign institutional investments, NRI deposits, tourism activities etc.

 

 

Exchange Rate Regimes in India

It is the set of rules governing the exchange of domestic currency with foreign currencies.

EXCHANGE RATE REGIME

    • Floating or Flexible
    • Fixed or Pegged
    • Managed Float / Dirty Float

 

  1. Floating or Flexible
  • In floating or flexible exchange rate is determined by the market forces of demand and supply.
  • Under the floating exchange rate regime, the market forces determine the value of domestic currency on the basis of the forces of demand and supply of the domestic currency.
  • In this system, neither the government nor the central bank intervenes and the market functions freely to determine the real value of domestic currency.
  • The floating exchange rate regime establishes trust among the foreign investors which can help in the increase in foreign investment in the domestic economy.
  • This system ensures that a country can get easy access to loans from the IMF and other international financial Institutions.
  • So if there are more number of Indian people wanting to import crude oil, gold, iPhone; Compared to the number of Americans interested to buy Indian goods, services; / coming to vacation in Kerala, then, demand for dollars will be more than that of rupees. So, $1 = 50 → $1=70
  • In this system, if rupees weakens, it is called “Depreciation” (e.g. 50 → 70); Makes the export look cheaper to the foreign buyer if ₹ strengthens it is called “Appreciation” (e.g. 70 → 50)

 

Challenge
Currency SpeculationWhen a person buys $ and other foreign currency with the hopes they become more expensive in future so he can sell at profit to others. In other words, he would be hoping for ₹ to depreciate / $ to appreciate. Such elements distort the exchange rate by hording foreign currencies.
Interest RatesIf US repo rate / Treasury Bonds are going at 2% whereas in Greece’s bonds going at 4% Then American investors will convert Dollars to invest in Greece. Later, when US fed increases their repo rate from 2% to 4% American investors might pull back from Greece. Because America commercial bank loans will become more expensive near about 5%, then there will be American companies willing to borrow by issuing Bond/debentures at 4.5%.

 

  • Fixed Exchange rate- IMF would decide for each country
  • Floating Exchange rate- Fixed exchange rate system has inherent risk of Payment crisis. Hence many countries started shifting to Floating Exchange Rate, first being UK in 1973
  • Mixed Exchange Rate
  • Where thec entral bank interferes whenever a crisis situation occurs. Otherwise the exchange rate is market driven on day to day basis

 

 

  1. Fixed or Pegged
  • Under the fixed exchange rate regime, the government or the central bank has complete intervention in the determination of the currency’s exchange rate. This is achieved by linking the domestic currency to the value of gold or with other major currencies such as US dollar etc.
  • For instance, when the central bank of a country itself decides the exchange rate of local currency to foreign currency e.g. People’s Bank of China (PBC) $1 = 6 Yuan.
  • If excess dollars are entering in their market, the central bank will print more Yuan to buy and absorb the excess dollars, to ensure Yuan doesn’t strengthen against Dollar ($1 = 6 → 5 Yuan). As a result their forex reserve will get large build-up of dollars, due to central bank’s purchase.
  • In future, if less dollars are entering in their market, the central bank will sell the (previously acquired) dollars from its forex reserve to ensure Yuan doesn’t weaken (₹ 1= 6 → 7 Yuan)
  • In this system, if Yuan is weakened by Central Bank’s official notification, it is known as ‘devaluation’ (e.g.  $1=6 → 7); usually done when it doesn’t have enough dollars in reserve to play the game and / or when it wants to deliberately weaken Yuan to encourage exports.

 

 

 

Benefit

It ensures stability in the exchange rate of the domestic currency.
It ensures that the domestic currency does not appreciate or depreciate beyond the predetermined level.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Challenge

This regime puts a massive burden on the government for maintenance of the exchange rate and the government may have to infuse a large amount of money for the maintenance of the exchange rates.
The foreign investment can reduce under the fixed exchange rate regime as investors may lose their confidence as they believe that the exchange rate of the domestic currency does not represent the real value of the economy.
If trade deficit widens or speculators are hoarding dollars or FPIs are pulling their money back to USA due to higher interest rates. It will create shortage of $ in local forex market. Then PBC will have to sell $ from its forex reserve to keep the exchange rate stable.
But since PBC will not have infinite amount of dollars in its reserve ultimately it will be forced to be devalue the local currency. This will made imports more expensive.
Therefore, most of the countries have abandoned this system after 70s. China too abandoned it in eventually, and shifted to Managed Floating Exchange Rate.

 

Floating exchange rate

  • Under the floating exchange rate regime, the market forces determine the value of domestic currency on the basis of the forces of demand and supply of the domestic currency.
  • In this system, neither the government nor the central bank intervenes and the market functions freely to determine the real value of domestic currency.
  • The floating exchange rate regime establishes trust among the foreign investors which can help in the increase in foreign investment in the domestic economy.
  • This system ensures that a country can get easy access to loans from the IMF and other international financial Institutions.

 

  1. Managed floating exchange rate
  • It is the middle path between the fixed exchange rate regime and the floating exchange rate regime.
  • In the system, the exchange rate of domestic currency is allowed to move freely based on the market forces of demand and supply.
  • However, during difficult circumstances, the central banks intervene to stabilize the exchange rate of the domestic currency.
  • RBI will not decide the exchange rate (unlike the fixed system). In the ordinary days, RBI will let the market forces of supply and demand decide the exchange rate.
  • But if there is too much volatility, then RBI will intervene to buy / sell $ to keep the volatility controlled.
  • Similarly, People Bank of China will not intervene in ordinary circumstances. They will intervene during volatilitye. if $ to Yuan value changes more than “x%” up or down compared to previous day’s exchange rate.
  • It can further be categorised as following:

 

  1. Managed floating exchange rate
    • Crawling peg system
    • Clean floating
    • Adjusted peg system
    • Dirty floating

 

 

 

 

Adjusted

peg system

Under this, the central bank tries to hold the exchange rate of domestic currency until the foreign exchange reserves of that country gets exhausted. After this, the central bank goes for the devaluation of the domestic currency to move to another equilibrium of the exchange rate.
 

 

 

Crawling

peg system

 

Under this, the central bank keeps on adjusting exchange rate based on the new demand and supply conditions of the exchange rate market. It follows a system of regular checks and balances and the central bank undertakes small devaluations based on the market conditions.
Clean floating

system

Under this, the exchange rate of domestic currency is based on the market forces of demand and supply without the government intervention. This system is identical to the floating exchange rate.
Dirty floating

system

Under this, the exchange rate is mainly determined by the market forces of demand and supply but the central banks occasionally intervened to remove excessive fluctuations from the foreign exchange markets.

 

 

 

 

 

 

 

 

 

Challenges in Managed Float System

 

Currency speculation and interest rates
Currency Manipulation: usually occurs when a central bank keeps buying dollars to create artificial scarcity of $ in the forex markets. This makes dollar more expensive. This makes local currency weak and helps in boost to exports.
US Department of the Treasury publishes a semi-annual report to track such nations. 2018: China, Germany, Japan, Switzerland, South Korea and India have been kept in (‘Watch list’) citing the (alleged) lack of transparency and consistency in their respective Central banks operations. USA has not officially labelled anyone as “Currency Manipulator”, since 1994.

 

Q. The price of any currency in international market is decided by: (CSE-2012)

  1. The World Bank.
  2. Demand for goods/services provided by the country concerned.
  3. Stability of the government of the concerned country.
  4. Economic potential of the country in question.

Answer codes:

  1. 1, 2, 3 and 4
  2. 2 and 3
  3. 3 and 4
  4. 1 and 4

 

EXCHANGE RATE REGIMES

 

  • Gold Standard (1870-1914)
  • Bretton Woods System (1946-1971)
  • Pegged regime(1971-1992):
  • Towards Managed Floating Exchange Rate: 1995 onwards

 

Fixed exchange rate system à Gold Standard (1870-1914)

  • USA would issue $1 note, if only it has 14 grams of gold in reserve, whereas England would issue one pound note if only it has 73 grams of gold in its reserve. Accordingly, their exchange rate will be 1 Pound =73/14 = about 5 USD.
  • And, each Central Bank Governor has promised to convert their currency into gold at a fixed amount. So, a person could walk with paper currency and demand the gold coins or gold bars in return.
  • When the gold mining production declined, nations gradually shifted to ‘bimetallism’g. $1 promised with 14 gm gold or 210 gm of silver whichever available with their Central Bank.
  • This system collapsed during the First World War (WW1) because the nation’s currency printing capacity was limited by their gold reserve, but their governments where more eager to print more money to finance the war (soldiers’ salaries, rifles, ammunition etc.)

 

Fixed exchange rate system à Bretton Woods System (1946-1971)

  • Here, USA agreed to fix price of its $1 = (1/35) ounces of gold. [1 ounce = 28 grams]. USA allowed free convertibility of Dollar to Gold. So if a person walked into the US Federal Reserve with $35, their chairman (Governor) will give him one ounce of gold.
  • Then IMF fixed the exchange rate of every country’s currency against USA. e.g.₹ 1= $0.30 = about 0.24 grams of Gold. So, that implied India can’t issue more currency if RBI does not have proportionately sufficient gold reserve of its own. Still if RBI issues more ₹ currency, International Monetary Fund (IMF) will order India to devalue its rupee exchange rate against dollar.
  • Robert Triffin (American Economist) claimed this system will collapse eventually because gold is a finite commodity and its price will continue to rise (from 1 ounce of gold = $35 to $40). So there is always danger of people converting the local currency into dollars and then converting dollars into gold at $35, then selling it in open market at profit, then US Feds Chairman can’t continue honouring his promise. It was called “Triffin Dilemma”. He therefore suggested an alternative SDR (Paper gold) system for IMF.
  • USA President Robert Nixon, in 1971 pulled out of Bretton Woods gold convertibility system, mainly because he wanted freedom to print more dollars to finance the Cold War and arms race against the USSR.
  • Thus, USA shifted to “Floating Exchange System”. Eventually most of the nations also shifted in that either floating / managed-floating system.
  • Ecuador adopted Dollarization in 2000.e. it abandoned the domestic currency and adopted the US dollar as their official currency.

 

 

Currency Exchange system in India

Towards Fixed Exchange Rate

1860 onwardsFixed Fiduciary System à i.e. British Indian Govt can issue Rs.10 crore notes on fiduciary (“trust”) backed by G-Sec. Beyond that every note must be backed by gold / silver.
1935 onwardsProportional Reserve à RBI must keep about 40% gold to the value of currency issued. British govt fixed exchange rate.
1946 onwardsBretton Woods / IMF system of fixed exchange rate à Wherein ₹ price was fixed (pegged) against dollar, and dollar price was fixed (pegged) against gold.
1956 onwardsWhile RBI could issue any amount of Indian currency but that has to be balanced by the Assets of the issue department (Remember M0). If RBI printed too much currency backed by only Indian G-sec but (without adequate Gold / Forex Reserve, then IMF may force devaluation of ₹ against Dollar). So, we adopted “Minimum Reserve System” i.e. RBI must keep ₹ 400 crore of foreign currency/security + ₹ ‘specified’ crore worth gold.

 

Towards Managed Floating Exchange Rate: 1995 onwards

  • Post 1995 onwards, “Minimum Reserve System; is continued but RBI is required to only keep ₹ ‘specified’ crores of gold. No compulsion for RBI to keep additional 400 crore worth foreign currency or foreign securities. RBI can print as much currency it wants as long as its balanced by the Assets of Issue Dept. (such as Indian G-sec, Foreign Securities, Gold etc.)

 

Big Mac Index – The Economist magazine’s informal index to measure PPP exchange rate using the price of one McDonald burger in USA vs the respective country.

 

Attracting Dollars: VRR and FAR

To prevent weakening of ₹, we have to attract more $ (and other foreign currencies) in India. So, RBI taken following notable measures:

Voluntary Retention Route (VRR)·         Launched in 2019: If an FPI buys Indian Union/State Governments’ G-Sec and Indian Corporates’ Bonds through this route → FPI will be given more freedom in certain technical regulations of RBI & SEBI.

·         But, with condition= FPI must remain invested in India for minimum 3 years. (Hot Money)

·         RBI decides quantitative limits to how much money can FPI invest through this route.

Fully Accessible Route (FAR)·         Budget-2020 had announced allowing non-resident investors to invest in G-Sec, without any restrictions.

·         2020-March: RBI announced this window, non-resident individual investors (who’re not FPI) can buy G-Sec. No limits on amount of investment.

Benefit – Investors will convert $ & other foreign currency into ₹ currency to buy G-Sec. so more $$ coming towards India which will help keeping BoP and currency exchange rate stable during crisis.

 

Currency Exchange Rate in COVID-19 Crisis

 

 

 

 

2020-Feb

Corona Virus Force Majeure àSENSEX dips so FPIs Selling shares from Indian companies= they got ₹₹ → converting them into $ → running back to USA to invest in (AAA rated) US treasury bonds which is safest investment. So there is a great shortage of dollars in the Indian market. If RBI does not supply dollars → further weakening of rupee ($1=₹75 → ₹80).
 

 

2020-March

RBI starts Dollars Swap with Indian banks. i.e. A bank shall buy US Dollars from the Reserve Bank and simultaneously agree to sell the same amount of US Dollars at the end of the swap period (6 months). It is done through auctioning, so, RBI to earn some % of profit.
COVID-19Dollar up-down movements, RBI signing more swap agreements, Indian Government borrowing more $$ from ADB, BRICS Bank etc.

 

Q. In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis? (CSE-2019)

  1. The foreign currency earnings of India’s IT sector.
  2. Increasing the government expenditure.
  3. Remittances from Indians abroad.

Answer Codes:

(a) 1 only

(b) 1 and 3 only

(c) 2 only

(d) 1,2 and 3 only

 

 

Q. Which one of the following is not the most likely measure the Government/RBI takes to stop the slide of Indian rupee? (CSE-2019)

  1. Curbing imports of non-essential goods and promoting exports
  2. Encouraging Indian borrowers to issue rupee denominated Masala bonds
  3. Easing conditions relating to external commercial borrowing
  4. Following an expansionary monetary policy.

 

 

IMF Special Drawing Rights (SDR)

  • After the collapse of Bretton Woods Exchange Rate System, IMF was converted into a type of ‘deposit bank’, where the members would deposit currencies in the proportion of quotas allotted to them (depending on size of their economy, openness etc).
  • IMF will pay them a small interest rate for their deposits. And IMF would lend this money to a member facing balance of payment crisis. To operationalize this mechanism, IMF would allot an artificial currency / accounting unit called SDR to the members based on their deposits.
  • Initially the price of SDR was fixed against the amount of gold but present mechanism:

 

Currency BasketWeightage
U.S. Dollar41.73
Euro30.93
Chinese Yuan (Renminbi *added in 2015)10.92

 

Japanese Yen8.33
Pound Sterling8.09

 

  • By applying a formula involving (weight * exchange rate), IMF will obtain value of 1 SDR = how many dollars?
  • Presently, 1 SDR = $1.40 = ₹ 98 (assuming $1 is trading at ₹ 70).
  • SDR is called ‘Paper Gold’ because it’s merely an accounting entry or artificial currency, without any gold involved.
  • SDR can be traded among the members, it can be converted into members’ currencies as per above method & be used to settle their Balance of Payment Transactions / Crisis.
  • If the BoP crisis is so big, that a country’s entire SDR quota exhausts, then member country may borrow more SDR from IMF (and then convert it into dollar etc. to pay off the import bill), but eventually member will have to repay this loan to IMF with interest.

 

2016-Reforms: The total quantity of SDR was increased, and India’s quota was increased from 2.44% to about 2.75%, accordingly, we are allotted around 13 billion SDR [25% of it is kept as reserve tranche position (RTP)]

 

  • India is 8th largest quota holder after USA (~18%), Japan (~7%), China (~6%)…
  • In IMF, a member’s voting power depends on his SDR quota contribution.
  • For India, this voting power is exercised by India’s Finance Minister as the ex-officio Governor in IMF’s Board of Governors.
  • If Finance Minister absent, then RBI Governor can vote as the Alternate Governor during the IMF’s meetings.

 

Q. Recently, which one of the following currencies has been proposed to be added to the basket of IMF’s SDR? (CSE-2016)

Answer codes:

(a) Rouble

(b) Rand

(c) Indian Rupee

(d) Renminbi

 

Currency Convertibility

  • Presently, India has managed floating exchange rate system wherein, currency exchange rate is determined by the market forces of supply and demand, however, during high level of volatility RBI will intervene to buy / sell ₹ or $ to stabilize the exchange rate.
  • But if people are allowed to convert the local and foreign currency in an unrestricted manner, this will led to so much volatility that RBI will not be able to manage.
  • So, RBI puts certain restrictions on the convertibility of Indian rupee to foreign currency using the powers conferred under:

 

  • Foreign Exchange Regulation Act, 1973 (FERA)
  • FERA was later replaced by Foreign Exchange Management Act, 1999 (FEMA)

 

 

RBI Restriction On Convertibility Of Rupee:

  1. CONVERTIBILITY OF RUPEE
    • Convertibility on Capital Account Transactions
    • Convertibility on Current account transactions

 

Convertibility on Capital Account Transactions:

 

External Commercial Borrowing

(ECB)

RBI’s External Commercial Borrowing (BoP → Capital Account → Borrowing → ECB) ceiling is up to $750 million (or equivalent other currency) per year for Indian Companies. That means even if Bank of America was willing to lend $1500 million to Reliance, it can’t bring all those dollars (or its converted rupee equivalent) in India. If he tries through illegal methods like Hawala, then Enforcement Directorate (ED) will take action for FEMA violation.
Foreign Portfolio Investors (FPI)An Foreign Portfolio Investors (BoP → Capital Account → Investment → FPI) can’t invest in more than 5% of available government securities in the Indian market and more than 20% of the available corporate bonds in the Indian market.

So, even if Morgan Stanley or Franklin Templeton investment fund has billions of dollars they can’t bring them all to India because of above restrictions.

Foreign Direct Investment (FDI)Similar restrictions on Foreign Direct Investment (FDI) as well. Govt decides FDI policy and RBI mandates the forex dealers accordingly to convert or not convert foreign currency into Indian currency. E.g. Las Vegas’s Flamingo Casino company can’t convert $ into ₹ to invest in Goa’s Casino (Because FDI prohibited in Casino). If they manage to ‘smuggle’ rupees through Hawala / Mafia boats then again ED will take action for FEMA violation.
 

Conclusion

Thus, Indian rupee is not fully convertible on capital account transactions.

 

Convertibility on Current account transactions

  • During 2013 to 2014, RBI’s 80:20 norms mandated min. 20% of the imported gold must be exported back.
  • Until then Jeweller/bullion dealers will not get permission to (convert their rupees into dollars/foreign currency) to import next consignment of gold.
  • However, if we disregard such few rare examples/restriction, Indian rupee is considered fully convertible on current account transactions (i.e. Import and export, remittance, income transfer gift and donations) since 1994.

 

FCRA 2010 violations:

  • If NGO / Universities were allowed to accept foreign donations in an unrestricted manner, they may become puppets of ISI / Pakistan / China / CIA.
  • So, Ministry of Home Affairs (MHA) requires them to ‘register’ and furnish annual reports under Foreign Contribution Regulation Act 2010 (FCRA). Those who fail to comply with it, are prohibited from accepting foreign donations.
  • But this angle takes us towards the ‘National security and sovereignty of India’. We need not confuse or mix it up with ‘Economics concept’ of Rupee convertibility under FEMA ACT.

 

Full convertibility of Rupee

MeaningIndia should permit unrestricted conversion of Indian ₹ to foreign currency for both current account and capital account transactions. This will infuse more FDI investment in India which will help in resolution of NPA problem, new factories, jobs, GDP growth, rivers of honey and milk will flow.

 

Anti-Arguments:

  • Before 1997, East Asian “Tiger” economies – (South Korea, Indonesia, Malaysia, Thailand, Vietnam Philippines etc.) allowed full capital account convertibility to attract FDI.
  • But 1997: Their automobile & steel companies filed bankruptcy. The foreign investors panicked, sold their shares and bonds and got local currency to convert into $ and ran away. The flight of this ‘Hot Money’ resulted into extreme depreciation of local currency $1 = 2000 Indonesian Rupiah → $1= 18,000 Indonesian Rupiah. All developments resulted into heavy inflation of petrol and diesel, social unrest, riots and political instability. None of their central banks had enough forex reserve to combat this crisis.
  • So, in 1998, their GDP growth rates fell in negative territory e.g. Indonesia (-13.7%) Because of their mistake of allowing full currency convertibility.
  • Whereas India and China grew at 6-8% because we had not allowed it.

S.S. Tarapore Committee (1997) on Convertibility of Rupee

  • Committee suggested India to allow full Capital Account Convertibility (CAC) only when the fundamentals of our economy become strong enough, such as:
    1. RBI must have enough forex to sustain 6 months’ import
    2. Fiscal deficit must not be more than 3.5% of GDP
    3. Inflation must not be more than 3-5%
    4. Banks’ NPA must not be more than 5% of their total assets, and among others.
  • So, time is not yet ripe for allowing full CAC.

Rupee Convertibility and RBI reforms (2004-2019)

  • While RBI has not permitted full convertibility of Indian rupee (on Capital Account), but over the years it has liberalised the norms, such as:
 

 

 

 

 

 

 

 

2004

Liberalised Remittance Scheme (LRS) for each financial year, An Indian resident (incl. minor) is allowed to take out upto $2,50,000 (or its equivalents in other currencies) from India. He may use it for either current account or capital account transaction as per his wish. (e.g. paying for college fees abroad, buying shares, bonds, properties, bank accounts abroad.)

Controversy à Panama papers allege certain Bollywood celebrities used LRS window to shift money from India in their shell companies in tax havens. Later used those shell companies for tax avoidance.

 

 

2016 onwards

RBI began relaxing the norms for External Commercial Borrowing (ECB), mainly to soften the NPA problem e.g. Software firms can bring up to $200 million in ECB, Micro-finance $500 mill, Infrastructure companies $750 million etc.
2018-19When ₹ started to depreciate heavily against dollars ($1 → ₹ 63 → ₹ 74), RBI had to encourage the flow of dollars into Indian economy. So, aforementioned sector- specific limits streamlinedall eligible companies automatically allowed to borrow upto $750 million via ECB route. (Although prohibited in certain categories e.g. purchase of farm house, tobacco, betting, gambling, lottery etc.)
2019RBI allowed ECB even for working capital & repayment of rupee loans.

Twin Deficit – It’s the term used when both Current Account Deficit and Fiscal Deficit are high.

 

CURRENCY WAR 2018

  • 2015: Chinese authorities announced they don’t manipulate/control Yuan exchange rate. They only intervene if Yuan’s exchange rate varies more than +/- 4% from previous day.
  • During 2018, People’s Bank of China pursued ‘Cheap (Dovish) Money Policy’ to injected more Yuan (renminbi) in the system to makes loans cheaper in domestic market and boost the consumption, demand, growth.
  • But, on the other side, US Feds pursued Dear (Hawkish) Money Policy, so dollar supply is shrinking, so dollar is becoming more expensive against other currencies.
  • Results à Increased supply of Yuan vs. reduced supply of $: resulted in $1=6.20 Yuan weakening to almost $1= 7 Yuan.
  • Trump alleges Yuan was deliberately weakened (due to PCB increasing Yuan supply) to make Chinese product more cheaper in global trade. He even accused Russia and Japan of playing similar ‘Currency War’ against him.

 

Currency War and Fall of Indian ₹ in 2018

2018: Turkey was suffering from high Inflation, current account deficit and political turmoil.

 

  • US Feds was pursuing Hawkish (Dear) monetary policy, so dollar supply shrinking and resultantly dollar is becoming more expensive against other currencies. In this atmosphere, foreign investors feared Turkish companies (who had previously borrowed lot of money from American financial market) will not be able to repay their loans in dollar currency.
  • So foreign investors began selling their shares and bonds from Turkey’s market. They got Lira currency and exchanged it to dollars and ran away from Turkey.
  • Because of this rush, demand of dollars strengthened even further and resultantly, other currencies became even weaker. (Including India: $1=₹ 63 in January → $1= ₹ 74 in Oct’18).
  • In 2019-20 also, India rupee continued to weaken towards $1=75₹ because Corona Force Majure which leads to dip in SENSEX. Foreign investors pulling out money from India.
  • While such depreciation is good for our exporters but bad for our importers.

 

To combat this fall, Govt and RBI initiated following steps:

  1. FPI’s investment limits in Bond market was relaxed. (So they feel encouraged to convert their Dollars into Rupees and invest in Indian bond market)
  2. External commercial borrowing (ECB) norms were also relaxed.
  3. RBI sold about 25 billion dollars from its forex reserve to calm down the demand of dollars.
  4. Further, to attract NRI’s dollar savings into India:
    1. RBI could announce more interest rates on Foreign Currency (Non-Resident) Account (Banks) [FCNR (B) Account] & then pay interest subsidy to Indian Banks, like they had done in 2013.
    2. Govt could also tell RBI to issue NRI bonds to attract their $ savings to India.
  5. But, Urjit Patel avoided doing 4A and 4B solutions because eventually such borrowed dollars have to be returned back to NRI with interest, which could result in exchange rate crisis in future.
  6. RBI could also pursue Hawkish Monetary Policy to reduce rupee supply in market (so that ₹ can also become expensive just like dollars). But, because RBI act mandates inflation control within 2-6% CPI, and by December 2018 the CPI has been falling towards 2% so RBI’s MPC had to actually reduce the policy rate (2019 Feb to August) to combat deflation.

 

2018-OctThe central banks of India and Japan signed Currency Swap Agreement of $75 billions i.e. either party can use that much dollar currency from other party’s forex reserve during the crisis. Even in 2008 and 2013 too they had signed similar agreement but lower amount was involved.
2019- MarchRBI’s $5 bn Currency Swap with Indian banks → RBI gains dollar reserve to fight future volatility in currency exchange rate, whereas Indian banks got extra rupee liquidity → (Hopefully) cheaper interest rates to combat deflation.
2018-DecIndia signed pact with Iran to pay crude oil bill in rupee currency. National Iranian Oil Co (NIOC) will open a bank account in India’s UCO Bank (a PSB). Indian oil companies will make payments there in ₹ currency. This will help curbing the demand of dollars in India.
Budget – 2019Nirmala S. announced various measures to attract more FPI and FDI investment in India
2020-FebCorona Virus Force Majeure = dip in SENSEX so FPIs Selling shares from Indian companies= they got ₹₹ → converting them into $ → running back to USA to invest in (AAA rated) US treasury bonds which is safest investment. So there is a great shortage of dollars in the Indian market. If RBI does not supply dollars → further weakening of rupee ($1=₹75 → ₹80).
2020-MarchRBI starts Dollars Swap with Indian banks. i.e. A bank shall buy US Dollars from the Reserve Bank and simultaneously agree to sell the same amount of US Dollars at the end of the swap period (6 months). It is done through auctioning, so, RBI to earn some % of profit.

 

Quantitative Easing and Federal Tapering

 

 

Quantitative Easing

Subprime crisis in USA (2007-08🙂 → Borrowers unable to repay the home loans → American Banks and NBFCs’ bad loans / NPA / toxic assets increased → to help them, US Federal Reserve printed new dollars & used it to buy those toxic assets → increased dollar supply in the system. Known as “Quantitative Easing”.
Fed Tapering

 

2013: US Federal Reserve gradually cut down its toxic asset purchasing program → less new dollars issued → called “Fed Tapering”

 

Result

  • shortage (perceived) of dollars in USA → Loans % become more expensive in USA so American investors began selling shares/bonds in other countries, and took their dollars back to USA (to lend to local businessmen).
  • This phenomenon was called “Taper Tantrum”. It resulted into weakening of other currencies against USD.

 

Helicopter Money & Zero interest rate regimes

  • Economist Milton Friedman (1969) introduced concept of ‘Helicopter Money’ to combat recession, a central bank should supply large amounts of money to the public at near zero interest rate, as if the money was being showered on them from a helicopter. It will encourage consumption, demand which will result into more factories, jobs and economic growth.
  • In the aftermath of sub-prime crisis and global financial crisis, there was fall in consumption, demand and so the deflation & recession scenario.
  • So, the Central Banks of Sweden, EU and Japan cut their deposit interest rates into negative figures (-0.1%) so if a commercial bank parked/deposited its surplus money into the central bank (through a reverse repo like mechanism), its money will be deducted in penalty instead of earning deposit interest.
  • Result à Commercial banks will proactively try to give away more loans to customers to boost demand in economy.

 

Purchasing Power Parity (PPP)

  • Hypothetical concept that tries to compare two currencies’ exchange rate through their purchasing power in respective countries.
  • So, If 1 cup of coffee in India = ₹ 20 whereas 1 cup of coffee costs $2 in USA then Dollar to Rupee exchange rate (PPP) should be $1 = ₹ 10. (According to OECD, exact figure is $1=₹ 17 at PPP).
  • This (hypothetical) exchange rate can happen in real life, if both the countries have Floating Exchange Rate without any intervention of the respective Central banks; and if the bilateral trade is free of protectionism (i.e. without tariff or non-tariff barriers).
  • GDP is the total market value of all goods and services produced in a country within a year. When we convert these GDP values from local currencies into PPP $ exchange rates, the largest economies of the world (GDP, PPP wise) are: USA⇒China⇒India⇒Japan⇒Germany

 

Q. Find correct statement(s) (CSE-2019)

  1. Purchasing Power Parity (PPP) exchange rates are calculated by the prices of the same basket of goods and services in different countries.
  2. In terms of PPP dollars, India is the sixth largest economy in the world.

Codes:

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

 

Yuan as global currency

  • In 2015, Yuan added in an SDR basket of currency. It increases the acceptance of Yuan in global economy.
  • China is also loaning Yuan to other nations for infra. development in One Belt One Road Initiative (OBOR), via AIIB and BRICS bank, and even via Panda Bonds.
  • In future, China may have to be less dependent on dollar while importing oil, missiles, metal and food commodities- as other nations begin to happily accept Yuan.
  • Such Yuan dominance may pose strategic challenges to USA and India.

 

Effective Exchange Rates

 

Effective Exchange Rates

1.Nominal effective exchange rate (NEER)

  • Weighted average of 36(6) currencies

2.Real effective exchange rate (REER)

  • Weighted average of 36(6) currencies adjusted to respective domestic inflations

 

 

NEER and REER

  • Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) are the indicators of external competitiveness.
  • Five-country and thirty six-country indices are being constructed by the Reserve Bank of India to help the researchers and analysts.

 

 

NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies.REER is the weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries, relates to the purchasing power parity (PPP) hypothesis.

 

 

  • In real life we are not just trading with USA but other countries, using foreign currencies other than US dollars (such as Euro, Pound, Yen, Yuan etc).
  • Therefore, only tracking $1=60 or $1=70 will not give a full picture. So, RBI also calculates geometric average of rupee’s exchange rate against upto 36 types of foreign currencies.
  • The formula will give weightage to each of those 36 foreign currencies depending on their trade-volume with India. The result is called “ Nominal effective exchange rate (NEER)”.
  • When NEER is mathematically adjusted as per the CPI-inflation levels in India and those foreign countries, it’s called “Real effective exchange rate (REER)”.
  • REER interpreted as the quantity of domestic goods required to purchase one unit of a given basket of foreign goods.
  • NEER vs REER values help analysing whether a currency is really weakening (depreciating) against the foreign currencies or not, thus helps to know our international competitiveness in exports.

Devaluation of a currency

  • Under the fixed rate regime, the central bank or the government decides the value of the currency with respect to other foreign currencies. The central bank or the government purchases or sells its currencies to maintain the exchange rate. When the government or the central bank reduces the value of its currency, then it is known as the devaluation of the currency.
  • For instance, in 1966 when the India was following the fixed exchange rate regime, the  Indian Rupee was devalued by 36 %.

 

Reasons and objectives of currency devaluation

  • To increase Exports: countries go for currency devaluation to boost their exports in the international market. Devaluation of currency makes its goods cheaper compared to its International competitors.
  • Competitive devaluation (race to the bottom):if one country devalues its currency other countries are also incentivized to devalue their own currency to maintain their competitiveness and the international export market.
  • To reduce trade deficits:currency devaluation makes a countries exports cheaper, while imports become more expensive. This leads to an increase in exports and decrease in imports. This situation favors the improved balance of payment and reduces trade deficits.
  • To reduce the sovereign debt burden:If the debt payments are fixed, devaluation of currency will make the domestic currency weaker and will ultimately make the payments less expensive over time.

 

 

Disadvantages of currency devaluation

  • Inflation: it can lead to increase in the inflation rate as essential imports such as oil etc will become more expensive. It can also lead to demand-pull inflation.
  • It reduces the purchasing power of the country’s citizens and foreign goods and foreign tours become expensive for them.
  • Large and quick devaluation of currency may reduce the faith of international investors in the domestic economy. Foreign investors would be less interested in holding the government debt as devaluation reduces the value of their holdings.
  • Devaluation of currency negatively impacts the corporates and individuals who hold debt in the foreign currency.

Depreciation of a currency

  • In the floating exchange rate regimes, the value of a country’s currency is determined by the market forces of demand and supply. The exchange rate of the currency changes on daily basis as per the demand and supply of that currency with respect to foreign currencies. A currency depreciates with respect to foreign currency when the supply of currency in the market increases while its demand falls.

 

 

Reasons responsible for currency devaluation

  • Decline in exports: The decline in a country’s overall exports leads to a decline in export revenues. This reduces the demand for the country’s currency and leads to its depreciation.
  • Large increase in imports:A large increase in the demand for imported goods and services can lead to a trade deficit. Increase in the current account deficit can lead to a net outflow of the currency which can weaken the exchange rate leading to currency depreciation.
  • Monetary policy of Central Bank:If the central bank reduces its policy interest rates it can lead to the outflow of hot money such as foreign portfolio investment etc. This can lead to the depreciation of domestic currency.
  • Open market operations of the central bank:If the Central bank (in Indian case, RBI) undertakes open market operations to buy foreign currency and gold etc. it can lead to the depreciation of domestic currency.

 

Devaluation vs depreciation

Both devaluation and depreciation lead to the decline in the value of domestic currency. However, there are certain differences between them.

 

 

DevaluationDepreciation
Devaluation is the official reduction in the value of a currency.Depreciation refers to an unofficial decline in the currency’s value.
Devaluation is the phenomena associated with fixed exchange rate regime.Depreciation of a currency is associated with the floating or managed floating exchange rate regime
Devaluation of the currency is done purposely by the central bank or the government

 

The market forces of demand and supply are responsible for the depreciation of a currency.
The impact of currency devaluation is for short term,

 

The depreciation of currency can affect the economy for a longer time.
Devaluation of currency is done occasionally by the central bank.Depreciation and appreciation of currency occur on a daily basis.

 

 

Long term impacts of currency devaluation and depreciation:

  • The long-term impacts of devaluation and depreciation differ.
  • The depreciation of the domestic currency in a floating exchange rate regime, can increase its exports, boost spending and can make the economy look better for the foreign investors.
  • This can increase the flow of foreign investment which can cancel out some of the effects of depreciation.
  • However, this is not possible in a fixed rate economy as only the government or Central bank change the exchange rates.

 

Revaluation

  • Revaluation refers to an upward adjustment to the country’s official exchange rate the relative to either price of gold or any other foreign currency.
  • Revaluation increases the value of the domestic currency with respect to the foreign currency.
  • Revaluation is a feature of the fixed exchange rate regime, where the exchange rate is determined by the central bank or the government.
  • Revaluation is opposite to devaluation, which is a downward adjustment.

 

 

Reasons for currency Revaluation

  • Current account surplus: the government can go for currency revaluation for reducing the current account surplus. This happens for economies where exports are higher than imports.
  • To manage inflation: the government may go for currency revaluation in order to manage that inflation rate. Revaluation can lead to either higher inflation or even lower inflation. Currency revaluation can make the imports cheaper which can reduce the inflation rate in the domestic economy.
  • Changes in the interest rates of other countries and changes in the global economic environmentcan also lead to currency revaluation in order to manage its impact on the domestic economy.

 

Currency Appreciation

  • Currency appreciation refers to the increase in the value of one currency with respect to other foreign currencies.
  • Currency appreciation is the unofficial increase in the value of any currency.
  • It is a feature associated with floating or managed floating exchange rate regimes.
  • Appreciation of a currency takes place when the supply of the currency is lesser than its demand in the foreign exchange market.

 

Causes of currency appreciation

  • Increase in the policy interest rate by the central bank:it would make the investors attractive to invest in the government bonds and domestic securities which can lead to inflow of foreign investment in the form of hot money.
  • Current account surplus:current account surplus can cause an inflow of foreign exchange in the economy leading to appreciation in the exchange rate of the domestic currency.
  • Increase in exports:it increase the demand for the domestic currency leading to its appreciation with respect to foreign currencies.
  • Intervention by the central bank through open market operations:buying of domestic currency from the foreign exchange market by the central bank can lead to an appreciation of the domestic currency.
  • Higher economic growthcan increase foreign investment in the economy which can cause appreciation in the exchange rate.

 

Appreciation of a currency associated with a floating or managed floating exchange rate system. Whereas revaluation of a currency is associated with the fixed exchange rate regime.

 

Previous Year Questions

 

GSM3-2016Justify the need for FDI for the development of the Indian economy. Why there is gap between MOUs signed and actual FDIs? Suggest remedial steps to be taken for increasing actual FDIs in India.
GSM3-2015Craze for gold in Indians have led to a surge in import of gold in recent years and put pressure on balance of payments and external value of rupee. In view of this, examine the merits of Gold Monetization Scheme.
GSM3-2015

 

There is a clear acknowledgement that Special Economic Zones (SEZs) are a tool of industrial development, manufacturing and exports. Recognizing this potential, the whole instrumentality of SEZs requires augmentation. Discuss the issues plaguing the success of SEZs with respect to taxation, governing laws and administration.
GSM2-2014

 

 

Though 100 percent FDI is already allowed in non-news media like a trade publication and general entertainment channel, the Government is mulling over the proposal for increased FDI in news media for quite some time. What difference would an increase in FDI make? Critically evaluate the pros and cons.
GSM3-2014

 

Foreign direct investment in the defence sector is now said to be liberalised. What influence this is expected to have on Indian defence and economy in the short and long run?