Foreign Exchange

Meaning : Foreign exchange refers to all the currencies of the rest of the world other than the domestic
currency of the country. For example, in India, US dollar is the foreign exchange

Foreign Exchange refers to all the foreign money which includes notes, cheques, bills of exchange, bank
balances and deposits in foreign currency

Every international financial transaction, whether foreign trade of goods and services, foreign investment,
international tourism, monetary movements requires the usage of foreign exchange.

Foreign Exchange Rate : Foreign Exchange Rate is defined as the price of the domestic currency with
respect to another currency. The purpose of foreign exchange is to compare one currency with another for
showing their relative values.

Foreign exchange rate can also be said to be the rate at which one currency is exchanged with another or
it can be said as the price of one currency that is stated in terms of another currency.

The rate at which one currency is exchanged for another is called Foreign Exchange Rate.

In other words, the foreign exchange rate is the price of one currency stated in terms of another currency.
For example, if one U.S dollar exchanges for 60 Indian rupees, then the rate of exchange is 1$ = Rs. 60 or
1 Rs = 1/60 or 0.0166 U.S. dollar.

Different types of quotations :

In the forex (foreign exchange) market, there are several types of quotations used to represent currency
pairs and their respective exchange rates. These quotations provide information on how much one
currency is worth relative to another currency. Here are the different types of forex quotations:

1. Direct Quotation: Represents the units of domestic currency in terms of one unit of foreign currency.
1$ = 75.123 Rs

2. Indirect Quotation: Represents the units of foreign currency in terms of one unit of domestic currency.
1Rs = 0.0012 $

3. Bid Price: The bid price represents the highest price at which a buyer is willing to purchase a particular
currency pair. It is the price at which traders can sell the base currency.

4. Ask Price: The ask price represents the lowest price at which a seller is willing to sell a particular
currency pair. It is the price at which traders can buy the base currency.

5. Spread: The spread is the difference between the bid price and the ask price. The spread is the profit
earned by the forex broker or market maker.
6. Cross quote : Involves 2 foreign currencies. Neither is the official currency of the country in question.
1$= 0.76 pounds could be a cross rate of USD and GBP in India.

Determination of Exchange Rate: Fixed, Flexible, Managed

Fixed exchange rate system:

(i) The system of exchange rate in which exchange rate is officially declared and fixed by the government
is called fixed exchange rate system.

(ii) When domestic currency is tied to the value of foreign currency, it is known as pegging.

(iii) To maintain stability in fixed exchange rate system, government buy foreign currency when
exchange rate appreciates and sell foreign currency when exchange rate depreciate. This process is called
Pegging operation, i.e., all efforts made by the central bank to keep the rate of exchange stable.

Such a rate of exchange has been associated with Gold Standard System during 1880-1914.

(ii) According to this system, value of every currency is determined in terms of gold. Accordingly, ratio
between gold value of the two countries was fixed as exchange rate between those currencies.

(iii) For example, Value of one dollar = 100 gms of gold.

Value of a rupee = 5 gms of gold Then, 1 dollar = 100/5 = Rs. 20

Arguments in favour of Fixed Exchange Rate system :

i) Stability: It ensures stability, in the international money market/exchange market. Day to day
fluctuations are avoided. It helps formulation of long term economic policies, particularly relating to
exports and imports.

(ii) Encourages international trade: Fixed exchange rate system implies low risk and low uncertainty of
future payments. It encourages international trade.

(iii) Co-ordination of macro policies: Fixed exchange rate helps co-ordination of macro policies across
different countries of the world. Long term economic policies can be drawn in the area of international
trade and bilateral trade agreements.

iv) Prevention of capital flights : Capital flight refers to a process of excessive capital outflow. As under
fixed rate fixed exchange rate system exchange rates remain stable, such capital outflow wouldn’t
happen.

v) Suitable for small countries : Development and growth of smaller countries was dependent on foreign
trade. Flexible Exchange rate if moving frequently could create issues of inflation in such countries.
Arguments against Fixed Exchange Rate system :

(i) Huge international reserves: Fixed exchange rate system is often supported with huge international
reserves of gold. This is because different currencies are directly or indirectly convertible into gold.
Following this system could mean owning large reserves of gold which is not possible for every country.

(ii) Restricted movement of capital: Fixed exchange rate restricts the movement of capital across different
parts of the world. Accordingly, international growth process suffers.

(iii) Discourages venture capital: Venture capital in the international money market refers to investments
in the purchase of foreign exchange in the international money market with a view to earn profits. Fixed
exchange rate system discourages such investments. Fixed exchange rate discourages venture capital in
the international money market.

iv) Impossible during wars: The fixed exchange rate system under gold standard, requires movements of
gold to settle payments which was not possible during wars

v) Monetary disturbance : This system requires central banks to maintain gold reserve- currency ratios
stable. This resulted in sudden expansion and contraction of currency in circulation, leading to
disturbances.

Flexible Exchange Rate System

Under this system, the exchange rate for the currency is fixed by the forces of demand and supply of
different currencies in the foreign exchange market. This system is also called the Floating Rate of
Exchange or Free Exchange Rate. It is also called as the Balance Of Payments Method.

It is so because it is determined by the free play of supply and demand forces in the international money
market.

Under the Flexible Exchange Rate system, there is no intervention by the government.

It is called flexible because the rate changes with the change in the market forces.

Merits of Flexible Exchange Rate System

With the flexible exchange rate system, there is no need for the government to hold any reserve.

It eliminates the problem of overvaluation or undervaluation of the currency.

It encourages venture capital in the form of foreign exchange.

It also enhances efficiency in the allocation of resources.

Demerits of the Flexible Exchange Rate System

It encourages speculation in the economy.

There is no stability in the economy as the exchange rate keeps on fluctuating as per demand and supply.

Under this, coordination of macro policies becomes inconvenient.

There is uncertainty in the economy that discourages international trade.

Demand of foreign exchange :

The demand for foreign exchange arises when a person has to make a payment in foreign currency. In
simple terms, it indicates the outflow of foreign currency. It is demanded by Indian residents for the
following reasons:

Import of Goods and Services: In the case of the Import of goods and services from a foreign country the
payment is made by the importer (the person who imports goods and services) in foreign currency; thus,
creating a demand for foreign exchange in India’s Foreign Exchange Market.

Unilateral Transfers Sent Abroad.

Tourism: To pay for expenses incurred during international tours, tourists require a foreign exchange,
which creates demand for it. Foreign tourists will create a demand for foreign exchange in India’s foreign
exchange markets.

Investments: When investments are made by India in other countries foreign exchange is required.
Therefore, demand for foreign exchange is created while making investments abroad.

Lending Abroad: If India provides loans to foreign countries, India will demand foreign exchange.

Repayment of Interest and Loans: If loans along with interest are paid to foreign lenders, there is a need
for foreign exchange. It results in an increase in the demand for foreign exchange.

Purchase of assets abroad: There is a demand for foreign exchange to make payments for the purchase of
assets like land, shares, bonds, etc., abroad.

Demand curve: There is an inverse relationship between the rate of foreign exchange and demand for
foreign exchange. It means the higher the rate, the lesser will be the demand for foreign exchange and
vice-versa. Due to this reason, the demand curve slopes downwards. The relationship between the rate of
foreign exchange and the quantity demanded for foreign exchange can be illustrated graphically with the
help of a downward-sloping curve

the graph, the exchange rate is shown on the Y axis, and demand for foreign exchange is shown on the X
axis. The demand curve DD shows the negative relation between the rate of exchange rate and demand
for foreign exchange. The DD demand curve (negative sloping) shows that at a lower rate of exchange
OR1 more foreign exchange is demanded OQ1, whereas at a higher rate of exchange, i.e., OR2 less
foreign exchange is demanded OQ2.

Supply of foreign exchange:

The supply of foreign exchange involves receipts of foreign exchange. Thus it indicates the inflow of
foreign currency into the domestic country. The major sources of supply of foreign exchange are stated
below:

Exports: Whenever the foreigner purchases goods and services from a domestic country (India), the
payment is made by the foreigner in foreign exchange. Thus, in the case of Exports of goods and services,
there is an increase in the supply of foreign exchange in India’s foreign exchange market.

Tourism: To pay for expenses incurred during international tours, tourists require foreign exchange. If
foreign tourists come to India, then they need our Indian Rupee for their stay. They supply foreign
exchange in return for the Indian Rupee which will in return increase the supply of foreign exchange in
India.

Foreign Direct Investments(FDI) in India: FDI refers to the investment made to get direct control of the
domestic market. When investments are made by Multinational Companies (like Pizza Hut, and
Dominos). In India, there is a flow of foreign exchange.

Foreign Portfolio Investments(FPI) by Foreign Investors: FPI refers to the investment made to earn profit
in the domestic market. These are made in form of shares, debentures, bonds, etc. Any purchase in the
Indian stock exchange by foreign investors results in the flow of foreign exchange in the Indian share
market.

Deposits by Non-Resident Indians(NRI): Foreign exchange flows in the Indian foreign exchange market
due to deposits by Non-Resident Indians(NRI) in India.

Speculation: Supply of foreign exchange arises when people earn money from the foreign exchange by
speculating.

Supply curve :

There is a positive relationship between the rate of foreign exchange and demand for foreign exchange.
This means the higher the rate of foreign exchange, the higher will be the supply of foreign exchange and
vice-versa. Thus supply curve slopes upwards. The relationship between the rate of foreign exchange and
the quantity supplied of foreign exchange can be illustrated graphically with the help of an upward-
sloping curve as shown.

In the graph, the exchange rate is shown on the Y axis, and the supply of foreign exchange is shown on
the X axis. The supply curve SS shows the direct (positive) relation between the rate of exchange rate and
the supply of foreign exchange. The supply curve (positive sloping) shows that when the rate of foreign
exchange rises from OR1 to OR2, then the supply of foreign exchange rises from OQ1 to OQ2.

Managed flexibility :

Managed floating exchange rate is a mixture of a flexible exchange rate (the float part) and a fixed
exchange rate (the Managed part).

It is the combination of the fixed rate system (the managed part) and the flexible rate system (the floating
part), thus it is also called a Hybrid System. It refers to the system in which the foreign exchange rate is
determined by the market forces and the central bank stabilizes the exchange rate in case of appreciation
or depreciation of the domestic currency.

Under this system, the central bank acts as a bulk buyer or seller of foreign exchange to control the
fluctuation in the exchange rate. The central bank sells foreign exchange when the exchange rate is high
to bring it down and vice versa. It is done for the protection of the interest of importers and exporters.

For this purpose, the central bank maintains the reserves of foreign exchange so that the exchange rate
stays within a targeted value.

However, the central bank follows the necessary rules and regulations to influence the exchange rate.

(b) In other words, it refers to a system in which foreign exchange is determined by free market forces
(demand and supply forces), which can be influenced by the intervention of the central bank in foreign
exchange market.

(c) Under this system, also called Dirty floating, central banks intervene to buy or sell foreign currencies
in an attempt to stabilize exchange rate movements in case of extreme appreciation or depreciation.

Foreign Exchange Market

Meaning : The foreign exchange market is a decentralized worldwide market.

it is a market in which buying and selling of foreign currencies take place. In this market buyers and
sellers constitute people who wish to buy or sell foreign exchange. The buyers can be individuals, firms,
commercial banks (like the State Bank of India), the central bank( Reserve Bank of India), commercial
companies, and investment brokers.

• The participants in the foreign exchange market include central banks, commercial banks, brokers etc.

• The central banks monitor market movements and sentiments and intervene according to government
policy.

• The function of buying and selling of foreign currencies in India is performed by authorized dealers /
moneychangers appointed by the RBI.
• The foreign exchange department of the major banks are linked across the world on a 24 hour basis.

• Major commercial centers are London, Amsterdam, Frankfurt, Milan, Paris, New York, Toronto,
Bahrain, Tokyo, Hong Kong and Singapore.

Structure of Foreign Exchange Market

The foreign exchange market is an international market that is not restricted by geographical barriers.

Its a 24-hour market.

It is a market in which national currencies are bought and sold against one another.

Customers: Customers are the ultimate users and providers of foreign exchange in the market. They
include exporters, importers, tourists, international students, foreign investors among others.

Authorized Dealers:

All scheduled commercial banks have been authorized in India by the Reserve Bank of India (RBI) to
deal in purchasing and selling foreign exchange to end users of foreign exchange. All authorized dealers
conduct transactions in accordance to the norms of exchange control regulations of the RBI.

Mediate between importers and exporters

Buy and sell foreign exchange to tourists, students travelling abroad.

Generate profits from trading in the foreign exchange markets taking advantage of fluctuating rates.

3. Speculators:

Speculators are participants in the foreign exchange market who transact to make profit arising out of
fluctuations in the foreign exchange rates in different countries. Banks, MNCs, NBFL, Governments and
other corporate entities can speculate in tne

market.

Central Bank:

The Reserve Bank of India is the central bank of the country. The primary responsibility of a Central bank
in a country is to maintain the external value of a country's currency. It manages the exchange rate and
also maintains foreign exchange reserves. For this purpose, it may choose to intervene in the foreign
exchange market.

Functions and Transactions of Foreign Exchange market :

Functions of Foreign Exchange Market

1. Transfer Function:

It is the primary function of the foreign exchange market. It facilitates the transfer of purchasing power in
terms of foreign exchange between the countries that are involved in the transactions. Purchasing power
(or buying power) is the number of products and services that one unit of currency can purchase. The
function is performed through credit instruments like bills of exchange, bank drafts, and telephonic
transfers. Therefore, it involves sending money or foreign currencies from one nation to another to settle
their accounts.

2. Credit Function:

Just like domestic trade, foreign trade also depends on credit. The Credit Function of the Foreign
Exchange Market implies the provision of credit in terms of foreign exchange for the export and import of
goods and services. For this, bills of exchange are generally used for making payments internationally.
The duration of Bills of Exchange is usually three months. The main purpose of credit is to help the
importer in taking possession of goods, sell them and obtain the money to pay the bills.

3. Hedging Function:

It implies to protection against risk related to fluctuations in the foreign exchange rate. Under this system,
buyers and sellers agree to sell and buy goods on a future date at some commonly agreed rate of
exchange. The basic purpose behind Hedging Function is to avoid losses that might be caused because of
variations in the exchange rate in the future.

Convertibility Concept

Convertibility is the ease with which a country's currency can be converted into gold or another currency
through global exchanges. It indicates the extent to which the regulations allow inflow and outflow of
capital to and from the country. Currencies that aren't fully convertible, on the other hand, are generally
difficult to convert into other currencies.

Currency convertibility is an important part of global commerce because it opens up trade with other
countries.

Having a convertible currency allows a government to pay for goods and services in a currency that may
not be the buyer's own. Having a nonconvertible currency makes it harder for a government to participate
in the international market because these transactions generally take longer to execute.

A nation's economy may be related to whether its currency is convertible. Stronger currencies tend to be
converted more easily than others, while growth may be stagnant for currencies with poor convertibility
because these countries may miss trade opportunities.

Convertibility on Current and Capital Account

1.5 Capital Account Convertibility (CAC)

Refers to the freedom to convert the domestic currency into other internationally accepted currencies and
vice versa. Convertibility in that sense is the obverse of controls or restrictions on currency transactions.
CAC would mean freedom of currency conversion in relation to capital transactions in terms of inflows
and outflows.

Article VIII of the International Monetary Fund (IMF) puts an obligation on a member to avoid imposing
restrictions on the making of payments and transfers for current international transactions. Members may
cooperate for the purpose of making the exchange control regulations of members more effective.

Article VI (3), however, allows members to exercise such controls as are necessary to regulate
international capital movements, but not so as to restrict payments for current transactions or which
would unduly delay transfers of funds in settlement of commitments.

1.6 Current Account Convertibility

Current account convertibility means freedom to convert rupee into dollars etc and vice versa for export
and import of goods and services. It also includes freedom to convert currencies to make/ receive
unilateral transfers like gifts, donations, etc and to pay/ receive interest, dividend, etc.

In India, there is full current account convertibility since August 20, 1993.

India had moved towards a market-determined exchange rate since March 1993. Then the RBI announced
in August 1993 that, effective from August 20, India has become fully convertible on the current account.
This was after India accepted the status and obligations of Article VIII with the IMF. It was a mere
formality as India had already come very close to Current Account Convertibility.

Refers to freedom in respect of payments and transfers for current international transactions. It allows
residents to make and receive trade-related payments, i.e. receive foreign currency for export of goods
and services and pay foreign currency for import of goods and services like travels, medical treatment and
studies abroad. It allows free inflows and outflows for all purposes other than for capital purposes such as
investments and loans. In other words, it allows residents to make and receive trade-related payments –
receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import
of goods and services, make sundry remittances, access foreign currency for travel, studies abroad,
medical treatment and gifts, etc.

Current account convertibility refers to freedom in respect of payments and transfers for current
international transactions. In other words, if Indians are allowed to buy only foreign goods and services
but restrictions remain on the purchase of assets abroad, it is only current account convertibility.

Advantages of current account convertibility

1. Export promotion: An important advantage of currency convertibility is that it encourages exports by
increasing their profitability. With convertibility profitability of exports increases because market
foreign exchange rate is higher than the previous officially fixed exchange rate. This implies that
from given exports, exporters can get more rupees against foreign exchange (e.g. US dollars) earned
from exports. Currency convertibility especially encourages those exports which have low import-
intensity.
2. Incentive to Import Substitution: Since free or market determined exchange rate is higher than the
previous officially fixed exchange rate, imports become more expensive after convertibility of a
currency. This discourages imports and gives boost to import substitution.
3. Incentive to send remittances from abroad: Thirdly, rupee convertibility provided greater incentives
to send remittances of foreign exchange by Indian workers living abroad and by NRI. Further, it
makes illegal remittance such ‘hawala money’ and smuggling of gold less attractive.
4. A self – Balancing Ability: Another important merit of currency convertibility lies in its self-
balancing mechanism. When balance of payments is in deficit due to over-valued exchange rate,
under currency convertibility, the currency of the country depreciates which gives boost to exports by
lowering their prices on the one hand and discourages imports by raising their prices on the other. In
this way, deficit in balance of payments get automatically corrected without intervention by the
Government or its Central bank. The opposite happens when balance of payments is in surplus due to
the under-valued exchange rate.
5. Integration of World Economy: Currency convertibility gives the chance to Indian economy to
interact with the rest the world economy. As under currency convertibility there is easy access to
foreign exchange, it greatly helps the growth of trade and capital flows between the countries. The
expansion in trade and capital flows between countries will ensure rapid economic growth in the
economies of the world. In fact, currency convertibility is said to be a prerequisite for the success of
Globalisation.

Adv and disadvantages of capital account convertibilty

1.5.1 Advantages of CAC

More capital available to the country, and the cost of capital would decline. The freedom to trade in
financial assets exists. It makes it difficult for a country to follow unwise macroeconomic policies. Tax
levels would move closer to international levels . It will grow competition among financial institutions.

1. Availability of large funds to supplement domestic resources and thereby promote economic growth.

2. Improved access to international financial markets and reduction in cost of capital.

3. Incentive for Indians to acquire and hold international securities and assets, and

4. Improvement of the financial system in the context of global competition.

5. Freedom to convert local financial assets into foreign ones at market-determined exchange rates

6. Leads to free exchange of currency at lower rates and an unrestricted mobility of capital
1.5.2 Disadvantages of CAC

1. It could lead to the export of domestic savings and expose the economy to larger macroeconomic
instability. Premature liberalization could initially stimulate capital inflows that would lead to
appreciation of real exchange rate and thereby destabilize an economy undergoing the fragile process
of transition and structural reform. It may bring low quality investment . It may generate financial
bubbles.
2. Exchange Rate Volatility: Convertibility exposes a currency to market forces, which can lead to
exchange rate volatility. Fluctuations in the value of the rupee can affect import/export costs, foreign
debt repayments, and the competitiveness of domestic industries. Sudden depreciation or appreciation
of the currency can disrupt economic stability and cause uncertainty.
3. External Vulnerabilities: Freely convertible currencies are susceptible to external shocks and
speculative attacks. Large inflows or outflows of capital can destabilize the economy, impacting
foreign exchange reserves, interest rates, and inflation. A sudden surge in capital outflows may
necessitate the implementation of capital controls to mitigate potential crises.
4. Impact on Domestic Industries: Convertibility can have mixed effects on domestic industries. While it
promotes competition and access to foreign markets, it can also expose domestic industries to
international competition, potentially leading to job losses and the decline of certain sectors.
Industries that are not globally competitive may struggle to survive in an open and competitive
environment.
5. Macroeconomic Policy Constraints: Convertibility imposes certain constraints on monetary policy
and exchange rate management. The central bank's ability to control interest rates and manipulate the
exchange rate becomes limited, as these are determined by market forces. This can restrict the
government's options for managing inflation, employment, and economic growth through monetary
policy measures.

FEMA

The Foreign Exchange Management Act, 1999 or FEMA regulates the whole foreign exchange market in
India.

Before this act was introduced, the foreign exchange market in India was regulated by the Reserve Bank
of India through the exchange Control Dept

Evolution of FEMA

After independence and in the decades that followed, India was facing foreign exchange scarcity.

FERA was introduced as a temporary measure to regulate the inflow of the foreign capital.
But with the economic and industrial development, the need for conservation of foreign currency was
urgently felt and on the recommendation of the Public Accounts Committee, the Indian government
passed the Foreign Exchange Regulation Act, 1973.

The Foreign Exchange Management Act (FEMA) replaced the Foreign Exchange Regulation Act of 1973
(FERA) in India on 1

June, 2000.

This made the usage of foreign exchange easy.

This Act was in line with the latest Industrial Policy, Foreign Investment Policy and Commercial Policies.

The enactment of FEMA also brought with it the Prevention of Money Laundering Act, 2002 (PMLA)
which came into effect from1July, 2005.

Under FEMA the Reserve Bank can prohibit, restrict or regulate the following actions which involve the
inflow and outflow of foreign exchange:

1. Transfer or issue of any foreign security by a person resident in India.

2. Transfer or issue of any security by a person resident outside India.

3. Deposits between persons resident in India and persons resident outside India.

4. Export, import or holding of foreign currency or currency notes.

Main Provisions

The main objective of Foreign Exchange Management Act, 1999 is to facilitate foreign payments and
foreign trade in India.

The provisions are designed to develop and maintain the foreign exchange market in India.

Since foreign exchange transactions in India are part of the Balance of Payment either classified as a
Current Account Transaction or a Capital Account transaction

Main provisions of FEMA 1999 include the following:

1. All Transactions of the Current Account to be Free: The FEMA allows all current account transactions
such as imports and exports of goods and services without restrictions.

2. Control on Realization of Export Earnings: The FEMA lays down norms with respect to realization of
export proceeds.
3. RBI Controls Transaction of Capital Account: Capital Account in the Balance of Payments records
Foreign Investments - FDI and FII; foreign loans and aids, NRI capital and Banking assets and liabilities.

4. Transactions through Authorized Dealers only: As per FEMA, all foreign exchange transactions has to
be transacted through Authorised dealers and authorized money changers only.

5. Violation of FEMA a Civil Offense: Any violation of any provision under FEMA is a civil offense.

6. Directorate of Enforcement: It provides for the formation of an Enforcement Directorate, which acts as
an investigative body.

7. Foreign Exchange Management: FEMA provides for the management and efficient use of foreign
exchange. It does not regulate and control its use.

8. Regulatory Mechanism: FEMA forms a regulatory body that helps the Government and RBI to enact
rules and make regulation for transactions relating to foreign exchange