Introduction of EXCHANGE RATE SYSTEM

To prepare for INDIAN ECONOMY for any competitive exam, aspirants have to know about
the Exchange Rate System. It gives an idea of all the important topics for the IAS Exam and the
Economy syllabus (GS-II). Important Exchange Rate System terms are important from Economy
perspectives in the UPSC exam. IAS aspirants should thoroughly understand their meaning and
application, as questions can be asked from this static portion of the IAS Syllabus in both the
UPSC Prelims and the UPSC Mains exams

In this article, you will read about meaning, method, types, importance and other aspects related
to the Exchange 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 dollars against the Indian rupee. If the demand for dollars increases, its value
increases, and the dollar appreciates while the Indian rupee depreciates with respect to the
dollar.

 Exchange Rate System: The price of one currency in terms of the other currency is called
the 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. 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.

 Exchange Rate System: 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 labeled as „Tobin
Tax‟.
Exploring the Objectives of Exchange Rate Management in India within the Global
Exchange Rate System

 To ensure that the economic fundamentals of the Indian economy are correctly reflected
in the external value of the 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 liberalization in 1993.

Understanding the Rupee: Exploring Key Factors Influencing the Exchange Rate of India

 The Exchange Rate System: Exploring the Intervention of the Reserve Bank of India

o During high volatility in the exchange rate system, RBI intervenes to prevent the
exchange rate going out of control.

o For example, the RBI sells dollars when the Indian rupee depreciates too much,
while it purchases dollars when the Indian rupee appreciates beyond a certain
level.

 Inflation rate:

o The increase in inflation rate can increase the demand for foreign currency which
can negatively impact the exchange rate system of the national currency.

o For example, an increase in the inflation level of petroleum oil can increase the
demand for foreign currency leading to the depreciation of the Indian rupee.

 Interest rate:

o Interest rates on government securities and bonds, corporate securities etc affect
the outflow and inflow of foreign currency.
 o 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
system of the Indian rupee.

 Exports and imports:

o Exports and imports affect the exchange rate system as exports earn of foreign
currency while imports require payments in foreign currency.

o Thus, if the overall exports increase, the national currency appreciates, while
increases in imports lead to the depreciation of the national currency.

o 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.

Understanding Exchange Rate Systems: Analyzing Exchange Rate Regimes in India

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

EXCHANGE RATE REGIME: Exploring the Dynamics of the Exchange Rate System

 Floating or Flexible

 Fixed or Pegged

 Managed Float / Dirty Float

1. Floating or Flexible

 A floating or flexible exchange rate system 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 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

When a person buys $ and other foreign currency with the hopes they become
Currency more expensive in future so he can sell at a profit to others. In other words, he
Speculation would be hoping for ₹ to depreciate / $ to appreciate. Such elements distort the
exchange rate by hoarding foreign currencies.

If 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 the US Fed increases their repo rate from 2% to 4% American
Interest Rates
investors might pull back from Greece. Because America commercial bank loans
will become more expensive by about 5%, then there will be American
companies willing to borrow by issuing Bond/debentures at 4.5%.

 Fixed Exchange rate system- 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 system, first being UK
in 1973

 Mixed Exchange Rate

 Where the central bank interferes whenever a crisis situation occurs. Otherwise the
exchange rate system 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 system. This is achieved
 by linking the domestic currency to the value of gold or with other major currencies such
as the US dollar etc.

 For instance, when the central bank of a country itself decides the exchange rate system
of local currency to foreign currency e.g. People‟s Bank of China (PBC) $1 = 6 Yuan.

 If excess dollars are entering 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 a large build-up of dollars, due to the
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.

It ensures stability in the exchange rate system of the domestic currency.

Benefit

It ensures that the domestic currency does not appreciate or depreciate beyond the
predetermined level.

This regime puts a massive burden on the government for maintenance of the
exchange rate system and the government may have to infuse a large amount of
money for the maintenance of the exchange rates.

Challenge The foreign investment can reduce under the fixed exchange rate regime as investors
may lose their confidence as they believe that the exchange rate system of the
domestic currency does not represent the real value of the economy.

If the trade deficit widens or speculators are hoarding dollars or FPIs are pulling their
money back to the USA due to higher interest rates. It will create a shortage of $ in
 the 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 an infinite amount of dollars in its reserve, ultimately it
will be forced to devalue the local currency. This will make imports more expensive.

Therefore, most of the countries have abandoned this system after the 70s. China too
abandoned it eventually, and shifted to Managed Floating Exchange Rate.

Understanding the Floating Exchange Rate System in the Global Exchange Rate System

 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.

2. Managed floating exchange rate system

 It is the middle path between the fixed exchange rate regime and the floating exchange
rate regime.

 In the system, the exchange rate system 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 system of the domestic currency.

 RBI will not decide the exchange rate system (unlike the fixed system). In the ordinary
days, RBI will let the market forces of supply and demand decide the exchange rate
system.

 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 volatility. if $ to Yuan value changes more than “x%” up or down
compared to the previous day‟s exchange rate.

 It can further be categorized as following:

3. Managed floating exchange rate

 Crawling peg system

 Clean floating

 Adjusted peg system

 Dirty floating

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

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

Under this, the exchange rate of domestic currency is based on the market forces of demand and
Clean
supply without the government intervention.This system is identical to the floating exchange rate
floating system
system.
 Under this, the exchange rate system is mainly determined by the market forces of demand and
Dirty
supply but the central banks occasionally intervened to remove excessive fluctuations from the
floating system
foreign exchange markets.

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 dollars
Challenges in more expensive. This makes local currency weak and helps in boost to exports.
Managed Float
System The 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. The USA has not
officially labeled anyone as “Currency Manipulator”, since 1994.

Exploring Exchange Rate Systems and 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)

 The USA would issue a $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 were 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, the USA agreed to fix the price of its $1 = (1/35) ounces of gold. [1 ounce = 28
grams]. The 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 the IMF fixed the exchange rate system of every country‟s currency against the
USA. e.g.₹ 1= $0.30 = about 0.24 grams of Gold. So, that implies India can‟t issue more
currency if RBI does not have proportionately sufficient gold reserves of its own. Still if
RBI issues more ₹ currency, the 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 the open market at a
profit, then the US Feds Chairman can‟t continue honoring his promise. It was called the
“Triffin Dilemma”. He therefore suggested an alternative SDR (Paper gold) system for
the 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, the USA shifted to the “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.

Rupee Realities: Understanding India’s Currency Exchange System

Towards Fixed Exchange Rate System

1860 Fixed Fiduciary System à i.e. The British Indian Govt can issue Rs.10 crore notes on fiduciary
onwards (“trust”) backed by G-Sec. Beyond that every note must be backed by gold / silver.

1935 Proportional Reserve à RBI must keep about 40% gold to the value of currency issued. British
onwards govt fixed exchange rate.

1946 Bretton Woods / IMF system of fixed exchange rate à Wherein ₹ price was fixed (pegged)
onwards against dollar, and dollar price was fixed (pegged) against gold.

While 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
1956
only Indian G-sec but (without adequate Gold / Forex Reserve, then IMF may force
onwards
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 System: 1995 onwards

 Post 1995 onwards, “Minimum Reserve System is continued but RBI is required to only
keep ₹ „specific‟ 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
system using the price of one McDonald burger in the USA vs the respective country.

Exchange Rate System Strategies: VRR and FAR Approaches for Attracting Dollars

To prevent weakening of ₹, we have to attract more $ (and other foreign currencies) in India. So,
RBI taken following notable measures:
 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.
Voluntary
Retention Route But, with conditions= FPI must remain invested in India for a minimum 3
(VRR) years. (Hot Money)

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

Budget-2020 had announced allowing non-resident investors to invest in G-

Fully Accessible Sec, without any restrictions.
Route (FAR) 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 keep BoP and currency exchange rate system
stable during the crisis.

Analyzing Currency Exchange Rate System Amidst the COVID-19 Crisis

Corona Virus Force Majeure àSENSEX dips so FPIs Selling shares from Indian companies= they
2020- got ₹₹ → converting them into $ → running back to USA to invest in (AAA rated) US treasury
Feb bonds which is the 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).

RBI starts Dollars Swap with Indian banks. i.e. A bank shall buy US Dollars from the Reserve
2020-
Bank and simultaneously agree to sell the same amount of US Dollars at the end of the swap
March
period (6 months). It is done through auctioning, so, RBI earns some % of profit.

COVID- Dollar up-down movements, RBI signing more swap agreements, Indian Government borrowing
19 more $$ from ADB, BRICS Bank etc.
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).

 The IMF will pay them a small interest rate for their deposits. And the IMF would lend
this money to a member facing a balance of payment crisis. To operationalize this
mechanism, the 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 Basket Weightage

U.S. Dollar 41.73

Euro 30.93

Chinese Yuan (Renminbi *added in 2015) 10.92

Japanese Yen 8.33

Pound Sterling 8.09

 By applying a formula involving (weight * exchange rate), IMF will obtain a 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
countries may borrow more SDR from IMF (and then convert it into dollars etc. to pay
 off the import bill), but eventually members 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 the 8th largest quota holder after the USA (~18%), Japan (~7%), China (~6%)…

 In the 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 the Finance Minister is absent, then the RBI Governor can vote as the Alternate
Governor during the IMF‟s meetings.

Exchange Rate System: Understanding the Power of Currency Convertibility in the Global
Financial Landscape

 Presently, India has managed a floating exchange rate system wherein, currency
exchange rate is determined by the market forces of supply and demand, however, during
high levels of volatility RBI will intervene to buy / sell ₹ or $ to stabilize the exchange
rate system.

 But if people are allowed to convert the local and foreign currency in an unrestricted
manner, this will lead 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)

Understanding RBI’s Exchange Rate System: Restrictions on Rupee Convertibility

1. CONVERTIBILITY OF RUPEE

 Convertibility on Capital Account Transactions

 Convertibility on Current account transactions

Convertibility on Capital Account Transactions:

 RBI‟s External Commercial Borrowing (BoP → Capital Account → Borrowing →
ECB) ceiling is up to $750 million (or equivalent other currency) per year for Indian
External
Companies. That means even if Bank of America was willing to lend $1500 million
Commercial
to Reliance, it can‟t bring all those dollars (or its converted rupee equivalent) in
Borrowing (ECB)
India. If he tries through illegal methods like Hawala, then the Enforcement
Directorate (ED) will take action for FEMA violation exchange rate system.

An Foreign Portfolio Investors (BoP → Capital Account → Investment → FPI)

can‟t invest in more than 5% of available government securities in the Indian market
Foreign Portfolio and more than 20% of the available corporate bonds in the Indian market.
Investors (FPI)
So, even if Morgan Stanley or Franklin Templeton investment fund has billions of
dollars they can‟t bring them all to India because of the above restrictions.

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 Direct foreign currency into Indian currency. E.g. Las Vegas‟s Flamingo Casino company
Investment (FDI) can‟t convert $ int ₹ 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.
Exchange Rate System: Understanding RBI’s Approach to Convertibility in Current
Account Transactions

 During 2013 to 2014, RBI‟s 80:20 norms mandated min. 20% of the imported gold must
be exported back.

 Exchange Rate System: Until then Jeweller/bullion dealers will not get permission to
(convert their rupees into dollars/foreign currency) to import the 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, the 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 as per the exchange rate
system.

 Exchange Rate System: But this angle takes us towards the „National security and
sovereignty of India‟. We need not confuse or mix it up with the „Economics concept‟ of
Rupee convertibility under FEMA ACT.

Full convertibility of Rupee

Meaning – India 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 the resolution of the 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.

 Exchange Rate System: 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 in extreme
depreciation of local currency $1 = 2000 Indonesian Rupiah → $1= 18,000 Indonesian
 Rupiah. All developments resulted in heavy inflation of petrol and diesel, social unrest,
riots and political instability. None of their central banks had enough forex reserves 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.

Exchange Rate System: Understanding the S.S. Tarapore Committee’s Vision for Rupee
Convertibility (1997)

 In Exchange Rate System-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) in the Exploring Exchange Rate
System

 Exchange Rate System: While RBI has not permitted full convertibility of Indian rupee
(on Capital Account), but over the years it has liberalized the norms, such as:

Liberalized 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 a current account or capital account
transaction as per his wish. (e.g. paying for college fees abroad, buying shares, bonds,
2004 properties, bank accounts abroad.)

Exchange Rate System – 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.

RBI began relaxing the norms for External Commercial Borrowing (ECB), mainly to
2016
soften the NPA problem e.g. Software firms can bring up to $200 million in ECB,
onwards
Micro-finance $500 mill, Infrastructure companies $750 million etc.
 When ₹ started to depreciate heavily against dollars ($1 → ₹ 63 → ₹ 74), RBI had
to encourage the flow of dollars into the Indian economy. So, aforementioned sector-
2018-19 specific limits streamlined → all 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.)

2019 RBI 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.

Money Clash 2018: Understanding Exchange Rate System in the Currency Battle

 2015: Chinese authorities announced they don‟t manipulate/control Yuan exchange rate.
They only intervene if Yuan‟s exchange rate system varies more than +/- 4% from the
previous day.

 During 2018, People‟s Bank of China pursued „Cheap (Dovish) Money Policy‟ to inject
more Yuan (renminbi) in the system to make loans cheaper in the domestic market and
boost the consumption, demand, and growth.

 But, on the other side, US Feds pursued Dear (Hawkish) Money Policy, so dollar supply
is shrinking, so dollars are 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 products more cheaper in global trade. He even accused Russia and Japan
of playing a similar „Currency War‟ against him.

Exchange Rate System: Understanding the 2018 Currency War and the Depreciation of the
Indian Rupee

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

 Exchange Rate System: 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 a lot of money from the American financial market) would 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 for dollars and ran away from Turkey.
  Because of this rush, demand for dollars strengthened even further and resultantly, other
currencies became even weaker. (Including India: $1=₹ 63 in January → $1= ₹ 74 in
Oct ‟18).

 Exchange Rate System: In 2019-20 also, India rupee continued to weaken towards
$1=75₹ because of Corona Force Majure which led to dip in SENSEX. Foreign investors
pulling out money from India.

 While such depreciation is good for our exporters but bad for our importers.

Strengthening the Rupee: Government and RBI’s Exchange Rate System Interventions in
Response to the Currency

1. FPI‟s investment limits in the Bond market were 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 for
dollars.

4. Further, to attract NRIs 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 an exchange
rate crisis in future.

6. RBI could also pursue Hawkish Monetary Policy to reduce rupee supply in the market (so
that ₹ can also become expensive just like dollars). But, because the 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- The central banks of India and Japan signed Currency Swap Agreement of $75 billions i.e.
Oct either party can use that much dollar currency from the other party‟s forex reserve during
the crisis. Even in 2008 and 2013 too they had signed similar agreements but lower
 amounts were involved.

RBI‟s $5 bn Currency Swap with Indian banks → RBI gains dollar reserve to fight future
2019-
volatility in currency exchange rate, whereas Indian banks got extra rupee liquidity →
March
(Hopefully) cheaper interest rates to combat deflation.

India signed a pact with Iran to pay crude oil bills in rupee currency. National Iranian Oil
2018- Co (NIOC) will open a bank account in India‟s UCO Bank (a PSB). Indian oil companies
Dec will make payments there in ₹ currency. This will help curbing the demand for dollars in
India.

Budget –
Nirmala S. announced various measures to attract more FPI and FDI investment in India
2019

Corona 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
2020-
(AAA rated) US treasury bonds which is the safest investment. So there is a great shortage
Feb
of dollars in the Indian market. If RBI does not supply dollars → further weakening of
rupee ($1=₹75 → ₹80).

RBI starts Dollars Swap with Indian banks. i.e. A bank shall buy US Dollars from the
2020- Reserve Bank and simultaneously agree to sell the same amount of US Dollars at the end
March of the swap period (6 months). It is done through auctioning, so, RBI earns some % of
profit.

Exploring the Impact of Quantitative Easing and Federal Tapering on Exchange Rate
Systems

Quantitative In Exchange Rate System – Subprime crisis in USA (2007-08 → Borrowers

Easing unable to repay the home loans → American Banks and NBFCs‟ bad loans / NPA
 / toxic assets increased → to help them, the US Federal Reserve printed new
dollars & used it to buy those toxic assets → increased dollar supply in the
system. Known as “Quantitative Easing”.

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

Result

 shortage (perceived) of dollars in USA → Loans % become more expensive in the USA
so American investors began selling shares/bonds in other countries, and took their
dollars back to the USA (to lend to local businessmen).

 This phenomenon was called “Taper Tantrum”. It resulted in weakening of other

currencies against USD.

Money from the Sky and No Interest: How They Affect Exchange Rate Systems

 Exchange Rate System – Economist Milton Friedman (1969) introduced the 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 in more
factories, jobs and economic growth.

 Exchange Rate System: In the aftermath of the subprime crisis and global financial crisis,
there was a 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 as er the exchange rate system.

 Exchange Rate System: Result à Commercial banks will proactively try to give away
more loans to customers to boost demand in the economy.

Understanding Exchange Rate Systems : The Power of 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, the
exact figure is $1=₹ 17 at PPP).
  This (hypothetical) exchange rate can happen in real life, if both the countries have
Floating Exchange Rate System 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 rate
system, 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 rate system 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 was added to an SDR basket of currency. It increases the acceptance of
Yuan in the global economy.

 Exchange Rate System 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 dollars while importing oil, missiles,
metal and food commodities- as other nations begin to happily accept Yuan.

 Such in the exchange rate system Yuan dominance may pose strategic challenges to the
USA and India.

Exploring Effective Exchange Rate systems in the Global Currency System

Effective Exchange Rate systems

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

Exchange Rate System: Understanding NEER and REER in the Global Economic

 Nominal Effective Exchange Rate System (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 the REER is the weighted average of nominal exchange rate
bilateral nominal exchange rate systems adjusted for relative price differential between the
system of the home currency in domestic and foreign countries, related to the purchasing
terms of foreign currencies. power parity (PPP) hypothesis.

 In real life we are not just trading with the 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 the geometric average of the rupee‟s exchange rate system 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)”.

 Exchange Rate System: 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 analyze whether a currency is really weakening
(depreciating) against the foreign currencies or not, thus helping to know our
international competitiveness in exports in the exchange rate system.

Devaluation of a currency: Understanding the Impact on Exchange Rate Systems

 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 system. 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 India was following the fixed exchange rate regime, the
Indian Rupee was devalued by 36 %.

Exploring Currency Devaluation: Reasons and Objectives within the Exchange Rate
System

 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.

 Exchange Rate System 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 country‟s 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
in the exchange rate system.

 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 in the Exchange Rate System

 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 as per the exchange rate system.
  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.

The Simple Story of Currency Depreciation in Exchange Rate System

 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 system of the currency
changes on a 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.

Exploring Reasons Behind Devaluation in Exchange Rate Systems

 Exchange Rate System-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 system leading to currency
depreciation.

 Monetary policy of the 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 as per the exchange rate system.

Dollars Going Down: Understanding Devaluation and Depreciation in Money Talk

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

Devaluation Depreciation

Devaluation is the official reduction in the Depreciation refers to an unofficial decline in the
value of a currency. currency‟s value.

Devaluation is the phenomena associated Depreciation of a currency is associated with the

with fixed exchange rate regime. floating or managed floating exchange rate regime
in exchange rate system

Exchange Rate System-Devaluation of the

The market forces of demand and supply are
currency is done purposely by the central
responsible for the depreciation of a currency.
bank or the government

The impact of currency devaluation is for The depreciation of currency can affect the
short term, economy for a longer time.

Devaluation of currency is done occasionally Depreciation and appreciation of currency occur

by the central bank. on a daily basis.

Examining the Long-Term Effects of Devaluation and Depreciation in Exchange Rate

Systems:

 The long-term impacts of devaluation and depreciation differ.

 Exchange Rate System: 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 changes the exchange rate systems.

Exploring the Dynamics of Currency Revaluation in Exchange Rate Systems

 Revaluation refers to an upward adjustment to the country‟s official exchange rate system
relative to either the 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
system is determined by the central bank or the government.

 Revaluation is opposite to devaluation, which is a downward adjustment.

Exchange Rate System: Simple Reasons Behind Revaluation in Money Matters

  Exploring Exchange Rate System: 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 imports cheaper which can reduce the inflation rate in the
domestic economy.

 Exchange Rate System: Changes in the interest rates of other countries and changes in the
global economic environment can also lead to currency revaluation in order to manage its
impact on the domestic economy.

In Exchange Rate System : 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.

Exploring the Causes of Currency Appreciation in Exchange Rate Systems

 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 system of the domestic
currency.

 Exchange Rate System Increase in exports:it increases 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 growth can increase foreign investment in the economy which can
cause appreciation in the exchange rate system.
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

Exchange rate system justifies the need for FDI for the development of the Indian
GSM3-
economy. Why is there a gap between MOUs signed and actual FDIs? Suggest remedial
2016
steps to be taken for increasing actual FDIs in India.

Craze for gold in Indians has led to a surge in import of gold in recent years and put
GSM3-
pressure on balance of payments and external value of rupee. In view of this, examine the
2015
merits of the Gold Monetization Scheme as per the exchange rate system.

Exchange Rate System-There is a clear acknowledgement that Special Economic Zones

GSM3- (SEZs) are a tool of industrial development, manufacturing and exports. Recognizing this
2015 potential, the whole instrumentality of SEZs requires augmentation. Discuss the issues
plaguing the success of SEZs with respect to taxation, governing laws and administration.

Though 100 percent FDI is already allowed in non-news media like a trade publication
GSM2- and general entertainment channel, the Government is mulling over the proposal for
2014 increased FDI in news media for quite some time. What difference would an increase in
FDI make? Critically evaluate the pros and cons.

Exchange Rate System-Foreign direct investment in the defense sector is now said to be
GSM3-
liberalized. What influence is this expected to have on Indian defense and economy in the
2014
short and long run?

Conclusion
The exchange rate system serves as a dynamic lens through which we understand the intricacies
of currency movements. The causes of currency appreciation, explored within this context, shed
light on the economic forces shaping global financial landscapes. As we navigate the exchange
rate system, recognizing the factors influencing currency value becomes crucial for informed
decision-making and economic stability.

What Is A Foreign Exchange Rate?

The forex rate is the rate at which a currency is exchanged. For example, if the Indian rupee
trades at Rs 72.96 to one dollar, the forex rate for the US dollar for the Indian rupee is 72.96.

This rate can change depending on many factors. Therefore, forex rates are closely watched by
currency traders and governments, who take steps to keep the rate advantageous to the country‟s
economic health.

These exchange rates can have a tangible impact on investor portfolios on a granular level in
terms of genuine returns.

Read on to find out more about important factors affecting exchange rates.

Factors Influencing Exchange Rates

1. Inflation

If a country has low inflation rates consistently, its currency value typically rises. This is because
the currency‟s purchasing power becomes higher than the other currencies with which it is
compared.

Conversely, higher inflation rates lead to the currency depreciating in value, losing out on
purchasing power and value against other currencies.

2. Interest Rates

If a country has a high-interest rate, lenders have the chance to earn more. This attracts foreign
capital looking to earn at higher rates. The result is that the country‟s foreign exchange rate rises,
making its currency stronger.

Interest rates are directly correlated to inflation as well as exchange rates.

A country‟s central bank will try to influence inflation or exchange rates via the interest rate
mechanism. High-interest rates mean a higher cost of borrowing. It could happen that despite an
interest rate hike, inflation does not come down in any meaningful sense, which will have less-
than-expected effects on the exchange rate.

Conversely, interest rate decreases tend to depress exchange rates.

3. Deficits

One of the most critical deficit parameters is the current account deficit – the difference between
a country‟s spending and what it earns. A current account deficit means that the country is
spending more to buy than what it earns.

Consequently, its foreign currency earnings via exports are not enough; it will need to borrow
money from abroad to make up the difference. This high demand for foreign currency lowers the
country‟s exchange rate.

4. Debt

When a country engages in large-scale infrastructure projects, it generally will not have all the
funds for them. So, it borrows funds domestically as well as from abroad.

These projects stimulate the economy; however, the deficit created by the public debt it takes
makes it an unattractive investment destination. A large public debt is a recipe for high inflation,
i.e., the country‟s currency gets weaker, and it will need more time to service debt and interest
payments, affecting borrowers‟ returns.

The worst-case scenario? If the country has to default on its loans because it cannot pay them
back due to its enormous debt, high inflation, and depressed exchange rates.

Also read How Does Inflation Impact the Stock Market?

5. Import-Export

Exporting earns a country some money, while importing is spending it. If a country‟s exports are
growing at a higher rate than its imports, it‟s a good sign for its currency exchange rate.

Higher exports mean increased demand for the country‟s currency and therefore its value.
Key Takeaways

 Inflation, interest rates, and forex rates are correlated. Each of these factors can affect the
other two.
 Low inflation and high-interest rates can attract foreign funds to a country, strengthening
its exchange rate.
 Countries with large public debt can see their exchange rates decrease because they are
viewed as unattractive investment destinations. This means the country needs to pay
more to service its debt.
 If the country‟s export growth rate is higher than its imports, it denotes more demand for
its currency, thus strengthening its currency and exchange rates.

FAQs

1. What is the impact of the economy on the exchange rate?

If a country is doing well economically, investors will look to invest there. They will move funds
from other countries that are not performing, resulting in more confidence in the country‟s
currency and subsequent strengthening of its forex rate.

2. How does inflation affect exchange rates?

Consistent low inflation rates have a positive effect on currency value. The currency‟s
purchasing power becomes stronger, and hence it gets stronger.

3. How do exports affect exchange rates?

Higher exports mean increased demand for the country‟s currency and therefore its value. So, if
a country‟s exports grow at a higher rate than its imports, it‟s a good sign for its currency
exchange rate.

4. How do interest rates affect exchange rates?

High-interest rates offer lenders the chance to earn more, thereby attracting foreign capital to the
country. This causes the foreign exchange rate to rise, making the home country‟s currency
stronger.

5. What is a current account deficit?

The current account deficit is the difference between a country‟s spending and its earnings. A
current account deficit means that it is spending more to buy than it is earning.