GD Topic : Forex, foreign exchange rate, convertibility

The GD topic that we has been taken up for analysis is

"With over USD 120 billion forex reserves, Rupee should become completely convertible"

The basic concepts behind forex reserves, exchange rate systems, rupee-dollar exchange rate and
convertibility are discussed below. This refresher will assist you during your group discussion on the
above topic. It is important that you get familiar with these economic and financial jargons and
understand what they mean. As your GD topic could be from economics or finance, your prowess in
these basic concepts will help you talk confidently in the GD.

What are Forex reserves?

Why hold forex reserves?
Historic Perspective on India's Forex Position
Exchange Rate - Fixed Regime to Market Determined Floating Regime
What is the Appropriate Level of Forex Reserves?
Cost and Benefits of Holding Forex

What are Forex reserves?

The amount of foreign currency, SDRs and gold that are held by the Reserve Bank of India or the
Central Bank of any country is known as the foreign exchange reserves of a country.

Why hold forex reserves?

Technically, it is possible to consider three motives

A. Transaction - International trade gives rise to currency flows, which are generally handled by
private banks driven by the transaction.
B. Speculative - Individual or Corporates trade and invest in foreign currencies for gain.
C. Precautionary - Reserve Bank's reserves are characterized primarily as a last resort stock of
foreign currency for unpredictable flows, which can classified as a precautionary motive

A list of objectives in broader terms may be encapsulated viz.,

a. Maintaining confidence in monetary and exchange rate policies - i.e the value of Rupee vis a
vis major foreign currencies like the dollar, euro etc does not nosedive suddenly.
b. Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks
during times of crisis including national disasters or emergencies;
c. Providing confidence to the markets especially credit rating agencies that external
obligations (like borrowings from IMF, World Bank etc) can always be met.

Historic Perspective on India's Forex Position

India's approach to foreign exchange reserve management, until the balance of payments crisis of
1991 was to maintain an appropriate level of reserves required for importing goods and services. It
was defined in terms of number of months of imports equivalent of reserves.

For example, let us say India's import for a year was USD 36 billion and India had a foreign exchange
reserve of USD 4.5 billion, then it was expressed as our reserves being the equivalent of one and a
half months of imports. Emphasis on import cover constituted the primary concern to managing
foreign exchange reserves till 1993-94.

The approach to reserve management underwent a paradigm shift in the mid 90s.

The relevant extracts are:

It has traditionally been the practice to view the level of desirable reserves as a percentage of the
annual imports-say reserves to meet three months imports or four months imports. However, this
approach would be inadequate when a large number of transactions and payment liabilities arise in
areas other than import of commodities.

These started happening with the liberalization that led to foreign investors investing in Indian
companies either through the Foreign Institutional Investor (FII) route (Morgan Stanleys of the world
investing in Indian stock markets) or through Foreign Direct Investment (FDI) route (Enron investing in
Dabhol Power Corporation!!). These were instance of foreign currency coming into the country. For
each of these inflows, there will be a future outflow either when the FIIs repatriate their investments
or the FDIs taking back profits of their investments.

In addition, liabilities may arise either for repaying loans or paying interest on loans. The new
approach was aimed at determining the level of forex reserve, by paying attention to the loan
repayment and interest payment obligations in addition to the level of imports.

In addition, with the opening up of the economy since the early 90s, the impact of changes in global
currency markets is bound to affect Indian shores as well. Further, emphasis was placed on gaining
the ability to take care of the seasonal factors in any balance of payments (foreign exchange inflows -
foreign exchange outflows) transaction with reference to the possible uncertainties in the monsoon
conditions of India and to counter speculative tendencies or anticipatory actions amongst players in
the foreign exchange market.

Exchange Rate - Fixed Regime to Market Determined Floating Regime

During the period 1991 to 1995, India moved from a fixed exchange rate system to partial float
exchange rate system to a free float or floating rate market determined exchange rate system.

In the fixed exchange regime, which India followed till 1991, the exchange rate was fixed by the RBI
and was pegged to a basket of currency - US Dollars, Pound Sterling (UK), Deutsche Marks (Germany)
and few other currencies.

After the Balance of Payment crisis in 1991, as part of the IMF's stabilization program, India moved to
a partial float mechanism. As per this mechanism, the inward flow of foreign currency into the
country by way of exports was converted into Rupee in the following ratio - 60% at a rate fixed by RBI
which was around Rs.28 to a USD and the balance 40% at a market determined rate - which was
generally higher at Rs.32 to a USD. However, anyone in India who wants to buy foreign currency for
importing goods has to pay the market determined higher rate of Rs, 32 to a USD.

This partial float of the currency was later changed to fully floating or a market determined exchange
rate system, where neither RBI nor the Government of India fixed the exchange rate and allowed the
players in the market determine the exchange rate. So any foreign exchange that was brought into
the country was converted at a rate determined by the market. It was the same case when anyone
wanted to procure dollars for imports or to travel abroad or to buy a book from Amazon.com
What is the Appropriate Level of Forex Reserves?
The foreign exchange reserves include three items; gold, SDRs and foreign currency assets. As of
November, 2002 India has over US $ 65 billion of total reserves, foreign currency assets account the
major share. Gold accounts for about US $ 3 billion. In July 1991, as a part of reserve management
policy, and as a means of raising resources, the RBI temporarily pledged gold to raise loans. The gold
holdings, thus have played a crucial role of reserve management at a time of external crisis. Since
then, Gold has played passive role in reserve management.

The level of foreign exchange reserves has steadily increased from US$ 5.8 billion as at end-March,
1991 to US$ 54.1 billion as at end-March 2002 and further to US$ 65 billion as of November, 2002. The
traditional measure of trade based indicator of reserve adequacy, i.e., the import cover (defined as
the twelve times the ratio of reserves to merchandise imports ) which shrank to 3 weeks of imports by
the end of December 1990, has improved to about 11.5 months as at end-March 2002.

The debt-based indicators of reserve adequacy show remarkable improvement in the 1990s. The
proportion of short term debt (i.e., debt obligations with an original maturity up to one year) to
foreign exchange reserves has substantially declined from 147 per cent as at end-March 1991 to 8 per
cent as at end-March 2001. i.e. most of the foreign exchange reserves that we have right now have a
repayment obligation that exceeds three years - which reflects a higher quality of reserves.
Cost and Benefits of Holding Forex
The direct financial cost of holding reserves is the difference between interest paid on external debt
and returns on external assets in reserves. I.e. let us say India has borrowed USD 20 billion @ 5% p.a.
rate of interest and has reserves of USD 40 bn which is kept in the equivalent of savings account at 3%
p.a rate of interest. Then the managers at RBI have the option of either repaying the USD 20 bn loan
on which they pay 5% while earning only 3% on the same thereby saving on net interest outflow or
continue paying 5% on the loan and get only 3% for their investment for sake of holding reserves.

Such costs have to be treated as insurance premium to assure and maintain confidence in the
availability of liquidity. The costs of comfort level in reserves are often met by some benefits, but
both are difficult to measure, in financial or economic, and in quantitative terms.
What is convertibility?
Convertibility can be related as the extent to which a country's regulations allow free flow of
money into and outside the country.

For instance, in the case of India till 1990, one had to get permission from the
Government or RBI as the case may be to procure foreign currency, say US Dollars, for
any purpose. Be it import of raw material, travel abroad, procuring books or paying fees
for a ward who pursues higher studies abroad. Similarly, any exporter who exports goods
or services and brings foreign currency into the country has to surrender the foreign
exchange to RBI and get it converted at a rate pre-determined by RBI.

After liberalization began in 1991, the government eased the movement of foreign
currency on trade account. I.e. exporters and importers were allowed to buy and sell
foreign currency, as long as the items that they are exporting and importing were not in
the banned list. They need not get permission on a CASE TO CASE basis as was prevalent
in the earlier regime. This was the first concrete step the economy took towards making
our currency convertible on trade account.

In the next two to three years, government liberalized the flow of foreign exchange to
include items like amount of foreign currency that can be procured for purposes like
travel abroad, studying abroad, engaging the services of foreign consultants etc. This set
the first step towards getting our currency convertible on the current account. What it
means is that people are allowed to have access to foreign currency for buying a whole
range of consumable products and services. These relaxations coincided with the
liberalization on the industry and commerce front - which is why we have Honda City
cars, Mars chocolate bars and Bacardi in India.

There was also simultaneous relaxation on the restriction on the funds that foreign
investors can bring into India to invest in companies and the stock market in the country.
This step led to partial convertibility on the Capital Account.

"Capital Account convertibility in its entirety would mean that any individual, be it
Indian or foreigner will be allowed to bring in any amount of foreign currency into the
country and take any amount of foreign currency out of the country without any
restriction."

Indian companies were allowed to raise funds by way of equities (shares) or debts. The
fancy terms like Global Depository Receipts (GDRs), Euro Convertible Bonds (ECBs),
Foreign currency syndicated loans became household jargons of Indian investors. Listing
in Nasdaq or NYSE became new found status symbols for Indian companies. However,
Indian companies or individuals still had to get permission on a case to case basis for
investing abroad.

In 2000, the forex policy was further relaxed that allowed companies to acquire other
companies abroad without having to go through the rigmarole of getting permission on a
case to case basis. Further, Indian debt based mutual funds were also allowed to invest
in AAA rated government /corporate bonds abroad. This got further relaxed with Indians
being allowed to hold a portion of their foreign exchange earnings as foreign currency,
subject to a limit in the recent monetary policy in October 2002.

In general, restrictions on foreign currency movements are placed by developing

countries which have faced foreign exchange problems in the past is to avoid sudden
erosion of their foreign exchange reserves which are essential to maintain stability of
trade balance and stability in their economy. With India's forex reserves increasing
steadily, it has slowly and steadily removed restrictions on movement of capital on many
counts.

The last few steps as and when they happen will allow an individual to invest in
Microsoft or Intel shares that are traded on Nasdaq or buy a beach resort on Bahamas
without any restrictions.
"Role and future of banking and insurance sector in India."
banking and insurance is life blood of RBI...dey play vitol role in development of
country..insurance get for double benifits both safety as well as investment.banking mainly for
liquidity of cash and secure sectors for financing problems...well govt think about both sectors
equally...lic helps to collects funds for country.
Role of it makes it future,I think the future role of banking and insurance sectore is to emphatic
in rural areas.More and more bank should open in rural areas so that our farmers get easiy loan
from bank and they would no more exploited by the local landlored and also more flexible
insurance policy should given to them as well as for their Crops also.By doing so there would be
bright future and huge market for banking and insurance sector.