Foreign exchange By: Dr C.S.

Adhikari

Table of Content Introduction Exchange Rates Concepts of exchange rates Different Exchange Rate R egimes Macroeconomic adjustments under difft exchange rate reigmes 6. Causes- Cu rrency crisis 7. Indias External Sector- Recent Trends 1. 2. 3. 4. 5.

Introduction External sector refers to the relation of one country with the other countries of the world in terms of trade, investment and capital mobility. The extent of this interrelationship depends on: o Contrib ution of international trade(imports and exports) in GDP. o Mobility of labour a nd capital across countries o The exchange rate regime.

Introduction Imports and exports of goods and services( current account) we have discussed with the BOP. In order to meet our requirements of imports and exports of Gs and Ss,demand for and supply of foreig n exchange and Rupee takes place. Further, the movements of foreign capital in t he capital account of BOP also influences demand and supply of F-Exchange.

Introduction Demand for and supply of foreign exchange vis-a-vis rupee determines exchange rate. The appreciation and deprecia tion of rupee influences the flow of exports and imports. The supply of money vi s-a-vis foreign exchange also influences price level,interest rates and growth o f GDP. Thus the study of exchange rates is important.

II Exchange Rates E-rate is the price of domestic currency in relation to foreign currency. When the value of rupee rises(appreciates) in r elation to the dollar, we say that exchange rate has fallen and vice-versa. Nomi nal exchange rate is simply the price of domestic currency in relation to anothe r currency.

NEER Since there is no one single foreign currency, a more meaningful way to define exchange rate is the value of domestic currency in relation to a basket of currencies. This is called Nominal Effectiv e Exchange Rate. It is arrived at as the weighted average of the price of rupee in relation to all other currencies where the weights reflect the importance of each currency in Indias foreign trade.

RER & REER Real exchange rate is defined as the nominal exchange rate times the foreign price level divided by the domestic pric e level. RER captures the competitiveness of a country s trade by additionally c onsidering the relative price changes between countries. Since we have BOP accou nts with more than one country, real effective exchange rate will be more meanin gful.

RER &REER A Country trades with different currencies like dollar, euro, yen etc. Suppose rupee appreciates against dollar by 5% but remains unchanged against other currencies and our trade with U.S. Acc ounts for 75% and with others 25%. In such case rupee s REER will be:5x75+0x25 i .e.3.5% and not 5%

Impact of changes in REER Trade Feed back Effect: It refers to the chain reaction of appreciation/depreciation in the currency on exports, GNP, imp orts etc. Suppose U.S. Dollar depreciates visa-vis yen and people find U.S. Comp uters cheaper than Japan. As a result U. S. economic activities will increase re sulting into higher GNP.

Trade feedback effect This in turn will increase U.S. Imports and with this the exports of the ROW will also increase. This is called trade fe edback effect. Subsequently economic activities of ROW will increase which will follow an increase in their imports and some of the imports may come form U.S.

Price feedback effect(PFE) PFE is nothing but exportation of inflation. Suppose Price level in India has gone up. This will result in increas e in Indian export prices resulting into increase in the import prices of U.S. W hich is importing form India. Along with this the general prices in U.S. Will go up which will result in increase in U.S. exports price as well as general price level in U. S.

Exchange Rate Regimes FIXED MANAGED FLOAT FLEXIBLE

Fixed Exchange Regime The central bank fixes the price of the domestic currency in relation to the foreign currency. The central bank will not allow the currency to depreciate and will sell the foreign exchange in the mark et from its reserves to increase the supply to maintain the fixed exchange rate and vice versa.

Advantages Provides businesses with sure basis for planning and pricing. Constraints on monetary policy imposes monetary discipline . Disadvantages To support a fixed exchange rate system the central bank must ha ve adequate foreign exchange reserves or access to foreign capital. In case of m acroeconomic imbalances prompt action required

Flexible Exchange Rate The exchange rate here is determined purely on the basis of demand for and supply of foreign exchange in the market p lace. The adjustment in the external sector takes place through change in exchan ge rate.

Advantages There is no overvaluation or under valuation of the currency. No scope of speculation The central bank can follow a n independent monetary policy. Disadvantages Since markets are imperfect market determined exchange rate is a myth. Exchange rate may show high degree of volati lity. Exchange rates are impacted by the monetary policy although the reverse is not true.

Managed Float Regime A compromise between fixed and floating rate regime, the central bank announces the exchange rate is market determined but to the extent the market is not perfe ct the central bank intervenes from time to time to bring orderly conditions in the market. The fluctuations in exchange rate is smoothened. It also reduces pos sibilities of speculation.

Financial Repression: It refers to a situation where the governmen follows a pol icy vis--vis the financial sector which impede the efficient functioning of the s ector. Ex: Imposition of credit controls, Administered interest rate,public owne rship of Financial institutions etc. Financial Sector Liberalization: It is mean t to undo the dangers posed to the Financial sector by financial repression. Fin ancial Sector Reforms: Creation of institutions & mechanisms which will provide a conducive environment for a Smooth transition from repressed financial system to a more liberalized.

Financial Sector Vulnerability Financial sector is prone to collapse when it resorts to financial sector libera lization without financial sector reforms Financial liberalization with poor reg ulation & supervision results in lending boom. Risky loans and poor asset qualit y make it vulnerable to macro economic shocks These shocks come in the form of h igh interest rates, persistent current a/c deficit.. The crisis results in a dec line in bank lending and a sharp contraction in real economic activity

Indias External Sector Trade Reforms: Policy changes in trade with respect to: Virtual elimination of l icensing and progressive shift of restricted items of imports under Open General Licenses. Lifting all quantitative restrictions on imports of goods Phased redu ction in peak tariff rates. Simplification & rationalization of EOUs EPZs Enactm ent of FEMA

Liberalization of Capital Flows Non Debt Capital Flows: Liberalization of FDI & FII by the automatic route or case by case basis. Debt C apital Flows: they are of four types namely ECBs, NonResident Deposits, Short Te rm Debt, Government account debt.

Foreign Exchange Reserve Management Indias short term debt obligation at 43.7% (should not exceed 60%) Foreign exchange enough to to cover 15 months impo rts compared to 6months, considered safe. Foreign exchange reserve as a proporti on currency 150.86% as against minimum requirement of 70%

Foreign Exchange Market Central Market Brokers & Immigrants.

Commercial Banks

Exporters, Importers Tourists, Investors

Functions of F. E. Markets Spot Mkt:refers to that segment of foreign exchange mkt in which sale and purchase transactions are settled within two days of the deal. The rate at which foreign currency is bough and sold in th e spot market is called spot exchange rate.

Contd.. Forward Market: refers to foreign exchange deals for sale and purchase of foreign currency at some future date, no rmally after 90 days. It is known as forward transaction.

Nature of transactions in FEM Hedging:is settling the exchange rate in advance for future transaction with a view to avoiding the loss that might arise due to exchange depreciation in future. Arbitrage: an act of simultaneous purch ase and sale of different currencies in two or more exchange markets.

Contd.. Speculation:an act of buying and selling a currency under the condition of uncertainty with a view to making profit.

Thank You