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Foreignexchange

By:DrC.S.Adhikari

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TableofContentIntroductionExchangeRatesConceptsofexchangeratesDifferentExchangeRateRegimesMacroeconomicadjustmentsunderdifftexchangeratereigmes6.Causes-Currencycrisis7.IndiasExternalSector-RecentTrends1.2.3.4.5.

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IntroductionExternalsectorreferstotherelationof

onecountrywiththeothercountriesoftheworldintermsoftrade,investmentandcapitalmobility.Theextentofthisinterrelationshipdependson:oContributionofinternationaltrade(importsandexports)inGDP.oMobilityoflabourandcapitalacrosscountriesoTheexchangerateregime.

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IntroductionImportsandexportsofgoodsand

services(currentaccount)wehavediscussedwiththeBOP.InordertomeetourrequirementsofimportsandexportsofGsandSs,demandforandsupplyofforeignexchangeandRupeetakesplace.Further,themovementsofforeigncapitalinthecapitalaccountofBOPalsoinfluencesdemandandsupplyofF-Exchange.

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IntroductionDemandforandsupplyofforeign

exchangevis-a-visrupeedeterminesexchangerate.Theappreciationanddepreciationofrupeeinfluencestheflowofexportsandimports.Thesupplyofmoneyvis-a-visforeignexchangealsoinfluencespricelevel,interestratesandgrowthofGDP.Thusthestudyofexchangeratesisimportant.

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IIExchangeRatesE-rateisthepriceofdomesticcurrency

inrelationtoforeigncurrency.Whenthevalueofrupeerises(appreciates)inrelationtothedollar,wesaythatexchangeratehasfallenandvice-versa.Nominalexchangerateissimplythepriceofdomesticcurrencyinrelationtoanothercurrency.

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NEERSincethereisnoonesingleforeign

currency,amoremeaningfulwaytodefineexchangerateisthevalueofdomesticcurrencyinrelationtoabasketofcurrencies.ThisiscalledNominalEffectiveExchangeRate.ItisarrivedatastheweightedaverageofthepriceofrupeeinrelationtoallothercurrencieswheretheweightsreflecttheimportanceofeachcurrencyinIndias

foreigntrade.

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RER&REERRealexchangerateisdefinedasthe

nominalexchangeratetimestheforeignpriceleveldividedbythedomesticpricelevel.RERcapturesthecompetitivenessofacountry

stradebyadditionallyconsideringtherelativepricechangesbetweencountries.SincewehaveBOPaccountswithmorethanonecountry,realeffectiveexchangeratewillbemoremeaningful.

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RER&REERACountrytradeswithdifferent

currencieslikedollar,euro,yenetc.Supposerupeeappreciatesagainstdollarby5%butremainsunchangedagainstothercurrenciesandourtradewithU.S.Accountsfor75%andwithothers25%.Insuchcaserupee

sREERwillbe:5x75+0x25i.e.3.5%andnot5%

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ImpactofchangesinREERTradeFeedbackEffect:Itreferstothe

chainreactionofappreciation/depreciationinthecurrencyonexports,GNP,importsetc.SupposeU.S.Dollardepreciatesvisa-visyenandpeoplefindU.S.ComputerscheaperthanJapan.AsaresultU.S.economicactivitieswillincreaseresultingintohigherGNP.

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TradefeedbackeffectThisinturnwillincreaseU.S.Imports

andwiththistheexportsoftheROWwillalsoincrease.Thisiscalledtradefeedbackeffect.SubsequentlyeconomicactivitiesofROWwillincreasewhichwillfollowanincreaseintheirimportsandsomeoftheimportsmaycomeformU.S.

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Pricefeedbackeffect(PFE)PFEisnothingbutexportationof

inflation.SupposePricelevelinIndiahasgoneup.ThiswillresultinincreaseinIndianexportpricesresultingintoincreaseintheimportpricesofU.S.WhichisimportingformIndia.AlongwiththisthegeneralpricesinU.S.WillgoupwhichwillresultinincreaseinU.S.exportspriceaswellasgeneralpricelevelinU.S.

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ExchangeRateRegimes

FIXED

MANAGEDFLOAT

FLEXIBLE

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FixedExchangeRegimeThecentralbankfixesthepriceofthe

domesticcurrencyinrelationtotheforeigncurrency.Thecentralbankwillnotallowthecurrencytodepreciateandwillselltheforeignexchangeinthemarketfromitsreservestoincreasethesupplytomaintainthefixedexchangerateandviceversa.

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AdvantagesProvidesbusinesseswithsurebasisfor

planningandpricing.Constraintsonmonetarypolicyimposesmonetarydiscipline.DisadvantagesTosupportafixedexchangeratesystemthecentralbankmusthaveadequateforeignexchangereservesoraccesstoforeigncapital.Incaseofmacroeconomicimbalancespromptactionrequired

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FlexibleExchangeRateTheexchangeratehereisdetermined

purelyonthebasisofdemandforandsupplyofforeignexchangeinthemarketplace.Theadjustmentintheexternalsectortakesplacethroughchangeinexchangerate.

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AdvantagesThereisnoovervaluationorunder

valuationofthecurrency.NoscopeofspeculationThecentralbankcanfollowanindependentmonetarypolicy.DisadvantagesSincemarketsareimperfectmarketdeterminedexchangerateisamyth.Exchangeratemayshowhighdegreeofvolatility.Exchangeratesareimpactedbythemonetarypolicyalthoughthereverseisnottrue.

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ManagedFloatRegimeAcompromisebetweenfixedandfloatingrateregime,thecentralbankannouncestheexchangerateismarketdeterminedbuttotheextentthemarketisnotperfectthecentralbankintervenesfromtimetotimetobringorderlyconditionsinthemarket.Thefluctuationsinexchangerateissmoothened.Italsoreducespossibilitiesofspeculation.

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FinancialRepression:Itreferstoasituationwherethegovernmenfollowsapolicyvis--visthefinancialsectorwhichimpedetheefficientfunctioningofthesector.Ex:Impositionofcreditcontrols,Administeredinterestrate,publicownershipofFinancialinstitutionsetc.FinancialSectorLiberalization:ItismeanttoundothedangersposedtotheFinancialsectorbyfinancialrepression.FinancialSectorReforms:Creationofinstitutions&mechanismswhichwillprovideaconduciveenvironmentforaSmoothtransitionfromrepressedfinancialsystemtoamoreliberalized.

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FinancialSectorVulnerabilityFinancialsectorispronetocollapsewhenitresortstofinancialsectorliberalizationwithoutfinancialsectorreformsFinancialliberalizationwithpoorregulation&supervisionresultsinlendingboom.RiskyloansandpoorassetqualitymakeitvulnerabletomacroeconomicshocksTheseshockscomeintheformofhighinterestrates,persistentcurrenta/cdeficit..Thecrisisresultsinadeclineinbanklendingandasharpcontractioninrealeconomicactivity

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IndiasExternalSectorTradeReforms:Policychangesintradewithrespectto:VirtualeliminationoflicensingandprogressiveshiftofrestricteditemsofimportsunderOpenGeneralLicenses.LiftingallquantitativerestrictionsonimportsofgoodsPhasedreductioninpeaktariffrates.Simplification&rationalizationofEOUsEPZsEnactmentofFEMA

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LiberalizationofCapitalFlowsNonDebtCapitalFlows:

LiberalizationofFDI&FIIbytheautomaticrouteorcasebycasebasis.DebtCapitalFlows:theyareoffourtypesnamelyECBs,NonResidentDeposits,ShortTermDebt,Governmentaccountdebt.

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ForeignExchangeReserveManagementIndiasshorttermdebtobligationat

43.7%(shouldnotexceed60%)Foreignexchangeenoughtotocover15monthsimportscomparedto6months,consideredsafe.Foreignexchangereserveasaproportioncurrency150.86%asagainstminimumrequirementof70%

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ForeignExchangeMarketCentralMarketBrokersCommercialBanksExporters,ImportersTourists,Investor

&Immigrants.

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FunctionsofF.E.MarketsSpotMkt:referstothatsegmentof

foreignexchangemktinwhichsaleandpurchasetransactionsaresettledwithintwodaysofthedeal.Therateatwhichforeigncurrencyisboughandsoldinthespotmarketiscalledspotexchangerate.

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Contd..Speculation:anactofbuyingandselling

acurrencyundertheconditionofuncertaintywithaviewtomakingprofit.

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ThankYou

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