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Foreign Exchange

Published on March 2017 | Categories: Documents | Downloads: 11 | Comments: 0



Introduction: Now we are discussing a very interesting lesson that is foreign exchange. Every one of us irrespective of his or her job profile wants to know the exchange rates. Whether we are into foreign exchange market or not than also we are concerned about the exchange rates. In general terms exchange rates can be anything or any rate for or with which we can exchange anything. But when talking to foreign exchange rate it can be defined as that rate by which we can exchange the currency of one nation with the another nations currencies Meaning of foreign exchange market: H.E. Evitt, has defined foreign exchange market as follows: “that section of economic science which deals with the means and methods by which rights to wealth in one country's currency are converted into rights to wealth in terms of another country's currency”. He further observes that, “it involves the investigation of the method by which the currency of one country is exchanged for that of another, the causes which render such exchange necessary, the forms which such exchange may take, and the ratios or equivalent values at which such exchanges are effected”. There are different interpretations of the term foreign exchange, of which the following two are most important and common: 1. Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another. 2. Secondly, the term foreign exchange is used to refer to foreign currencies. For example, the Foreign Exchange Regulation Act, 1973 (FERA) defines foreign exchange as “foreign currency and includes all deposits and balance payable in any foreign currency and any drafts, traveler’s cheques, letters of credits and bills of exchange, expressed or drawn in Indian currency, but payable in any foreign currency. FUNCTIONS OF FOREIGN EXCHANGE MARKET The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought and sold against one another. A foreign exchange market performs three important functions: Transfer of Purchasing Power The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign exchange 1

markets plays a very important role in facilitating international trade and capital movements. Provision of Credit The credit function performed by foreign exchange markets also plays a very important role in the growth of foreign trade, for international trade depends to a great extent on credit facilities. Exporters may get pre-shipment and post shipment credit. Credit facilities are available also for importers. The Eurodollar market has emerged as a major international credit market. Provision of Hedging Facilities The other important function of the foreign exchange market is to provide hedging facilities. Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to guard themselves against losses arising from fluctuations in exchange rates. METHODS OF AFFECTING INTERNATIONAL PAYMENTS There are five important methods to effect international payments. Telegraphic Transfer By this method, a sum can be transferred from a bank in one country to a bank in another part of the world by cable or telex. It is, thus, the quickest method of transmitting funds from one centre to another. Mail Transfer Just as it is possible to transfer funds from a bank account in one centre to an account in another centre within the country by mail, international transfers of funds can be accomplished by Mail Transfer. These are usually made by air mail. Cheques and Bank Drafts International payments may be made by means of cheques and bank drafts. The latter is widely used. A bank draft is a cheques drawn on a bank instead of a customer's personal account. It is an acceptable means of payment when the person tendering is not known, since its value is dependent on the standing of a bank which is widely known, and not on the credit-worthiness of a or individual known only to a limited number of people. Foreign Bill of Exchange A bill of exchange is an unconditional order in writing, addressed by one person to another, requiring the person to whom it is addressed to pay a certain sum on demand or on a specified future date. There are two important differences between inland and' foreign bills. The date on which an inland bill is due for payment is calculated from the date on which it was drawn, but the period of a foreign bill runs from the date on 2

which the bill was accepted. The reason for this is that the interval between a foreign bill being drawn and its acceptance may be considerable, since it may depend on the time taken for the bill to pass from the drawer's country to that of the acceptor. The second important difference between the two types of bill is that the foreign, bill is generally drawn in sets of three, although only one of them bears a stamp, and of course, one of them is paid. Nowadays, it is mostly the documentary bill that is employed in international trade. This is nothing more than a bill of exchange with the various shipping documents-the bill of lading, the insurance certificate and the consular invoice-attached to it. By using this, the exporter can make the release of the documents conditional upon either (a) payment of the bill, if it has been drawn at sight, or (b) its acceptance by the importer if it has been drawn for a period. Documentary (or reimbursement) Credit Under this method, a bill of exchange is necessarily employed, but the distinctive feature of the documentary credit is the opening by the importer of a credit in favour of the exporter, at a bank in the exporter's country. Illustration: To illustrate the use of the documentary credit, let us assume that Mr. Menon of Cochin intends to purchase goods from Mr Ronald of New York and that the terms of the deal have been agreed upon 'by them. Then the transaction would be carried through the following stages. (a) Mr Menon, the importer, instructs his bank, say the State Bank of India (SBI), to open a credit in favour of Mr Ronald, the exporter, at the New York branch of the SBI (if the SBI has no branch in New York, it will appoint some other bank to act as its agent there). The SBI will then inform Mr Ronald by a letter of credit that it will pay him a specified sum in exchange for the bill of exchange and the shipping documents. (b) Mr Ronald may now despatch the goods to Mr Menon at Cochin, drawn bill of exchange on the SBI and then present the documentary bill to the New York branch of the SBI. If all the documents are in order, the bank will pay Mr Ronald. The bank will charge for its services, and will also charge interest if the bill is not payable at sight. (c) The New York branch of the SBI then sends the documentary bill to its Cochin office for payment or acceptance, as the case may be, by Mr Menon. When the bill is paid, Mr Menon's account will be debited by that amount. Every thing being in order, the banker will release the bill of lading from the bill to enable Mr Menon to claim the goods on their arrival at the Cochin port. TRANSACTIONS IN THE FOREIGN EXCHANGE MARKET A very brief account of certain important types of transactions conducted in the foreign exchange market is given below. 3

Spot and Forward Exchanges The term spot exchange refers to the class of foreign exchange transaction which requires the immediate delivery, or exchange of currencies on the spot. In practice, the settlement takes place within two days in most markets. The rate of exchange effective for the spot transaction is known as the spot rate and the market for such transactions is known as the spot market. The forward transaction is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the, contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market. The foreign exchange regulations of various countries, generally, regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions. Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations by entering into an appropriate forward exchange contract. Forward Exchange Rate With reference to its relationship with the spot rate, the forward rate may be at par, discount or premium. At Par If the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract, the forward exchange rate is said to be at par. At Premium The forward rate for a currency, say the dollar, is said to be at a premium with respect to the spot rate when one dollar buys more units of another currency, say rupee, in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis. At Discount The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on per annum basis.


The forward exchange rate is determined mostly by the demand for and supply of forward exchange. Naturally, when the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and, conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par. Swap Operation Commercial banks who conduct forward exchange business may resort to a swap operation to adjust their fund position. The term swap means simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency. The spot is swapped against forward. Operations consisting of a simultaneous sale or purchase of spot currency accompanied by a purchase or sale, respectively, of 'the same currency for forward delivery, are technically known as swaps or double deals, as the spot currency is swapped against forward. Arbitrage Arbitrage is the simultaneous buying and selling of foreign currencies with the intention of making profits from the differences between the exchange rate prevailing at the same time in different markets. For illustration, assume that the rate of exchange in London is £ I = $ 2 while in New York £ 1 = $ 2.10. This presents a situation where in one can purchase one pound sterling in London for two dollars and earn profit of $ 0.10 by selling the pound sterling in New York for $ 2.10. This situation would, hence, lead to an increase in demand for sterling in London and consequently, an increase in the supply of sterling in New York. Such operations, i.e., arbitrage, could result in equalising the exchange rates in different markets (in our example London and New York). Arbitrage in foreign currencies is possible because of the ease and speed of modern means of communication between commercial centers throughout the world. Thus, an operator in New York might buy dollars in Amsterdam and sell them a few minutes later in London. The effect of arbitrage, as has already been mentioned, is to iron out differences in the rates of exchange of currencies in different centres, thereby creating, theoretically speaking, a single-world market in foreign exchange. DETERMINATION OF EXCHANGE RATES How are exchange rates between different currencies determined under the paper currency standard? There are two important theories which attempt to explain the mechanism of exchange rate determination, namely, the purchasing power parity theory and the balance of payments or the demand and supply theory 5

Diagrammatical representation of exchange rate and quantity of foreign exchange

Purchasing Power Parity Theory
According to the purchasing power parity theory, put forward by Gustav Cassel in the years following the First World War, when the exchange rates are free to fluctuate, the rate of exchange between two currencies in the long run will be determined by their respective purchasing powers. In the words of Cassel, "the rate of exchange between two currencies must stand essentially on the quotient of the internal purchasing powers of these currencies.4 The essence of the theory is clearly expressed by Professor S.E. Thomas as follows: ...while the value of the unit of one currency in terms of another currency is determined at any particular time by the market conditions of demand and supply, in the long run, that value is determined by the relative values of the two currencies as indicated by their relative purchasing power over goods and services (in their respective countries). In other words, the rate of exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two currencies. This point is called the purchasing power parity.5 Thus, according to the purchasing power parity theory, the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. For example, assume that a particular bundle of goods in India costs Rs 45.00 and the same in USA costs $ 1. Then the exchange rate will be in equilibrium if the exchange rate is $ 1 = Rs 45.00. Once the equilibrium is established, the market forces will operate to restore the equilibrium if there are some deviations. For example, if the exchange rate changes to $ 1 = Rs 46.50 when the purchasing powers of these currencies remain stable, dollar holder will 6

convert dollars into rupees because, by doing so, they can save Rs 1.50 when they purchase a commodity worth $ 1. This will increase the demand for the Indian currency and the supply of dollars will increase in the foreign exchange market and ultimately, the equilibrium rate of exchange will be re-established. A change in the purchasing power of currencies will be reflected in their exchange rates. The index number of prices may be made use of to determine the purchasing power parity. If there is a change in prices (i.e., the purchasing power of the currencies), the new equilibrium rate of exchange can be found out by the following formula.

Pd = Domestic price index Pf = Foreign country's price index

Criticisms of the Theory
The purchasing power parity theory is subject to the following criticisms: (i) The theory makes use of the price index number to measure the changes in the equilibrium rate of exchange and hence the theory suffers from the various limitations of the price index number. (ii) The composition of the national income varies in different countries and hence the types of goods and services included in the index number may vary from country to country, rendering comparisons on the basis of such index number unrealistic. (iii) The quality of goods and services may vary from country to country. (iv) Comparison of prices without regard to the quality is unrealistic. (v) The price index number includes the price of all commodities and services, including those which are not internationally traded and hence the rate of exchange calculated on the basis of such price indices cannot be realistic. (vi) The theory is rendered further unrealistic by ignoring the cost of transport in international trade. (vii) Another very unrealistic assumption made by the theory is that international trade is free from all barriers. (viii) The purchasing power parity theory ignores the effects of international capital movements on the foreign exchange market. International capital movements may cause changes in the exchange rate. For example, if there is capital inflow to India from USA, the supply of the dollar and the demand for rupees increases in the foreign exchange market, causing an appreciation in the value of the rupee and depreciation in the value of the dollar. 7

(ix) Another defect of the theory is that it ignores the impact of changes in the exchange rates on the prices. For example, if, as a result of large capital inflows to India, Indian currency appreciates in terms of foreign currencies, Indian exports may decline and as a result, the supply of goods in India may exceed the demand and may cause a fall in prices. (x) The theory does not explain the demand for supply of foreign exchange. When the exchange rate is determined largely by demand and supply conditions, any theory that does not pay adequate attention to these aspects proves to be unsatisfactory. (xi) The purchasing power parity theory starts with a given rate of exchange, but rails to explain how that particular rate of exchange is arrived at. Thus, the theory only tells us how, with a given rate of exchange, changes in the purchasing powers or two currencies affect the exchange rate. (xii) The theory is based on the wrong assumption that the elasticity of demand for exports and imports is equal to unity i.e., this theory is valid only if the exports and imports change in the same proportion as the change in prices. But this is a very rare occurrence. (xiii) No satisfactory explanation of short term changes in exchange rates is provided by the theory. (xiv) Lastly, the purchasing power parity theory goes contrary to general experience. Critics point out that there has hardly been any case when the rate of exchange between two currencies has been equivalent to the ratio of their purchasing powers. Despite its many defects and deficiencies, the purchasing power parity theory exposes some very important aspects of exchange rate determination. (i) It indicates the relationship between the internal price levels and exchange rates. (ii) It explains the state of the trade of a country as well as the nature of its balance of payments at a particular time. (iii) Further, the theory is applicable, to some extent, to all sorts of monetary standards.


EXCHANGE CONTROL Learning outcomes After studying this unit, you should be able to: Know what is exchange control Objectives of exchange control Define Exchange rate system determine exchange rates classify exchange

Exchange control is one of the important means of achieving certain national objectives like an improvement in the balance of payments position, restriction of inessential imports and conspicuous consumption, facilitation of import of priority items, control of outflow of capital and maintenance of the external value of the currency. Under the exchange control, the whole foreign exchange resources of the nation, including those currently occurring to it, are usually brought directly under the control of the exchange control authority (the Central Bank, treasury or a specially constituted agency). Dealings and transactions in foreign exchange are regulated by the exchange control authority. Exporters have to surrender the foreign exchange earnings in exchange for home currency and the permission of the exchange control authority have to be obtained for making payments in foreign exchange. It is generally necessary to implement the overall regulations with a host of detailed provisions designed to eliminate evasion. The allocation of foreign exchange is made by the exchange control authority, on the basis of national priorities. Though the exchange control is administered by a central authority like the central bank, the day-to-day business of buying and selling foreign exchange is ordinarily handled by private exchange dealers, largely the exchange department of commercial banks. For example, in India there are authorised dealers and money changers, entitled to conduct foreign exchange business.

Objectives of Exchange Control
The important purposes of exchange control are outlined below.

1To Conserve Foreign Exchange
The main objective of foreign exchange regulation in India, as laid dawn in the Foreign Exchange Regulation Act (FERA), 1973, is the conservation of the foreign exchange resources of the country and the proper utilisation thereof in the interest of the national development. This is one of the important objectives of foreign exchange regulation of many other countries too.


2 To Check Capital Flight
Exchange control may be employed to prevent flight of capital from the country and to regulate the normal day-to-day capital movements. As Krause remarks, if adequately implemented and enforced, exchange control tends to be highly effective in curbing erratic outflows of capital. When exchange control authorities refuse to sell foreign exchange for this purpose, they close the only legal avenue through which capital may leave a country.

3 To Improve Balance of Payments
Exchange control is one of the measures available to improve the balance of payments position. This can be achieved by restricting imports by means of exchange control.

4 To Curb Conspicuous Consumption
In the developing countries especially, there is a craze far the consumption of imported articles, which are regarded as inessential 'luxury' goods. Exchange control may be used to prevent their import and, thereby, their consumption.

5 To make Possible Essential Imports
Due to the non-availability of or scarcity within the country, the developing countries generally have to import capital goods, knowhow and certain essential inputs and consumer goods. By giving priority to such imports in the allocation of foreign exchange, exchange control may ensure availability of foreign exchange far these imports.

6 To Protect Domestic Industries
Exchange control may also be employed as a measure to protect domestic industries from foreign competition.

7 To Check Recession-induced Exports into the Country
If foreign economies are undergoing recession when 'the domestic economy is free from it, the decline in prices of foreign goods, due to the recession, may encourage their exports into the country not yet affected by recession. Exchange control may be employed to check such recession-induced exports into the country.

8 To regulate foreign companies.
Exchange Control may also seek to regulate the business of foreign companies in the country. For instance, the FERA provided that non-residents, foreign national resident in India, companies (other than banking companies) incorporated abroad and having more than 40 per cent non-resident interest could not carry on in India, or establish a branch/office or other place of business in the country for carrying on any activity of a trading, commercial or industrial revenue, without the permission of the Reserve Bank of India.

9 To regulate Export and Transfer of Securities
Exchange control may be employed also for the purpose of controlling the Import and transfer of securities form the country. The FERA for instance, prohibited the sending or transferring of securities from the country to any person outside India, without the permission of the Reserve Bank of India.


10 Facilitate Discrimination and Commercial Bargaining
Exchange control offers scope for discrimination between different countries. It would be used to accord exchange concessions, on a reciprocal basis, between different countries.

11 Enable the Government to Repay Foreign Loans
The system of exchange control empowers the government to acquire foreign exchange from the residents of the country, it becomes easy for the government to repay foreign loans.

12 To Lower the Price of National Securities held Abroad
It may be possible to reduce the price of national securities held abroad by preventing nationals from buying them. This would enable the government to purchase such securities at a lower price.

13 To Freeze Foreign Investments and Prevent Repatriation of Funds
Exchange control may be used to freeze investments, including bank deposits, of foreigners in the home country and to prevent the repatriation of funds out of the country. This is sometimes done by hostile countries.

14 To Obtain Revenue
Governments may use exchange control to obtain some revenue. The government/government agency can make profit out of the foreign exchange business by keeping certain margin between the average purchase price and the average selling price of the foreign exchange. Methods of Exchange Control The various methods of exchange control may be broadly classified into (1) Unilateral methods and (2) Bilateral/multilateral methods. Unilateral Methods Unilateral measures refer to those methods which may be adopted by a country unilaterally i.e., without any reference to or understanding with other countries. The important unilateral methods are outlined below. Regulation of Bank Rate - A change in the bank rate is usually followed by changes in all other rates of interest and this may affect the flow of foreign capital. For example, when the internal rates of interest rise, foreign capital is attracted to the country. This causes an increase in the supply of foreign currency and the demand for domestic currency in the foreign exchange market and results in the appreciation of the external value of the currency. A lowering of the bank rate is expected to produce the opposite results.


Regulation of Foreign Trade The rate of exchange may be controlled by regulating the foreign trade of the country. For example, by encouraging exports and discouraging imports, a country can increase the demand for, in relation to supply, its currency in the foreign exchange market and thus bring about an increase in the rate of exchange of the country's currency. Rationing of Foreign Exchange By rationing the limited foreign exchange resources, a country may restrict the influence of the free play of market forces of demand and supply and thus maintain the exchange rate at a higher level. Exchange Pegging Exchange pegging refers to the policy of the government of fixing the exchange rate arbitrarily either below or above the normal market rate. When it is fixed above the free market rate, it is known as pegging up and when it is fixed below the free market rate, it is known as pegging down. Exchange pegging is resorted to, generally, during war times to prevent violent fluctuations in the exchange rate. Multiple Exchange Rate Multiple exchange rates refer to the system of the fixing, by a country, of the different rates of exchange for the trade or different commodities and/or for transactions with different countries. The main object of the system is to maximise the foreign exchange earning of country by increasing exports and reducing imports. The entire structure of the exchange rate is devised in a manner that makes imports cheaper and exports more expensive. The multiple exchange rate system has been severely condemned by the IMF. Exchange Equalisation Fund The main object of the Exchange Equalisation Fund, also known as the Exchange Stabilisation Account, is to stabilise the exchange rate of the national currency through the sale and purchase of foreign currencies. When the demand for domestic currency exceeds its supply, the fund starts purchasing foreign currency with the help of its own resources. This results in an increase in the demand for foreign currency and increases the supply of the national currency. The tendency of the rate of exchange of the national currency to rise can thus be checked. When the supply of the national currency exceeds demand and the exchange rate tends to fall, the Fund sells the foreign currencies and this increases the supply of foreign currencies and arrests the tendency of the exchange rate of the domestic currency to fall. This sort of an operation may be resorted to eliminate short term fluctuations. Blocked Accounts In the case of blocked accounts, foreigners are prevented from withdrawing money from their deposits with banks, for the purpose of remitting abroad. This measure makes the foreign exchange position of the country more comfortable. This is generally regarded as a wartime measure. Under this method, domestic debtors may be required to deposit their dues to foreign creditors into specifically designated bank accounts.

Bilateral/Multilateral Methods
The important bilateral/multilateral methods are the following: Private Compensation Agreement Under this method, which closely resembles barter, a firm in one country is required to equalise its exports to the other country with its imports from that country so that there will be neither a surplus nor a deficit. Clearing Agreement Normally, importers have to make payments in foreign currency and while exporters are paid in foreign currency. Under the clearing agreement, however, importers make payments in domestic currency to the clearing account and exporters obtain payments in domestic currency from the clearing fund. Thus, under the clearing agreement,


the importer does not directly pay the exporter and hence, the need for foreign exchange does not arise, except for settling the net balance between the two countries. Standstill Agreement The standstill agreement seeks to provide debtor country some time to adjust her position by preventing the movement of capital out of the county through a moratorium on the outstanding short-term foreign debts. Payments Agreement Under the payments agreement, concluded between a debtor country and a creditor country, provision is made for the repayment of the principal and interest by the debtor country to the creditor country. The creditor country refrains from imposing restrictions on the imports from the debtor country in order to enable the debtor to increase its exports to the creditor. On the other hand, the debtor country takes necessary measures to encourage exports to and discourage imports from the creditor country. EXCHANGE RATE SYSTEMS Broadly, there are two important exchange rate systems, namely the fixed exchange rate system and flexible exchange rate system. Fixed Exchange Rates Countries following the fixed exchange rate (also known as stable exchange rate and pegged exchange rate) system agree to keep their currencies at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so. Under the gold standard, the values of currencies were fixed in terms of gold. Until the breakdown of the Bretton Woods System in the early 1970, each member country of the IMF defined the value of its currency in terms of gold or the US dollar and agreed to maintain (to peg) the market value of its currency within I per cent of the defined (par) value. Following, the breakdown of the Bretton Woods System, some countries took to managed floating of their currencies while a number of countries still embraced the fixed exchange rate system. Arguments for the Stable Exchange Rate System The relative merits and demerits of the fixed and flexible exchange rate systems have long been a topic for debate. A number of arguments have been put forward for and against each system. The important arguments supporting the stable exchange rate system: (i) Exchange rate stability is necessary for orderly development and growth of foreign exchange. If exchange rate stability is not assured, exporters will be uncertain about the amount they will receive and importers will be uncertain about the amount they will have to pay. Such uncertainties and the associated risks adversely affect foreign trade. A great advantage of the fixed exchange rate system is that it eliminates the possibilities of such uncertainties and risks. (ii) Especially the developing countries, which have a persistant balance of payment deficits, should necessarily adopt the stable exchange rate system. (Iii) Exchange rate stability is necessary to attract foreign capital investment as foreigners will not be interested to invest in a country with an unstable currency. Thus, exchange rate stability is necessary to augment resources and foster economic growth.


(iv)Unstable exchange rates may encourage the flight of capital. Exchange rate stability is necessary to prevent its outflow. (v) A stable exchange rate system eliminates speculation in the foreign exchange market. (vi)A stable exchange rate system is a necessary condition for the successful functioning of regional groupings and arrangements among nations. (vii) Foreign trade plays a very important role in case of a number of countries. For certain countries, the value of foreign trade exceeds GNP, while for others, the value of foreign trade is more than 50 percent of their GNP. Exchange rate stability is especially important for such countries to ensure the smooth functioning of the economy. Its absence will give rise to uncertainties and this would disturb the foreign trade sector and, thereby, the economy. (viii) A stable exchange rate system is also necessary for the growth of international money and capital markets. Due to the uncertainties associated with unstable exchange rates, individuals, firms and institutions may shy away from lending to and borrowing from the international money and capital markets.

Flexible Exchange Rates Under the flexible exchange rate system, exchange rates are freely determined by open market primarily by private dealings, and they, like other market prices, vary from day-to-day. Under the flexible exchange rate system, the first impact of any tendency toward a surplus or deficit in the balance of payments is on the exchange rate. Surplus in the balance of payments will create an excess demand for the foreign currency and the exchange rate will tend to rise. On the other hand, deficit in the balance of payments will give rise to an excess supply of the country’s currency and the exchange rate will, hence, tend to fall. Automatic variations in the exchange rates, in accordance with the variation in the balance of payment position, tend to automatically restore the balance of payments equilibrium. A surplus in the balance of payments increases the exchange rate. This makes foreign goods cheaper in terms of the domestic currency and domestic goods more expensive in terms of the foreign currency, This, in turn, encourages, imports and discourages exports, resulting in the restoration of the balance of payments equilibrium. On the other hand, if there is a payments


deficit, the exchange rate falls and this makes domestic good cheaper in terms of the foreign currency and foreign goods more expensive in terms of the domestic currency. This encourages exports discourages imports and thus helps to establish the balance of payments equilibrium: Theoretically, this is how the flexible exchange rate system works.

Cases for and against Flexible Exchange Rates
A number of economists strongly advocate the adoption of the flexible exchange rate system. Nobel laureate, Milton Friedman, for instance, argues, There is scarcely a facet of international economic policy for which the implicit acceptance of a system of rigid exchange rates does not create serious and unnecessary difficulties. He is of the view that ...sooner a system of flexible exchange rates is established, the sooner unrestricted multilateral trade will become a real possibility. And it will become one without, in any way, interfering with the pursuit by each nation of domestic economic stability according to its own rights. A number of economists, however, point out that certain serious problems are associated with the system of flexible exchange rates. We present here some important arguments against and for flexible exchange rates. 1. Flexible exchange rates present a situation of instability, creating uncertainty and confusion. Friedman disputes this view and argues that a flexible exchange rate need not be an unstable exchange rate. If it is primarily because there is underlying instability in the economic conditions governing international trade. And a rigid exchange rate may, while itself remaining nominally stable, perpetuate and accentuate other elements of instability in the economy. The mere fact that a rigid official exchange rate does not change while a flexible rate does is no evidence that the former means greater stability in any more fundamental sense. 2. The system of flexible exchange rates, with its associated uncertainties, makes it impossible for exporters and importers to be certain about the price they will have to pay or receive for foreign exchange. This will have a dampening effect on foreign trade. Friedman encounters this objection by pointing out that under flexible exchange rates, traders can almost always protect themselves against changes in the rate by hedging in the future market. Such markets in foreign currency readily develop when exchange rates are flexible. However, as Sodersten points out, it is certainly true that no market exists today that can protect against all the risks connected with a system of flexible exchanges, and it is doubtful if such a market can be established in the future, if a system of flexible exchanges were introduced. A system of flexible exchanges might, (therefore, have a considerably dampening effect on the volume of foreign trade. 3. Under flexible exchange rates, there will be widespread speculation, which will have a destabilising effect. Against this, it is argued that normally, speculation has a stabilising influence on exchange rates. Friedman observes that if speculation is supposed to be destablising, it implies that speculators lose money on their activity. However, Farrell question this argument and shows that it might be possible, under what seems to be fairly general assumptions, that speculation can be, at the same time, profitable and destabilizing.


4. The system of flexible exchange rates gives an inflationary bias to an economy. When the currency depreciates due to payments deficit, imports become costlier and this stirs up an inflationary spiral. The supporters of the flexible exchange rates, however, counter this criticism by stating that when Imports become costlier, the demand for them falls, compelling foreign suppliers to reduce prices. Though it is theoretically possible, it may not be realised. The general feeling is that flexible exchange rates may have an infla-tionary impact on the economy. We have reviewed the arguments for and against the fixed and flexible systems. Which system, then, should a country adopt? The answer will depend on circumstances. It will depend on the characteristics of the economy, and it will change with time as the economy changes. Value judgements are also involved, and ultimately the answer could depend on values and views of a political nature.

Following are different types of exchange rate regimes and how they work. Single Currency Peg: The country pegs to a major currency-usually the US dollar or the French franc-with infrequent adjustment of the parity. (About 100 number of developing countries have single currency pegs). Composite Currency Peg: The country pegs to a basket of currencies of major trading partners to make the pegged currency more stable than if a single currency peg were used. The weights assigned to the currencies in the basket may reflect the geographical distribution of trade, services, or capital flows. They may also be standardised, as in the SDR and the European Currency Unit. Limited Flexibility vis-a-vis a Single Currency The value of the currency is maintained within certain margins of the peg (this system applies to four Middle East countries). Limited Flexibility through Cooperative Arrangements This applied to countries in the exchange rate mechanism of the European Monetary System (EMS) and was a cross between a peg of individual EMS currencies to each other and a float of all these currencies jointly vis-avis non-EMS currencies. Greater Flexibility through Adjustment to an Indicator The currency is adjusted more or less automatically to changes in selected indicators. A common indicator is the real effective exchange rate, which reflects inflation-adjusted changes in the currency vis-a-vis major trading partners. Greater Flexibility through a Managed Float The Central bank sets the rate but varies it frequently. Indicators for adjusting the rate include, for example, the balance of payments position, reserves, and parallel market developments. Adjustments are not automatic.


Full Flexibility through an Independent Float Rates are determined by market forces. Some industrial countries have floats-except for the EU countries-but the number of developing countries in this category has been increasing in recent years.

Free convertibility of a currency means that the currency can be exchanged for any other convertible currency, without any restriction, at the market determined exchange rates. Convertibility of the rupee, thus means that the rupee can be freely converted into dollar, pound sterling', yen, Deutsche mark, etc. and vice versa at the rates of exchange determined by the demand and supply forces. After the collapse of the Bretton Woods System in 1971, the rupee was pegged to pound sterling for four years after which it was linked to a basket of 14 and later 5 major currencies. In 1981, a rise in dollar due to high interest rates in the US led to rupee appreciation which adversely affected India's exports due to fall in the export profitability. It prompted the Reserve Bank of India to experiment with a managed float, pegging the rupee to dollar and pound sterling alternatively depending on which was going down, to guard against the appreciation of the rupee that would adversely affect the exports. A considerable exchange rate adjustment (devaluation) was made in July 1991. As a part of the economic policy reforms, partial convertibility of the rupee on the current account was announced by the Finance Minister in his Budget speech for 1992-93 and the rupee became partially convertible since March 1992. The move towards convertibility of the rupee was in line with the worldwide trend towards currency convertibility. According to the IMF, 70 countries accepted current account convertibility by 1990 while another 10 joined them in 1991. Many other countries including the East European countries and Russia have been contemplating the convertibility move. According the Liberalised Exchange Rate Management System (LERMS) introduced in March 1992, 60 per cent of all receipts under current transactions (merchandise exports and invisible receipts) could be converted at the free market exchange rate quoted by the authorised dealers. The rate applicable for the remaining 40 per cent was the official rate fixed by the Reserve Bank of India. This 40 per cent of the total foreign exchange receipts under the current account was exclusively meant to cover government needs and to import essential commodities. In addition, foreign exchange at official rate was to be made available to meet 40 percent of the value of the advance licenses and special import licenses. In short, it was a dual exchange rate system.

Why Partial Convertibility?
One major reason for introducing partial convertibility was to make foreign exchange available at a low price for essential imports so that the prices of the essentials would not be pushed up by the high market price of the foreign exchange. It was risky to introduce full convertibility when the current account showed large deficit. While introducing the partial convertibility, the government announced its intentions to introduce full convertibility on the current account in three to five years. However, full convertibility on trade account was introduced by the Budget for 1993-94.


The fact that the free market rate was ruling fairly stable at a reasonable level might have encouraged the government to introduce full convertibility. Rupee was showing remarkable stability in the months which followed the Introduction of the full convertibility.

Capital Account Convertibility
The convertibility of the capital account is usually introduced only after the interval of certain period of time after the introduction of the current account. Capital account convertibility is usually introduced only after experimenting with the current account convertibility for a reasonable time, stabilisation programmes have been successfully carried out and favourable conditions have been ensured. The introduction of capital account convertibility for certain types of capital flows-helps attract resources from abroad. It also enables residents to hold internationally diversified investment portfolios, thereby having more risk bearing capacity. However, capital account convertibility cannot be introduced until certain conditions are satisfied. "In the absence of confidence in the macroeconomic stability and the competitiveness of domestic enterprises, establishment of capital account convertibility entails the risks of capital flight and greater volatility in exchange rate, external reserves or interest rate. It is because of this, many countries have maintained various restrictions on various types of capital flows until their economies are well developed." It may be noted that under completely free capital account convertibility an Indian can sell his property here and take the money out of the country. Due, to such factors, even when capital account convertibility is introduced, several restrictions may have to be attached.

Merits of Convertibility
The convertibility or the floating of the Rupee has certain avowed merits. (i) It gives an indication of the real value of the rupee. (ii) It encourages exports by increasing the profitability of the exports (iii) profitability increases as the free market rate is higher than the official exchange rate. (iv) It encourages those exports with no or less import intensity. As the proportion of the imported inputs in the exportables increases, the profitability clause of the higher free market exchange rate gets correspondingly reduced. This could encourage import substitution in export production. (v) The high cost of foreign exchange could encourage import substitution in other areas also It provides incentives for remittances by NRIs. (vi) The convertibility and the liberalisation of gold imports have been expected to make illegal remittances and gold smuggling less attractive. thereby increasing the remittances through proper channels. (vii) It is described as a self balancing mechanism because the total imports and other current account payments will be confined to the total current account receipts unless there are imports financed by foreign currency loans. Points (ii) to (v) Of above on the assumption that Rupee will not appreciate. Problems: The convertibility would cause some problems unless certain conditions are satisfied.


(i) Convertibility could cause an increase in prices because of the increase in the import prices. (ii) Under full convertibility, if the tree market exchange rate is very high, the cost of essential imports will correspondingly increase. (III) If the current account balance is not kept under control, the free market rate would rise very high. Pre-requisites For the successful functioning of the convertible system, certain essential conditions will have to be satisfied. These include: (i) Maintenance of domestic economic stability (ii) Adequate foreign exchange reserves iii) Restrictions on inessential imports as long as the foreign exchange position is not very comfortable (iv) Comfortable current account position (v) An appropriate industrial policy and a conducive investment climate (vi) An outward oriented development strategy and sufficient incentives for export growth. Experiences of Other Countries The experiences of other countries with currency convertibility present a fixed picture. Britain which introduced full convertibility in July 1947 had to beat a hasty retreat the very next month because of large scale flight of capital. In 1958 Britain introduced restricted convertibility. South Korea which faced problems with partial convertibility in the beginning rescinded it in 1985 but ultimately restored it in 1989 and succeeded. Fiji which introduced current account convertibility in 1985 made a retreat in 1987. Although Pakistan's balance of payments crisis was more severe than that of India, after the convertibility their rupee more or less stabilised. The experience of countries like Mexico, Argentina, Peru and Chile have also been encouraging.


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