At the Forex Association of India Conference in Singapore, RBI Deputy Governor B.P. Kanungo said that the exchange rate dynamics in India is driven by the capital flows rather than current account balances. He also highlights that India’s forex reserves are borrowed and they are not built out of export surplus. The intervention by the central bank in the foreign exchange market was aimed at curbing sudden economic disturbances which are not backed by the economic fundamentals.
What are the foreign reserves?
The assets which are held by the central bank of the country in foreign currencies, gold reserves, Special Drawing Rights (SDR) with IMF, etc. They also include foreign treasury bills, foreign bank deposits, and foreign government securities. The foreign reserves act as a defense in case of an economic slowdown. Foreign reserves also affect monetary policy. US Dollar ($), Euro (€), British Pound, Japanese Yen, and Chinese Yuan are the foreign currencies held as forex reserves. As per the weekly report published by the RBI on August 23, 2019, India’s Foreign exchange reserves stand at US$430.501 billion with Foreign exchange assets: US$398.327 billion, Gold Reserves: US$27.110 billion, Special Drawing Rights with IMF US$1.438 billion and US$3.625.4740 billion reserve position in IMF. Source: https://m.rbi.org.in/Scripts/WSSView.aspx?Id=23179
Foreign Exchange Market:
It is the place where international foreign currencies are purchased and sold simultaneously is known as the foreign exchange market or forex market. Banks, Corporate firms, individual investors, merchants, and government are allowed to buy and sell foreign currencies.
India’s Forex Market:
India’s forex market was started in 1978 and since its establishment, the forex market has grown significantly over these years and its annual turnover touched a new high of $430.57 billion. Indian economy which is an open economy provides investment opportunities to the investors which lead to an increase in capital flows.
India’s forex market structure:
The main stakeholders of the Indian forex market consist of:
- RBI: The central bank is responsible for the regulation and determination of monetary policy of India. RBI regulates the forex market through exchange control department with the help of the Foreign Exchange Dealers Association. The dealers are authorized by RBI. The forex market is regulated under the FEMA Act, 1999.
- The commercial banks of India have legally authorized entities and they are allowed for handling the foreign currency. The banks allow their customers to create accounts to access the forex market for trading.
- Traders: they are that individual public who are also corporate customers of the commercial banks. Here, they use the commercial banks as their authorized dealers in the forex market for trade.
However, the structure of the forex market is similar to other countries but the Indian Forex market is not advanced as developed countries have. The total value of the foreign exchange market is big in terms of assets but in terms of transaction rates, it is not large. Foreign Exchange Rate: The amount of national currency required to get a unit of foreign currency. It is determined by the relative purchasing powers of the two currencies defined by the Purchasing Power Parity theory. For Example: if a product costs $50 in the US and Rs 150 in India, then the exchange rate between India and the US would be (150/50=3), $1=Rs. 3. Types of Exchange Rate regime: Fixed Exchange Rate:
- Under this system, the central bank and the government has complete intervention in the forex market. It is determined by the central bank and the government by linking the national currency to the gold value or with other major foreign currencies like $US Dollar etc.
- The government is responsible to maintain the exchange rate equilibrium in the cases of economic fluctuations due to any cause.
- This system ensures stability and that the national currency does not appreciate and depreciate below the pre-determined level.
- The system puts a heavy burden on the government for maintaining it.
- This system is avoided by the foreign investors as they don’t trust the system and have fear to lose their money because they believe that it doesn’t reflect the real image of the country’s economy.
Floating Exchange Rate:
- Here the market determines the exchange rate on the basis of demand and supply of the national currency.
- The government and central bank cannot intervene and the market functionaries are free to determine the exchange rate.
- Unlike the fixed exchange rate system, this systems built trust among the investors which help in increasing the foreign investment in the country’s economy.
- This system provides easy access to loans from the IMF and other international financial entities.
- The demerit of this system is that it fluctuates a lot on a day to day basis.
Managed Floating Exchange Rate: This system is in between the fixed exchange rate system and the floating exchange rate system. The exchange rate is determined by the market on the basis of demand and supply but in odd circumstances, the central banks are allowed to intervene to stabilize the exchange rate of the currency. These are classified into:
- Adjusted Peg System: the central bank should try to hold the national currency till the foreign exchange reserves get exhausted. Once the forex reserves get exhausted. The bank devaluates national currency to move to other equilibrium of the foreign exchange rate.
- Crawling Peg System: the central bank keeps on adjusting the rate on the basis of new demand and supply conditions. In this system, a country should follow a system of check and balances regularly and according to the market conditions undertakes small devaluations.
- Clean Floating: this system is identical to the floating exchange rate because here also the exchange rate is determined by the market forces without any intervention from the central bank and the government.
- Dirty Floating: It is determined by the market on the basis of demand and supply conditions but here government or the central bank are allowed to remove excessive fluctuations from the forex markets.
Exchange Rate Management in India: Since independence the exchange rate system in India has changed from fixed exchange rate where the Indian Rupee was pegged to the UK Pound to a number of currencies during the 1970s -1980s and to the present form of market-determined exchange rate regime after the liberalization in 1993.
- Par value system till 1971: here, the government fixes the external value of rupee to the UK pound sterling and gold.
- Pegged regime (1971-1992): the value of Indian rupee was pegged to US dollar (1971-1991) and to the pound sterling (1971-1975). After the breakdown of Bretton woods system and the collapse of the pound sterling, the value of Indian rupee was pegged on the basis of a weighted average of a number of currencies of the major trading partners of India.
- After 1991: this transition was the result of the Balance of Payment crisis of 1991. India introduces partial convertibility of rupee under liberalized Exchange Rate Management System (LERMS).
- Liberalized Exchange Rate Management System (LERMS): India followed a dual exchange rate policy in the ratio of 60:40, where 40 percent were to be converted at the official exchange rate and the remaining 60 percent were to be converted at the market-based. The official rate was to be used for essential imports like crude, oil, fertilizers, life savings drugs, etc. and for all other imports, the market-based exchange rate was used.
- Market-based exchange rate Regime since 1993: LERMS was removed in the budget 1994. After then, RBI intervenes in the market only to reduce excessive fluctuations and sudden appreciation or depreciation of Indian rupee.
Factors Affecting the Exchange rate of India:
- Demand and Supply conditions of the country is an important factor in it. The exchange rate of rupee is also affected due to the following factors:
- The intervention of the central bank: the central bank intervenes to curb volatility to prevent it. For example- trade tensions between the US and China affect the volatility. RBI intervenes through selling dollars when Indian currency depreciates too much.
- Inflation rate: an increase in inflation rate increases the demand for foreign currency which affects the national currency. Like an increase in the prices of petroleum due to gulf disturbance and other factors.
- Interest rate: a high rate on the government bonds compared to the other nation forex markets can increase the inflow of currency which affects it.
- Imports and Exports: an overall increase in the exports, the currency of a nation would appreciate while the increase in the imports leads to the depreciation.
- The exchange rate dynamics in India has been driven by the capital flows rather than the current account balances.
- India’s forex reserves are borrowed reserves and not built out of export surplus.
Conclusion: The fluctuations in the forex markets in these circumstances due to the factors affecting the exchange rate don’t leave any option other than the market intervention to restore the stability in the market. Trade wars between the global economies can contribute to economic slowdown globally. So this is the need of the hour to consult over any possibility of rational and logic quick resolution of the tension and prevent the economic slowdown. Source: The Hindu