Finance Essays - Foreign Exchange Currency - Free Essay Example

Foreign Exchange Currency The term foreign exchange is normally used to denote foreign currency surrendered or asked for in any of its current forms, i.e. a currency note or a negotiable instrument or transfer of funds through cable or mail transfer or a letter of credit transaction requiring sale and purchase of foreign exchange or conversion of one currency into another, either at the local center or an overseas center. The banks, dealing in for exchange and providing facilities for conversion of one currency into another or vice versa are known as Authorized Dealers or Dealers in Foreign Exchange. A bank is said to buy or sell foreign exchange when it handles the claims drawn in foreign currency or the actual legal tender money, i.e., foreign currency notes and coins of other countries. The theory of Foreign exchange covers different means and methods by which the claims expressed in terms of one currency are converted into another currency and specifically deal with the rates at which such conversion takes place. With partial or complete exchange control, as exercised by countries since World War II exchange markets are no longer free. Exchange rates today are not entirely determined by market forces but are officially fixed and maintained by Central Forex Markets The foreign exchange market, like the market for any other commodity, comprises of buyers and sellers of foreign currencies. The operations in the foreign exchange market originate in the requirements of customers for making remittances to and receiving them from other countries. But the bulk of transactions take place among banks dealing in foreign exchange for their own requirements as they do cover operations. Banks undertake large and frequent deals with other banks through the agency of Exchange Brokers, and it is these deals which give the market its significance. In addition, there are other transactions which take place in the foreign exchange market. All transactions of the exchange market may be divided into five categories: Transactions between banks and their customers. Transactions between different banks in the same centre. Dealings between banks in a country and their correspondents, and overseas branches. The purchase and sale of currencies between the central bank of a country and the commercial banks. The transactions of the central banks of one country, with central banks of other countries. There is not much difference between one market and another as far as the international transaction between markets at different centres is concerned. But local dealings, among members of the same market are organized in two different forms. One of them is the pattern adopted in Great Britain, U.S. A. and some other countries, where foreign exchange dealers never meet each other but transact business through a network of telephone lines linking the banks, with exchange brokers who act as intermediaries. In India also the foreign exchange market is organized on these lines. The other type is the markets in countries of Western Europe, where the dealers in Foreign exchange meet on every working day at a meeting place for business proposals-They fix the exchange rates for certain kind of business particularly with-customers. The foreign exchange markets in these countries are like commodity exchange or stock exchange. However, the global important of these markets, is comparatively small. ( Bhalla, V.K (june 2000). International Finance Management. 6th ed. New Delhi: Kalyani Publishers ) Indian Foreign Exchange Market A Historical Perspective The evolution of Indiarsquo;s foreign exchange market may be viewed in line with the shifts in Indiarsquo;s exchange rate policies over the last few decades from a par value system to a basket-peg and further to a managed float exchange rate system. During the period from 1947 to 1971, India followed the par value system of exchange rate. Initially the rupeersquo;s external par value was fixed at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the permitted margin of plusmn;1 per cent using pound sterling as the intervention currency. Since the sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates of rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable. The devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. The exchange r ate of the rupee remained unchanged between 1966 and 1971. Given the fixed exchange regime during this period, the foreign exchange market for all practical purposes was defunct. Banks were required to undertake only cover operations and maintain a lsquo;squarersquo; or lsquo;near squarersquo; position at all times. The objective of exchange controls was primarily to regulate the demand for foreign exchange for various purposes, within the limit set by the available supply. The Foreign Exchange Regulation Act initially enacted in 1947 was placed on a permanent basis in 1957. In terms of the provisions of the Act, the Reserve Bank, and in certain cases, the Central Government controlled and regulated the dealings in foreign exchange payments outside India, export and import of currency notes and bullion, transfers of securities between residents and non-residents, acquisition of foreign securities. ( Sukumar,N (1996). international finance: the Indian perspective. 3rd ed. Pune: National Institute of Bank Management. ) With the breakdown of the Bretton Woods System in 1971 and the floatation of major currencies, the conduct of exchange rate policy posed a serious challenge to all central banks world wide as currency fluctuations opened up tremendous opportunities for market players to trade in currencies in a borderless market. In December 1971, the rupee was linked with pound sterling. Since sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971, the rupee also remained stable against dollar. In order to overcome the weaknesses associated with a single currency peg and to ensure stability of the exchange rate, the rupee, with effect from September 1975, was pegged to a basket of currencies. The currency selection and weights assigned were left to the discretion of the Reserve Bank. The currencies included in the basket as well as their relative weights were kept confidential in order to discourage speculation. It was around this time that banks in India became interested in trading in foreign exchange. The impetus to trading in the foreign exchange market in India came in 1978 when banks in India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and were required to comply with the stipulation of maintaining lsquo;squarersquo; or lsquo;near squarersquo; position only at the close of business hours each day. The extent of position which could be left uncovered overnight (the open position) as well as the limits up to which dealers could trade during the day was to be decided by the management of banks. The exchange rate of the rupee during this period was officially determined by the Reserve Bank in terms of a weighted basket of currencies of Indiarsquo;s major trading partners and the exchange rate regime was characterized by daily announcement by the Reserve Bank of its buying and selling rates to the Authorized Dealers (ADs) for undertaking merchant transactio ns. The spread between the buying and the selling rates was 0.5 per cent and the market began to trade actively within this range. ADs were also permitted to trade in cross currencies (one convertible foreign currency versus another). However, no lsquo;positionrsquo; in this regard could originate in overseas markets. As opportunities to make profits began to emerge, major banks in India started quoting two-way prices against the rupee as well as in cross currencies and, gradually, trading volumes began to increase. This led to the adoption of widely different practices (some of them being irregular) and the need was felt for a comprehensive set of guidelines for operation of banks engaged in foreign exchange business. Accordingly, the lsquo;Guidelines for Internal Control over Foreign Exchange Businessrsquo;, were framed for adoption by the banks in 1981. The foreign exchange market in India till the early 1990s, however, remained highly regulated with restrictions on externa l transactions, barriers to entry, low liquidity and high transaction costs. The exchange rate during this period was managed mainly for facilitating Indiarsquo;s imports. The strict control on foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets for foreign exchange in the world, i.e., the hawala (unofficial) market. ( siddiki, J (1998). ; Black market exchange rates in India, an empirical analysis. surrey: kingston upon thames, faculty of human science, kingston university. ) Formative Period: 1978-1992 By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and structural factors had contributed to balance of payments difficulties. Devaluations by Indiarsquo;s competitors had aggravated the situation. Although exports had recorded a higher growth during the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8 per cent of GDP in 1990-91), trade imbalances persisted at around 3 per cent of GDP. This combined with a precipitous fall in invisible receipts in the form of private remittances, travel and tourism earnings in the year 1990-91 led to further widening of current account deficit. The weaknesses in the external sector were accentuated by the Gulf crisis of 1990-91. As a result, the current account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital flows also dried up necessitating the adoption of exceptional corrective steps. It was against this backdrop that India embarked on stabilization and structural reforms in the early 1990s. ( Srinivasan, V (2001). Structural changes in the Indian foreign exchange market; an empirical investigation. storrs: Center for International Business Education and Research (CIBER). Post-Reform Period: 1992 onwards This phase was marked by wide ranging reform measures aimed at widening and deepening the foreign exchange market and liberalization of exchange control regimes. A credible macroeconomic, structural and stabilization programmed encompassing trade, industry, foreign investment, exchange rate, public finance and the financial sector was put in place creating an environment conducive for the expansion of trade and investment. It was recognized that trade policies, exchange rate policies and industrial policies should form part of an integrated policy framework to improve the overall productivity, competitiveness and efficiency of the economic system, in general, and the external sector, in particular. As a stabilization measure, a two-step downward exchange rate adjustment by 9 per cent and 11 per cent between July 1 and 3, 1991 was resorted to counter the massive draw down in the foreign exchange reserves, to instill confidence among investors and to improve domestic competitiveness. A two-step adjustment of exchange rate in July 1991 effectively brought to close the regime of a pegged exchan ge rate. After the Gulf crisis in 1990-91, the broad framework for reforms in the external sector was laid out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). Following the recommendations of the Committee to move towards the market-determined exchange rate, the Liberalized Exchange Rate Management System (LERMS) be put in place in March 1992 initially involving a dual exchange rate system. Under the LERMS, all foreign exchange receipts on current account transactions (exports, remittances, etc.) were required to be surrendered to the Authorized Dealers (ADrsquo;s) in full. The rate of exchange for conversion of 60 per cent of the proceeds of these transactions was the market rate quoted by the ADrsquo;s, while the remaining 40 per cent of the proceeds were converted at the Reserve Bankrsquo;s official rate. The ADrsquo;s, in turn, were required to surrender these 40 per cent of their purchase of foreign currencies to the Reserve Bank. They were free to retain the balance 60 per cent of foreign exchange for selling in the free market for permissible transactions. The LERMS was essentially a transitional mechanism and a downward adjustment in the official exchange rate took place in early December 1992 and ultimate convergence of the dual rates was made effective from March 1, 1993, leading to the introduction of a market-determined exchange rate regime. The dual exchange rate system was replaced by a unified exchange rate system in March 1993, whereby all foreign exchange receipts could be converted at market determined exchange rates. On unification of the exchange rates, the nominal exchange rate of the rupee against both the US dollar as also against a basket of currencies got adjusted lower, which almost nullified the impact of the previous inflation differential. The restrictions on a number of other current account transactions were relaxed. The unification of the exchange rate of the Indian rup ee was an important step towards current account convertibility, which was finally achieved in August 1994, when India accepted obligations under Article VIII of the Articles of Agreement of the IMF. With the rupee becoming fully convertible on all current account transactions, the risk-bearing capacity of banks increased and foreign exchange trading volumes started rising. This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with the Government to remove market distortions and deepen the foreign exchange market. The process has been marked by lsquo;gradualismrsquo; with measures being undertaken after extensive consultations with experts and market participants. The reform phase began with the Sodhani Committee (1994), which in its report submitted in 1995 made several recommendations to relax the regulations with a view to vitalizing the foreign exchange market. ( Srinivasan, V (2001). Structural changes in the Indian foreign exchange m arket; an empirical investigation. storrs: Center for International Business Education and Research (CIBER). ( Khasnobis, B (1998). sensitivity of the rupee dollar exchange rate, a VAR analysis. Mumbai: Indira Gandhi institute of development research. ) Indian Foreign Exchange Market The Indian foreign exchange market, broadly concentrated in big cities, is a three-tier market. The first tier covers the transactions between the Reserve Bank and Authorized Dealers (Ads). As per the Foreign Regulation Act, the responsibility and authority of foreign exchange administration is vested with the RBI. It is the apex body in this area and for its own convenience, has delegated its responsibility of foreign exchange transaction functions to Ads, primarily the scheduled commercial banks. They have formed the Foreign Exchange Dealersrsquo; Association of India which framers rules regarding the conduct of business, coordinates with the RBI in the proper administration of foreign exchange control and acts as a clearing house for information among Ads. Besides the commercial banks, there are money- changers operating on the periphery. They are well-established firms and hotels doing this business under license from the RBI. In the first tier of the market, the RBI buys an d sells foreign currency from and to Ads according to the exchange control regulations in force from time to time. Prior to the introduction of the Liberalized Exchange Management System, Ads had to sell foreign currency acquired by them from the primary market at rates administered by the RBI. The latter too sold pounds sterling or US dollars, spot as well as forward, to Ads to cover the latterrsquo;s primary market requirements. But with the unified exchange rate system, the RBI now intervenes in the market to stabilize the value of the rupee. The second of the market is the inter-bank market where Ads transaction business among themselves. They normally do their business within the country, but they can transact business also with overseas bank in order to cover their own position. Through they can do it independently, they do it normally through a recognized broker. The brokers are not allowed to execute any deals on their own account or for the purpose of jobbing. With in the country, the inter-bank transactions can be both sport and forwards. These may be swap transactions. Any permitted currency can be sued. But while dealing with the overseas Ads, because the Indian market lacks depth in other currencies; the Indian banks can deal mainly in two currencies, viz, the US branches must cover only genuine transactions relating to a customer in India or for the purpose of adjusting or squaring the bankrsquo;s own position. Forward trading with overseas banks is also allowed if it is done for the above two purpose, that is for covering genuine transactions or for squaring the currency position, and does not exceed a period of six months. In case the import is made on deferred payment terms and the period exceeds six months, permission has to be obtained from the RBI. Cancellation of forward contracts is allowed in India, although it has to be referred to the RBI. Previously, the banks used to get the forward transactions covered with the RBI, bu t since 1994-95 the RBI has stopped giving this cover and has permitted the banks to trade freely in the forward market. Cancellation of a forward contract involves entering into a reverse transaction at the going rate. Suppose US $1,000 was bough forward on 1 February for three months at Rs. 40/US $. On 1 March, it is cancelled involving selling the US dollar at the rate prevalent on this day. If the exchange rate on 1 March is Rs. 39.50/US $ there will be a loss of Rs. 500 (the dollar sold for Rs. 39.5 minus dollar bought at Rs. 40.00). The loss is borne by the customer. If the value of the US dollar is greater on the cancellation day, the customer shall reap the profit. The third tier of the foreign exchange market is represented by the primary market where Ads transact in foreign currency with the customers. The very existence of this tier is the outcome of the legal provision that all foreign exchange transactions of the Indian residents must take place through Ads. The t ourists exchange currency, exporters and importers exchange currency, and all these transactions come under the primary market. (Pandey, I M (1999). International Finance management. New Delhi: Kalyani Publishers. )