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Exchange Rate Mechanisms And Regimes In India Finance Essay

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India has gone through several stages of economic development ever since it received Independence on the 15th of August, 1947. Most notable of these stages would be the liberalisation of the economy in 1991.

Until the liberalization of 1991, India was largely and intentionally isolated from the world markets, to protect its economy and to achieve self-reliance. Foreign trade was subject to import tariffs, export taxes and quantitative restrictions, while foreign direct investment (FDI) was restricted by upper-limit equity participation, restrictions on technology transfer, export obligations and government approvals.*

Following a Balance of Payments crisis in the year 1991, India was literally forced to open its doors to international business, a notion previously held as most evil to the country's growth by its leaders. It had to change its stance on several aspects of international trade, including the Exchange Rate policy adopted.

But, in hindsight, we would all agree that liberalisation was a smart, if delayed, move on part of the country's government. The economy is flourishing like never before. India is now considered a powerhouse on the global stage rather than a Third-World country. The country's international transactions are now becoming a worrying concern for yesteryears' champions like the United States and Great Britain.

Since liberalization, the value of India's international trade has become more broad-based and has risen to Rs. 63,080,109 crores in 2003-04 from Rs.1,250 crores in 1950-51. India's major trading partners are China, the US, the UAE, the UK, Japan and the EU. The exports during April 2007 were $12.31 billion up by 16% and import were $17.68 billion with an increase of 18.06% over the previous year.*

This document will give a brief overview of the Exchange Rate policy currently adopted by the country's central banker, the Reserve Bank of India (RBI), which has made all of this possible.

*Source: Wikipedia - Economy of India (http://en.wikipedia.org/wiki/Economy_of_India)

History of Exchange Rate Regimes in India*

During the period 1950-1951 until mid-December 1973, India followed an exchange rate regime with Rupee linked to the Pound Sterling, except for the devaluations in 1966 and 1971. When the Pound Sterling floated on June 23, 1972, the Rupee's link to the British units was maintained; paralleling the Pound's depreciation and effecting a de facto devaluation.

On September 24, 1975, the Rupee's ties to the Pound Sterling were broken. India conducted a managed float exchange regime with the Rupee's effective rate placed on a controlled, floating basis and linked to a "basket of currencies" of India's major trading partners.

In early 1990s, the above exchange rate regime came under severe pressures from the increase in trade deficit and net invisible deficit. In the aftermath of a balance of payments crisis in 1991, stabilization was undertaken simultaneously with structural reforms over wide areas of the Indian economy. This dramatic change in context fundamentally altered the manner in which monetary policy began to be formulated, especially the forex policy adopted by the country. This shift led the Reserve Bank of India (RBI) to undertake downward adjustment of Rupee in two stages on July 1 and July 3, 1991. This adjustment was followed by the introduction of the Liberalized Exchange Rate Management System (LERMS) in March 1992 and hence the adoption of, for the first time, a dual (official as well as market determined) exchange rate in India. However, such system was characterized by an implicit tax on exports resulting from the differential in the rates of surrender to export proceeds.

Subsequently, in March 1993, the LERMS was replaced by the unified exchange rate system and hence the system of market determined exchange rate was adopted. However, the RBI did not relinquish its right to intervene in the market to enable orderly control.

In addition, the foreign exchange market of India was characterized by the existence of both official and black market rates with median premium. However, such black market premium steadily declined during the following decades until 1993.

RBI's official position on the current Exchange Rate Policy:

"The objective of the exchange rate management has been to ensure that the external value of the Rupee is realistic and credible as evidenced by a sustainable current account deficit and manageable foreign exchange situation. Subject to this predominant objective, the exchange rate policy is guided by the need to reduce speculative activities, help maintain an adequate level of reserves, and develop an orderly foreign exchange market."

*Source: International Economics - Historical Exchange Rate Regimes of Asian Countries (http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=15)

Exchange Rates

In international transactions, if we export goods to other countries, our exporter in India would like to be paid in Indian Rupees whereas the foreign buyer would like to pay in his home currency. If the buyer is in United States, he will pay only in US Dollars. Thus, it becomes necessary to convert this US Dollars into Indian Rupees. The rate at which USD is converted into Indian Rupees is known as "Exchange Rate". In short, exchange rate is the ratio used to convert one currency into another.

Exchange rates are quoted under two methods:

Direct method

Indirect method.

Direct Quotations

While quoting the exchange rate for a currency if the unit of foreign currency is kept constant and its value is expressed in terms of variable home currency the method of quoting exchange rate is known as Direct Quotation. In this case, the unit of home currency will be varying for every unit of foreign currency.

e.g., USD 1 = Rs. 48.85

GBP 1 = Rs. 75.2550

Effective from August, 6, 1993 we have changed our system of quoting exchange rates to Direct Quotations. By adopting this system, we have fallen in line with the International practice. It has become more transparent for the dealing public and it will be easier for them to follow up the movement of exchange rates.

Indirect Quotations

When the unit of home currency is kept constant and the unit of home currency is expressed in terms of variable units' foreign currency, then this method of quoting exchange rate is called Indirect Quotation.

Prior to August 1993, we were following this system for quoting exchange rates.

e.g., Rs.l00/- = USD 2.2400

Rs.l00/- = GBP 1.2400

Two Way Quotes

In other commercial transactions whenever we enquire the price of a commodity the seller will immediately quote his selling price. But in Foreign exchange market exchange rates are always quoted for buying and selling i.e., one rate for buying and the other rate for selling. For example, if Bank X calls for the rates from Bank Y for USD/INR Bank Y will quote: USD/INR = 42.15/16

It means that Bank Y is prepared to buy USD at Rs.42.15 and sell at 42.16. This method of quoting both buying and selling rates is known as "Two Way Quotation". For all practical purposes if we treat Foreign Exchange as a commodity, the logic and application of this 'Two-way quotation' can be understood easily, i.e., a trader will always be willing to buy a commodity at a lesser price and sell at a higher price.

The principle or maxim involved in this method of quotation is:

"BUY LOW - SELL HIGH" (Under Direct Quotation)

Different Transactions and Relevant Exchange Rates

In the above examples, (a) is an outward remittance, which does not involve any additional labor. Bank will be recovering the rupee equivalent from the customer and remit the foreign exchange to their correspondent Bank as per their drawing arrangements with instructions to pay to the lending financial institution on behalf of their customer. If it is a remittance relating to an import bill, (b), as a banker, bank will be verifying the documents, entering them in their register, presenting the bill to the importer for payment and also check whether all the conditions stipulated by the correspondent bank are complied with. For this nature of involvement of manpower, Bank is eligible for some additional compensation. This compensation will be loaded or adjusted while quoting the exchange rate for this import transaction. In other words, the exchange rate for import transaction will be costlier to the customer when compared to the exchange rate for clean outward remittances. The different rates quoted for these two transactions are TT selling and bill selling.

Likewise, Bank will quote different buying rates for export bills and for other clean inward remittances.

Following are the different rates, which are quoted to the customer depending upon the nature of transaction:

Buying Rates:

A.l. TT Buying Rate: (NATURE OF TRANSACTIONS)

Clean inward remittance (TT, PO, MT, and DD) for which cover has already been provided in AD's Nostro Account abroad.

Conversion of proceeds of instruments sent on collection basis. [When proceeds are credited to Nostro Account]

Cancellation of outward TT, MT, PO, DD etc.

Cancellation of forward sale contract.

Undrawn portion of an Export Bill realised.

A.2. Bill Buying Rate: (NATURE-OF TRANSACTIONS)

1. Purchase/ negotiation/ discounting of export bills and other instruments.

Selling Rates:

B.l. TT Selling Rate. (NATURE OF TRANSACTIONS)

Outward remittance in foreign currency (TT, MT, PO, DD)

Cancellation of purchase transactions, i.e., Bill purchased earlier is returned unpaid Bill purchased earlier is transferred to collection account.

Inward remittance received earlier (converted into rupees) is refunded to the remitting bank.

Cancellation of Forward purchase contract.

Remittances relating to payment of import bills, which are directly received by the importer.

Crystallisation of overdue export bills.

NOTE: If the remittance is a clean remittance i.e. no documents are to be handled by the banks, TT Selling rate will be applied.

B.2. Bill Selling Rate.

1. Transaction involving remittance of proceeds of import bill (except

bills received directly by the. importer)

NOTE: Even if the proceeds of the import bills are to be remitted in foreign Currency by way of DD, MT, TT, and PO rate to be applied will be Bill Selling rate.

2. Crystallisation of overdue import bills.

Apart from the above, separate rates will be quoted for selling and buying of Traveler's Cheques and Foreign currency notes.

Calculation of Merchant Rates

FEDAI has provided detailed guidelines for calculation of exchange rates for merchant transactions. Following factors are to be taken into account by banks before quoting rates to customers:

STEP 1. Arrive at the cover rate i.e. the rate at which ADs will be covering the transaction in the market immediately the customer delivers the instrument. It may also be treated as the rate at which the AD can dispose off / acquire the Foreign Exchange in/from the market.

STEP 2. Load the prescribed profit margin.

EXCHANGE MARGIN:

FEDAI has left the discretion of loading profit margin to the individual banks.

It is now purely at the discretion of the individual Bankers to load the appropriate exchange margin and improve the exchange rate depending upon the volume and nature of the transaction.

STEP 3. Rounding off the transaction to the nearest 4 decimals, i.e., .0025/50/75/00.

EXAMPLE:

Exporter has submitted a bill for USD 100,000. Inter-bank exchange rate - 48.02/03 Profit margin - 1.5 paise

STEP 1: Select the appropriate base rate at which the bank can dispose off the USD against Indian Rupee in the market. In this case, Bank may be able to dispose off USD 100000 at Rs. 48.02 in the Inter Bank market at the market-buying rate.

STEP 2: Load the prescribed profit margin: Base rate Rs.48.02

Deduct the profit margin: Rs.48.0200 - 0.0150 = Rs.48.0050

Since Bank will be paying Indian Rupees to exporter customer, Bank will be deducting their profit margin from the rupee proceeds.

STEP 3: Round off to the nearest 4 decimals.

In the above transaction, Bank will be quoting the rate as 48.0050 to the customer.

Cross Rates / Chain Rule

If a Corporate wants to purchase Euro (EUR) since this currency is not normally quoted in India, AD will procure US Dollars from Inter-bank market against Rupees and will contact any of the overseas market to get Euro by disposing the US Dollars.

E.g., A customer wants to retire an import bill for EUR 50,000 and the Inter Bank rate for USD/INR is at 39.02/03 and the overseas market rate for EUR/USD is 0.8920/30. In order to arrive at the EUR/INR exchange rate Bank will be applying following Chain Rule method. It should be noted that the market quote for EUR/USD is expressed under Indirect quotation i.e., one unit of Euro will be equivalent to how much USD.

First leg of the transaction is, Authorised Dealer procures USD against Indian Rupees from inter-bank market:

USD $1 = Rs.39.03 i.e. to procure US$ 1, AD will pay Rs.39.03 in the Interbank.

With this USD, AD will go to London market and procure EUR paying USD 0.8930 for one EUR.

By applying Chain Rule :

1 EUR = USD 0.8930

1 USD = INR 48.03

Then 1 EUR will be equivalent to 0.8930*39.03 = INK 39.8907

Rounding off to 4 decimals = Rs.39.8925

This method of arriving at the value of other currencies through US Dollar or any other third currency is known as Cross Rate or Chain Rule.

Card Rates

Dealing room of all banks as soon as open for that day's business, works out the exchange rate for all the major currencies and for all types of transactions. This rate will be communicated to all branches of the bank. This rate will be the indicative rates and this rate will be applicable only for transaction up to the prescribed level i.e., smaller value transactions.

Spot Rates - Forward Rates

We have learnt that exchange rate is the price at which one currency can be bought or sold for another currency.

The date on which currencies are exchanged can be any date from the date starting from the date of transaction to any future dates. Transactions may be either Spot or forward depending upon the delivery of the Foreign Exchange.

Under Spot, we have CASH-SPOT, TOM-SPOT. If the exchange of currencies takes place on the same day of transaction, it is known as CASH DEAL. If the exchange of currencies takes place on the next working day, i.e. tomorrow, it is known as TOM-DEAL. If the exchange of currencies takes place on the second working day after the date of transaction it is known as SPOT DEAL. Normally exchange rates are quoted on spot basis i.e., the settlement will take place on the second working day after the date of transaction. Wherever foreign exchange will be delivered after SPOT date, it is known as Forward transactions.

Going back to the above Import transaction, if the Importer gets the information that his shipment will be reaching India only after 3 months it is possible that due to exchange fluctuations he may have to pay more in Rupee terms. If he feels that the exchange rate on the third month, at the time of retirement of the import bill, will not be favorable to him, he may like to fix an assured rate for his future transaction. This type of fixing the exchange rate for a future transaction, at the desired time earlier to the date of actual transaction is known as Forward contracts.

Premium/Discount on Direct Quotations

If we are familiar with commodity or share market it would be known that spot rate, forward rates are different, and they need not be the same. This is so because the anticipated demand and supply and the cost situations at the forward date may not necessarily be identical with that of the existing at present. The commodity/share could be quoted at a higher (premium) or lower (discount) rate for future deliveries.

We shall illustrate this with an example:

Spot interbank rate of USD 1 = Rs.39.25

3 months forward USD 1 = Rs.39.95

If one has to buy dollar three months forward against Rupees, he has to pay 70 paise more for the same dollar, i.e., 3 months dollar will be costlier by 70 paise compared to spot rate. Therefore US Dollar is said to be at premium in forwards vis-a-vis rupee. In direct quotations premium is always added to both the buying and selling spot rates.

In another situation:

Spot interbank rate of USD 1 = JPY 108.50

3 months forward USD 1 = JPY 106.50

From the above illustration it will be seen that the USD/JPY for 3 months forward is available at a cheaper rate as compared to spot. In other words USD is cheaper by 2 JPY forward compared to spot.

i.e., USD is at discount in forwards vis-a-vis JPY direct quotations. Discount factor is always deducted from the buying and selling spot rate.

From the above it is now clear that if we compare spot and forward rates we are able to arrive at the following three possibilities:

a. If the spot rate and the forward rate are the same they are at par.

b. In direct quotations if forward rate is more than the spot rate the base

currency is said to be at premium.

c. In direct quotations if forward rate is less than the spot rate the base

currency is said to be at discount.

Quoting Forward Rates

Forward differentials are always quoted in two figures like, 15/16 and 15/14. It will be either at ascending or descending order. If the first figure is less than the second figure {in ascending order} then the base currency is said to be at premium.

In direct quotations premium is always added to both the buying and selling rates. If it is a buying transaction for the bank, the quoting bank will add lesser of the two premium figures so as to give minimum rupees. Likewise if it is a selling transaction, the quoting bank, will add higher of the two premium figures to take the maximum amount in rupees for selling a foreign currency.

EXAMPLE

Interbank market rates:

Spot USD: Rs.39.2025/2100

1 month forward 15/16

a) We have an export bill transaction.

Since the forward differentials are in ascending order the base currency, USD is at premium. Hence, it should be added with the spot rate to arrive at the forward rate. Out of the two premium figures (15/16) since Bank will be giving Indian rupees, they will give minimum amount in rupees.

Step 1: Spot buying rate USD 1 = Rs.39.2025

Step 2: To arrive at the forward rate: Since the base currency is at premium and Bank has to give rupees, add the minimum premium, i.e., add 15 paise to the spot rate.

Spot buying rate USD 1 = Rs. 39.2025

Add premium = Rs. 00.1600

Rs. 39.3625

Hence, the forward rate for this export transaction will be Rs.39.3625.

b) In an import transaction, while recovering rupees from the importer customer, for one-month forward rate, Bank will add the maximum premium i.e. 16 paise and the forward rate for Bank's selling transaction would be:

Spot selling rate USD 1 = Rs. 39.2100

Add premium = Rs. 00.1600

Forward rate for selling = Rs.39.3700

If the forward differentials are on the descending order i.e., 25/24, the base currency is said to be at discount.

In direct quotations, if the base currency is at a discount, discount factor is always deducted from the spot rate. When two discount figures are quoted if it is a buying transaction (export bills) in which bank will be giving rupees, they will be deducting higher of the two figures and give minimum rupees.

EXAMPLE:

Interbank market Spot USD 1 = Rs.39.2725/00

1 month forward 25/24 (paise)

To arrive at the 1-month forward rates:

Buying

Selling

(Export bill)

(Import bill)

Inter-bank Spot

39.2725

39.2800

Deduct the discount

0.2500

0.2400

1 month forward rate

39.0225

39.0400

From the above example, in direct quotations, in selling transactions, lesser amount of discount is deducted to take maximum rupees for every dollar.

RBI Regulations on Forward Contracts

A person resident in India may enter into a forward contract with an authorized dealer to hedge an exposure to exchange risk subject to production of satisfactory documentary evidence about the genuineness of the underlying exposure.

This has been relaxed on 1.12.2001 -vide RBI guidelines EC/CO/FMD/453/18.07.01 /2001-02 - wherein Reserve Bank permits Authorized Dealers to book FWD contracts based on a declaration of an exposure subject to:

FWD contracts booked in aggregate, should not exceed 50%of the average of previous 3 financial years actual import/export turnover subject to a cap of USD 100 Mn or equivalent.

Declaration to AD about amount booked with other Authorised Dealers

Undertaking to produce supporting documentary evidence before maturity of the FWD contract.

Substitution of contracts for hedging trade transactions may be permitted on satisfactory reasons

Contracts involving rupee as one of the currencies, once cancelled shall not be re-booked although they can be rolled over at ongoing rates on or before maturity. This restriction shall not apply to contracts covering export transactions, which may be cancelled, rebooked or rolled over at on-going rates.


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