Exchange rate policy of india

Sangeeta Mondal
Roll No. 12
GBO-semester II
What is exchange rate?
 Definition
Rate at which one currency may be converted into
another

Converting one currency to another, eg, travel purpose

to some foreign land, investing in foreign exchange
market.
 Different exchange rate
systems
 Floating exchange rates

Managed floating exchange rates

 Fixed exchange rate system (pegged exchange rate)

 REER (Real effective exchange rate )
It is used to determine an individual country's currency value
relative to the other major currencies in the index, as adjusted for
the effects of inflation
In 2004, RBI replaced its five-country indices of nominal
effective exchange rate (NEER) and real effective exchange rate
(REER) with new six-currency indices. It is also revising its 36
country indices.
NEER (Nominal effective exchange rate)
It represents the relative value of a home country's
currency compared to the other major currencies being
traded. 
A higher NEER coefficient (above 1) means that the home
country's currency will usually be worth more than an
imported currency
 A lower coefficient (below 1) means that the home
currency will usually be worth less than the imported
currency. 
The NEER also represents the approximate relative price
a consumer will pay for an imported good
 Fixed exchange rate
A fixed, or pegged, rate is a rate the government sets and
maintains as the official exchange rate.

A set price is determined against a major world currency

(usually the U.S. dollar)

 In order to maintain the local exchange rate, the central

bank buys and sells its own currency on the foreign
exchange market in return for the currency to which it is
pegged
 Advantages
Fixed rates should eliminate destabilising speculation
Reduced risk in international trade – By maintaining a
fixed rate, buyers and sellers of goods internationally can
agree a price and not be subject to the risk of later
changes in the exchange rate
Introduces discipline in economic management - the
burden of adjustment to equilibrium is thrown onto the
domestic economy, governments have a built-in incentive
not to follow inflationary policies since unemployment and
balance of payments problems are certain to result as the
economy becomes uncompetitive.
 Disadvantages…
No automatic balance of payments adjustment –
with a fixed rate, the problem would have to be solved by a
reduction in the level of aggregate demand. As demand
drops people consume less imports and also the price level
falls making you more competitive.
Large holdings of foreign exchange reserves required
It is not a long term solution if the underlying economy is
weak.
 International disagreement might be created when a
country sets its exchange rate on a too low level
 Floating exchange rate
Currency is set by the foreign-exchange market through supply and
demand for that particular currency relative to other currencies

 Clean floating– the central bank stands aside completely and allows
the exchange rate to be freely determined in the forex market –
official reserve transactions are zero

 Managed floating-the central bank intervenes to buy or sell foreign

currencies periodically in an attempt to influence the exchange rates
 Advantages…
Disequilibrium in balance of payment is auto stabilized

 No need to maintain large forex reserve

It gives the government / monetary authorities flexibility in

determining interest rates. This is because interest rates
do not have to be set to keep the value of the exchange
rate within pre-determined bands
 Disadvantages…
Volatility in the markets

Speculation
 Economics vocabulary
 Devaluation – the price of foreign currencies under a
fixed exchange rate regime is increased by official action
 Revaluation - the price of foreign currencies under a
fixed exchange rate regime is decreased by official
action
 Depreciation – is the loss of value of a country's
currency with respect to one or more foreign reference
currencies, typically in a floating exchange rate system
 Appreciation - under a floating rate system, price of
foreign currencies decreases because of market
adjustment
 History
Before 1991…
Indian rupee had followed the initial devaluation with
Sterling in 1949 and was maintained at the same per value
for the next 16 years.
In 1966 the rupee was devaluated by 57.5% to Rs.7.50
per again US dollar.
In 1975 India delinked from sterling and pegged. With in
2.25 % until January 1980.
 Foreign exchange regulation act
1973
To regulate dealings in foreign exchange and securities
To regulate the transaction indirectly affecting foreign
exchange
To regulate import and export of currency and bullion
To regulate employment of foreign nationals
To regulate foreign companies
To regulate acquisition, holding etc of immovable property
in India by non-residents
The process of steady depreciation of rupee began in
1980s from 7.96 to 18.07.

IMF’s assistance of 5million SDR during Indira Gandhi’s

regime.
 Policy before LPG…
Exchange rate was highly over-valued.

Strict exchange controls applied to not just capital

account but also current account transactions

Foreign investment was subject to stringent restrictions

Foreign investment amounted to a paltry $100-200 million

annually
 1991 crisis…
Indian economy underwent a severe balance-of-payments
crisis
By the summer of 1991, India's foreign exchange reserves
covered less than two weeks of imports.
High rate of inflation

Fleeing non-resident deposits

 Declining production and a serious likelihood of an

unprecedented external payments default by India.
The 1991 Balance of Payments crisis forced India to
procure a $1.8 billion IMF loan.

The economic reforms were thus introduced because of

the IMF conditionalities and not because of any sudden
change of economic philosophy by the Government.

The fiscal tightening and devaluation of the rupee by

nearly 25% adequately reduced the current account
deficit.
 Post LPG…
 RBI's announced depreciation of the rupee, in two
instalments — on July 1 and 3, 1991.

 The value of the rupee declined by 18-19 % against

major currencies to improve the competitiveness of Indian
exports.

In march 1992 the LERMS (Liberalized Exchange Rate

Management System )involving dual exchange rate was
introduced
 LERMS
All foreign exchange receipts on current account
transactions (exports, remittances, etc.) were required to be
surrendered to the Authorized Dealers (ADs) 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 ADs
 Remaining 40 per cent of the proceeds were converted at
the Reserve Bank’s official rate
The ADs, in turn, were required to surrender these 40 per
cent of their purchase of foreign currencies to the Reserve
Bank
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.
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.
 FERA to FEMA
1st June 2000, FERA was repealed to FEMA(Foreign
exchange management act.)
FERA had a controversial 27 year stint during which
Indian Corporate world found themselves at the mercy of
the Enforcement Directorate.
Offense under FERA was a criminal offence liable to
imprisonment, whereas FEMA seeks to make offenses
relating to foreign exchange civil offences.
Money laundering and the hawala (unofficial) market.
 What is convertibility?
The freedom to convert one currency into other
internationally accepted currency
 CAC
Capital Account Convertibility (CAC) means the freedom
to convert local financial assets into foreign financial assets
and vice versa at market determined rates of exchange

It refers to the removal of restraints on international flows

on a country's capital account, enabling full currency
convertibility and opening of the financial system
 Now and then…

 In 1991, India pawned 67 tons of gold to tide over a balance of payments

crisis.
 18 years later, the Reserve Bank of India has bought thrice that amount of
gold from the IMF to diversify its assets
 In a nuttshell
We emulated the Russian school of thought
The collapse of the Soviet Union and its economy
Phenomenal success of China since the opening of its
economy to foreign trade and investment in 1978
The crisis of 1991
Opening up of Indian economy.
 The road ahead…

Capital account convertibility???