Introduction:

Foreign Exchange rate (ForEx rate) is one of the most important means through
which a country’s relative level of economic health is determined. A country's foreign
exchange rate provides a window to its economic stability, which is why it is constantly
watched and analyzed. If you are thinking of sending or receiving money from overseas, you
need to keep a keen eye on the currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency may be
converted into another." It may fluctuate daily with the changing market forces of supply and
demand of currencies from one country to another.
An exchange-rate regime is the way an authority manages its currency in relation to
other currencies and the foreign exchange market. Between the two limits of fixed and freely
floating exchange regimes, there can be several other types of regimes. In their operational
objective, it is closely related to monetary policy of the country with both depending on
common factors of influence and impact.
The exchange rate regime has a big impact on world trade and financial flows. The
volume of such transactions and the speed at which they are growing makes the exchange
rate regime a central piece of any national economic policy framework.

In Fig. 21.2, as one moves from point A on the left to point B on the right, both the
frequency of intervention by domestic monetary authorities and required level of
international reserves tend to be lower.
Under a pure fixed-exchange-rate regime (point A), authorities intervene so that the
value of the domestic currency vis-a-vis the currency of another country, say the US Dollar,
is maintained at a constant rate. Under a freely floating exchange-rate regime, authorities do
not intervene in the market for foreign exchange and there is minimal need for international
reserves.

Determinants of Exchange Rates:

1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A
country with a lower inflation rate than another's will see an appreciation in the value
of its currency. The prices of goods and services increase at a slower rate where the
inflation is low. A country with a consistently lower inflation rate exhibits a rising
currency value while a country with higher inflation typically sees depreciation in its
currency and is usually accompanied by higher interest rates
2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex
rates, interest rates, and inflation are all correlated. Increases in interest rates cause a
country's currency to appreciate because higher interest rates provide higher rates to
lenders, thereby attracting more foreign capital, which causes a rise in exchange rates
3. Country’s Current Account / Balance of Payments
A country’s current account reflects balance of trade and earnings on foreign
investment. It consists of total number of transactions including its exports, imports,
debt, etc. A deficit in current account due to spending more of its currency on
importing products than it is earning through sale of exports causes depreciation.
Balance of payments fluctuates exchange rate of its domestic currency.
4. Government Debt
Government debt is public debt or national debt owned by the central
government. A country with government debt is less likely to acquire foreign capital,
leading to inflation. Foreign investors will sell their bonds in the open market if the
market predicts government debt within a certain country. As a result, a decrease in
the value of its exchange rate will follow.
5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the
ratio of export prices to import prices. A country's terms of trade improves if its
exports prices rise at a greater rate than its imports prices. This results in higher
revenue, which causes a higher demand for the country's currency and an increase in
its currency's value. This results in an appreciation of exchange rate.
6. Political Stability & Performance
A country's political state and economic performance can affect its currency
strength. A country with less risk for political turmoil is more attractive to foreign
investors, as a result, drawing investment away from other countries with more
political and economic stability. Increase in foreign capital, in turn, leads to an
appreciation in the value of its domestic currency. A country with sound financial and
trade policy does not give any room for uncertainty in value of its currency. But, a
country prone to political confusions may see a depreciation in exchange rates.
7. Recession
 When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency weakens in
comparison to that of other countries, therefore lowering the exchange rate.
8. Speculation:
If a country's currency value is expected to rise, investors will demand more of
that currency in order to make a profit in the near future. As a result, the value of the
currency will rise due to the increase in demand. With this increase in currency value
comes a rise in the exchange rate as well.

Exchange Rate System in India:

India was among the original members of the IMF when it started” functioning in
1946. As such, India was obliged to adopt the Bretton Woods system of exchange rate
determination. This system is known as the par value system of pegged exchange rate
system. Under this system, each member country of the IMF was required to define the value
of its currency in terms of gold or the US dollar and maintain (or peg) the market value of its
currency within ± per cent of the defined (par) value.
The Bretton Woods system collapsed in 1971. Consequently, the rupee was pegged to
pound sterling for four years after which it was initially linked to the basket of 14 currencies
but later reduced to 5 currencies of India’s major trading partners.
This system continued through the 1980s; through the exchange rate was allowed to
fluctuate in a wider margin and to depreciate modestly with a view to maintaining
competitiveness. However, the need for adjusting exchange rate became precipitous in the
face of external payments crisis of 1991.
As a part of the overall macro-economic stabilisation programme, the exchange rate
of the rupee was devalued in two stages by 18 per cent in terms of the US dollar in July
1991. With that, India entered into a new phase of exchange rate management.

Objectives of Exchange Rate Management:

The main objectives of India’s exchange rate policy is to ensure that the economic
fundamentals are truly reflected in the external value of the rupee.
Subject to this predominant objective, the conduct of exchange policy is guided by
the following:
i. Reduce volatility in exchange rates, ensuring that the market correction of exchange
rates is effected in an orderly and calibrated manner;
ii. Help maintain an adequate level of foreign exchange reserves;
 iii. Prevent the emergence of destabilisation by speculative activities; and
iv. Help eliminate market constraints so as to assist the development of a healthy
foreign exchange market.

Exchange Rate Reforms:

Exchange rate reforms have proceeded gradually beginning with a two- stage
cumulative devaluation of rupee by about 20 per cent effected in July 1991. Subsequently,
the Liberalised Exchange Rate Management System (LERMS) was introduced in 1992,
which was later replaced by the Unified Exchange Rate System (UERS) in 1993. The net
result was an effective devaluation of the rupee by around 35 per cent in nominal terms and
25 per cent in real terms between July 1991 and March 1993.

Features of the Current Regime:

The principal features of the current exchange rate regime in India can
be briefly stated as follows:
i. The rates of exchange are determined in the market.

ii. The freely floating exchange rate regime continues to operate within the
framework of exchange control.
iii. Current receipts are surrendered (or deposited) to the banking system, which in
turn, meets the demand for foreign exchange.
iv. RBI can intervene in the market to modulate the volatility and sharp depreciation
of the rupee. It effects transactions at a rate of exchange, which could change within a margin
of 5 per cent of the prevailing market rate.
v. The US dollar is the principal currency for the RBI transactions.
vi. The RBI also announces a Reference Rate based on the quotations of select banks
on Bombay at twelve noon every day. The Reference Rate is applicable to SDR transactions
and transactions routed through the Asia Clearing Union.
In short, the India rupee has matured to a regime of the floating exchange rate from
the earlier versions of a ‘managed float’.

Convertibility on Current Account:

The current regime of the exchange rate has been accompanied by full ‘Convertibility
on current account with effect from August 20, 1994. Accordingly, several provisions like
remittances for service, education, basic travel, gift remittances, donation, and provisions of
the Exchange Earners’ Foreign Currency Account (EEFCA) were relaxed.
 In a further move, announced in 1997, the RBI liberalised the existing regulations in
regard to payments for various kinds of feasibility studies, legal services, postal imports and
purchases of designs and drawings. With this, India acquired a status called as the IMF
Article VIII Status.
By attaining the Article VIII status, India has reached a position by which it can instill
confidence among the international investor community, paving the way for further inflow of
foreign capital. Further, India is also committed to allowing free outflow of current account
payments (like interest) even if there is a serious foreign exchange crisis.
Notwithstanding the above, the government still retains many controls on current
account.
Among these, the following may be specifically mentioned:
i. Repatriation of export proceeds within six months;
ii. Caps on the amounts spent on the purchase of services abroad;
iii. Restrictions on the repatriation of interest on rupee debt;
iv. Dividend-balancing for FDI in some consumer goods industries;
v. Restrictions on the repatriation of interest on NRI deposits;
vi. The rupee is not allowed to be officially used as international means of payment.
Indian banks are not permitted to offer two- way quotes to NRIs or-non-resident banks.
With the help of these controls, the governments can significantly alter the flow of
foreign exchange and the exchange rate of rupee. Additionally, the RBI can influence the
exchange rate through direct purchase and sale of foreign exchange in the market.

Convertibility on Capital Account:

Drawing on the experience of the past decade and a half, the extent and timing of
capital account liberalisation is sequenced with other reforms like strengthening of banking
systems, fiscal consolidation, market development and integration, trade liberalisation, etc.
all of which are in tune with the changing domestic and external economic environment.
A hierarchy is thus established in the sources and types of capital flows. The priority
has been to liberalise inflows relative to outflows, but all outflows associated with inflows
have been totally freed. Among the type of inflows, FDI is preferred for its stability, while
short-term external debt is avoided. A differentiation is made between Corporates,
individuals and banks.
For outflows, the hierarchy for liberalisation has corporate at the top, followed by
financial intermediaries and individuals. Restrictions have been eased for corporate Seeking
investments and acquisitions abroad, which strengthen their global presence. Banks and
financial intermediaries are considered a source of greater volatility as their assets are
relatively illiquid and their liabilities are demandable.
They are thus susceptible to self-fulfilling crisis of confidence leading to contagion
effect. In view of this, liberalisation for outflows in this sector has been tied to financial
sector reforms. For individuals, residents are treated differently from nonresidents, and non-
resident Indians are accorded a well-defined intermediate status between residents and non-
residents.

Intervention by RBI:
The current exchange rate regime, introduced in 1993, the RBI has been, actively
intervening in the foreign exchange market with the objective of maintaining the real
effective exchange rate (REER) stable.
The RBI uses two types of intervention in this regard:
i. Direct Intervention:
It refers to purchases and sales in international currency (i.e. US dollars and euro) both on
the spot and also in forward markets.
ii. Indirect Intervention:
It refers to the use of reserve requirements and interest rate flexibility to smoothen temporary
mismatches between demand and supply of foreign currency.
Intervention by the RBI has raised a question as to whether or not there should be an
exchange rate band within, which the central bank should allow the currency to fluctuate.
The Tarapore Committee in its report on Capital Account Convertibility had, while
suggesting transparency in the exchange rate policy of the central bank, recommended a band
within which it would allow the currency to move.
The RBI has been, in contrast, saying that there cannot be such rigidities in exchange rate
policy, and, therefore, the bank should have the right to intervene at its discretion. Such
interventions are considered necessary till the rupee is made fully convertible.

Foreign Exchange Management in India:

Foreign Exchange Management Act, 1999 (FEMA) came into force by an act of
Parliament. It was enacted on 29 December 1999. This new Act is in consonance with the
frameworks of the World Trade Organisation (WTO). It also paved the way for the
Prevention of Money Laundering Act, 2002 which came into effect from July 1, 2005.
It is a set of regulations that empowers the Reserve Bank of India to pass regulations
and enables the Government of India to pass rules relating to foreign exchange in tune with
the foreign trade policy of India. FEMA replaced Foreign Exchange Regulation Act (FERA).
FERA (Foreign Exchange Regulation Act) legislation was passed in 1973. It came into effect
on January 1, 1974. FERA was passed to regulate the financial transactions concerning
foreign exchange and securities. FERA was introduced when the Forex reserves of the
country were very low. FERA did not comply with the post-liberalization policies of the
Government.it was the main principle for replacing FERA.

Main Features of Foreign Exchange Management Act,

1999:
1. It gives powers to the Central Government to regulate the flow of payments to and
from a person situated outside the country.
2. All financial transactions concerning foreign securities or exchange cannot be carried
out without the approval of FEMA. All transactions must be carried out through
“Authorised Persons.”
3. In the general interest of the public, the Government of India can restrict an
authorized individual from carrying out foreign exchange deals within the current
account.
4. Empowers RBI to place restrictions on transactions from capital Account even if it is
carried out via an authorized individual.
5. As per this act, Indians residing in India, have the permission to conduct a foreign
exchange, foreign security transactions or the right to hold or own immovable
property in a foreign country in case security, property, or currency was acquired, or
owned when the individual was based outside of the country, or when they inherit the
property from individual staying outside the country.

Categories of Authorised Persons under FEMA

Category Authorized Dealer – Authorized Dealer Authorized Full Fledged Money
Category I Category – II Dealer Changers
Category – III

Entities 1.Commercial Banks 1. Upgraded FFMC 1. Select 1. Department of Post

2.State Co-operative 2. Co-operative Banks Financial and 2.Urban Co-operative
Banks other Institutions Banks
3. Regional Rural Banks
3.Urban Co-operative (RRB’s), others 3. Other FFMC
Banks

Activities As per RBI All activities permitted Foreign Purchase of foreign

Permitted guidelines, all current to FFMC and specified exchange, exchange and sale for
and capital account non-trade related current transactions private and business
transactions account transactions related visits abroad

Importance of the Act:

 With the passage FEMA, the act made all the criminal offences as civil offences. The
main objective of FEMA was to help facilitate external trade and payments in India. It was
also meant to help orderly development and maintenance of foreign exchange market in
India. It defines the procedures, formalities, dealings of all foreign exchange transactions in
India.
FEMA (Foreign Exchange Management Act) is applicable to the whole of India and
equally applicable to the agencies and offices located outside India (which are owned or
managed by an Indian Citizen). The head office of FEMA is situated at New Delhi and
known as the Enforcement Directorate.

FEMA gives power to the central government for imposing restrictions on activities
like making payments to a person situated outside of the country or receiving money through
them. Apart from this, foreign exchange as well as foreign security deals are also restricted
by FEMA.

Under Fema, the adjudicator (an officer with the ED) can impose a penalty three
times the size of the contravention involved where the sum is quantifiable. In case the
contravention is not quantifiable, the penalty is set at Rs 2 lakh. Further, where the violation
is a continuing one, an additional penalty of Rs 5,000 per day of contravention can be
imposed.

Conclusion:
FEMA only permits an authorized person to deal in Foreign exchange or foreign
security (shares, stocks, bonds etc). FEMA became the need of an hour to be replaced by an
old act which was FERA as FERA was stringent and FEMA is liberal and also more flexible
than FERA. 
Any person who wants to do business in a foreign country or to buy foreign securities
he/she needs an authorised person to do that and also to understand this Act in order to avoid
penalties and he/she should also be aware of the restrictions on it.
The main objective of FEMA was to consolidate and amend the laws relating to the
foreign exchange with the reason to facilitate the external trade and payments and for the
maintenance of the foreign exchange market in India. FEMA’s replacement with FERA to an
extent has boosted the Indian economy as it is flexible and also a civil offence in comparison
with FERA.
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