Foreign Exchange Management

Foreign Exchange Management

Question and Answers

1. What is FEMA?

Foreign Exchange Management Act (FEMA) is an act which aims to liberalize

the foreign exchange market in India and provide a framework for the
management of foreign exchange transactions for trade, payments, and other
business activities.

The act also defines certain offenses, such as contraventions of foreign

exchange regulations, and provides for penalties and fines. The act also
provides for the creation of an appellate tribunal to hear appeals against the
decisions of the enforcement directorate.

2. Explain the features of FEMA.

There main features of FEMA

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.

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3. Describe the objectives of FEMA.

The main objective of FEMA was to help facilitate external trade and payments
in India; but also has following secondary objectives: -

1. To help orderly development and maintenance of foreign exchange

market in India.
2. To facilitate transactions involving foreign exchange or foreign security
and payments from outside the country to India only through an authorised
person.
3. To encourage dealings in foreign exchange under the current account
through an authorised person and to keep restrictions with the help of Central
Government based on public interest.
4. To authorise Reserve Bank of India to subject the capital account
transactions to a number of restrictions.
5. To carry out transactions in foreign exchange by residents of India,
foreign security or to own or hold immovable property abroad if the currency,
security or property was owned or acquired when resident was living outside
India, or when it was inherited by that resident from someone living outside
India.

4. Briefly explain the Fundamental Principle under FEMA

The Foreign Exchange Management Act (FEMA) aims to regulate the foreign
trade in the country and promote economic growth. Some of the fundamental
principles of the act include

1. Simplification of regulations − The act simplifies the regulations

governing foreign exchange transactions in India, making them more
conducive to the country's economic development.
2. Liberalized regime − The act provides a liberalized regime for foreign
exchange transactions, allowing for greater flexibility in the use of foreign
exchange resources.
3. Promotion of external trade and payments − The act aims to facilitate
external trade and payments and promote the proper growth of the foreign
exchange market.

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4. Encouragement of foreign investment − The act aims to encourage

foreign investment in India by providing a more predictable and transparent
regulatory framework.
5. Compliance and enforcement − The act provides for compliance and
enforcement mechanisms to ensure that foreign exchange regulations are
followed, including penalties for non-compliance.
6. Appellate Tribunal The act provides for the creation of an appellate
tribunal to hear appeals against the decisions of the enforcement directorate.

5. How to apply the FEMA?

FEMA (Foreign Exchange Management Act) applies to the entire country of

India as well as agencies and offices operating outside of India (which are
owned or managed by an Indian Citizen). The Enforcement Directorate, FEMA’s
headquarters, is located in New Delhi.

The Foreign Exchange Management Act (FEMA) is responsible for:

1. Foreign currency exchange.

2. Foreign security.
3. Any commodity and/or service exported from India to a country outside
of India.
4. Importation of any product or service from a country other than India.
5. Securities in the sense of the Public Debt Act, 1994.
6. Any form of purchase, sale, or exchange (i.e. Transfer).
7. Banking, financial, and insurance services are all available.
8. Any NRI (Non-Resident Indian) who owns 60% or more of a company in
another country.
9. Any Indian citizen, whether residing inside or outside the nation (NRI).

6. What is a foreign currency account? State the types of foreign currency

account

Foreign Currency Account (FCA) is a transactional account denominated in a

currency other than the home currency and can be maintained by a bank in the
home country (onshore) or a bank in another country (offshore).

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Types of Foreign Currency Accounts

1. Nostro Account:
In Latin, ‘Nostro’ means “our account with you”. Nostro account is the account
maintained by an Indian bank with an overseas/foreign bank. For example,
PNB may maintain an account with Citibank, New York. The account would be
in the host country’s currency, i.e., in US dollar. All foreign exchange
transactions are routed through Nostro accounts by Indian Bank.

2. Vostro Account:
In Latin, ‘Vostro’ means “your account with us”. A foreign bank, say Citibank,
New-York, may open Rupee account with State Bank of India. The account
would be maintained in home currency where account is opened, i.e., Indian
Rupees.

3. Loro Account:
Loro account’ word stands for ‘Their account with you’, in Latin. Say, State
Bank of India is maintaining an account with Citibank, New York. When
Syndicate Bank of India likes to refer this account during the course of
correspondence with Citibank, it would refer to it as ‘Loro Account’.

7. Difference between fixed and floating rates.

Fixed Exchange Rates Floating or Flexible Exchange Rates

It ensures stability in exchange rate Deficit or surplus in Balance of

which encourages foreign trade. Payment is automatically corrected

A fixed exchange rate ensures that

major economic disturbances do There is no need for the government
not occur. to hold any foreign exchange reserve

It prevents capital outflow &

speculation in foreign exchange It helps in optimum resource
market. allocation

Fixed exchange rates are more It frees the government from the
conducive to expansion of world problem of balance of payment.

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trade because it prevents risk and

uncertainty in transactions

8. What is IMF? State the objectives of international monetary fund.

International Monetary Fund came into existence on 27th December 1945

and has its headquarters located in Washington DC, United States. It has 190
countries as its members as of December 2022. Its board is constituted of
members from as many as more than 180 countries worldwide, thus each
representing its own nation
Objectives of International Monetary Fund (IMF)
• International Monetary Cooperation:
The most important objective of the IMF was to establish monetary
cooperation among the various member countries. One of the major causes of
the Second World War was the absence of monetary cooperation amongst the
countries of the world. Hence it was considered necessary to establish
international monetary cooperation to prevent the outbreak of war in future.
• To Ensure Stability in Foreign Exchange Rates:
There was a lot of instability in foreign exchange rates before the Second
World War, which produced adverse repercussions on international trade. So,
IMF was established to eliminate this instability of foreign exchange.
• To Eliminate Exchange Control:
Every country has resorted to exchange control as a device to fix its exchange
rate at a particular level before the Second World War, which produced
adverse effects on international trade. So IMF came up to remove or relax
these exchange controls.
• To Promote International Trade:
Another important objective of the IMF was to promote international trade by
removing all the obstacles and hindrances, which had the effect of restricting
it.
• To Promote Investment of Capital in Backward and Underdeveloped
Countries:
IMF exports capital from the richer to the poorer countries so that the poor
countries can develop their economic resources for achieving a higher
standard of living.
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• To Eliminate or Reduce the Disequilibrium in the Balance of Payments:

IMF helps to reduce the disequilibrium in the balance of payments by selling or
lending foreign currencies

9. What is the convertibility of rupee?

Convertibility of currency means when currency of a country can be freely
converted into foreign exchange at market determined rate of exchange that
is, exchange rate as determined by demand for and supply of a currency. For
example, convertibility of rupee means that those who have foreign exchange
(e.g. US dollars, Pound Sterlings etc.) can get them converted into rupees and
vice-versa at the market determined rate of exchange. Rupee is both
convertible on capital account and current account.

10. What is balance of payments? Briefly explain the components of

balance of payments.

The balance of payments is a comprehensive and systematic record of a

country's economic transactions with the rest of the world, encompassing
goods, services, and capital flows within a specified time frame. It comprises
the current, capital, and financial accounts, each reflecting different types of
transactions.
BoP can be classified as:

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1. Current Account
Current Account refers to the account, which records all the transactions that
relate to the actual receipts and payments of the visible items, invisible items,
and unilateral transfers during a specific period of time. It is a statement that
records the trade of goods & services and current transfers during a specific
period. In simple words, the current account focuses on the transactions
related to tangible items(goods), intangible items( services), and one-sided
transfers(gifts and grants).
Components of Current Account
It can be further categorized into:
1. Export and Import of Goods (Visible Trade or Merchandise Transactions)
Transactions in foreign trade mostly include the export and import of goods or
visible items. Payment for the import of visible items or goods is recorded on
the debit side and receipt from exports of visible items is recorded on the
credit side of the Balance of Payment Account. The balance of the visible
export and imports of goods is called Balance of Trade or Trade Balance.
2. Export and Import of Services (Invisible Trade)
It is also known as Invisible Trade because the services being intangible can
not be spotted moving across the border.
For example, insurance and banking. The balance of the invisible items
(exports – imports) is known as the Balance of Invisible Trade. The payments
of services are recorded on the debit side and receipts on the credit side of the
Balance of Payment Account. Services can be categorized into three parts; viz.,
Banking, Insurance, and Shipping.
3. Unilateral or Unrequited Transfers to and from abroad (One-sided
Transactions)
These transfers occur between a resident and a non-resident in the form of
gifts, grants, and donations. It also includes official transfers, like grants in cash
and donations. These are one-sided transactions and are commonly named
transfers for free. These are payments and receipts that occur without
receiving any in-kind services. It is generally considered as a part of ‘invisible’ in
the BoP account. The receipt of unilateral transfers from the rest of the world
is recorded on the credit side and payments on the debit side of BoP.
4. Income receipts and payments to and from abroad

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It involves investment income in the form of rent, profits, and interest.

2. Capital Account
It comprises all the transactions, which has a direct or indirect impact on the
assets and liabilities of the country or government with regard to the outside
world. Under this, transactions like loans and investments are recorded among
a country and the outside world. Thus, it can be concluded that capital
accounts cause potential claims. Sometimes, there is confusion regarding
whether the export and import of capital goods are to be included in the
Capital account or not. But the answer to this question is ‘No’. It is so because
the export and import of goods (whether capital or consumer) are included in
the current account. Thus, it is irrelevant in the case of the capital account. In
simple terms, a capital account includes those transactions, which cause a
change in the assets or liabilities of a country’s residents or its government.

Components of Capital Account

1. Borrowings and Lendings to and from abroad
The capital account consists of all the transactions related to borrowings from
abroad by the government, private sector, etc. The receipts and repayments of
such loans are recorded on the credit side of the BoP. Similarly, all the
transactions related to ‘lending to abroad’ by the government and private
sector are included in the capital account. These transactions are recorded on
the debit side of the BoP.
2. Investments to and from abroad
The second component of the Capital Account consists of all the investments
by the rest of the world in shares of Indian companies, real estate, etc. These
transactions from the rest of the world are recorded on the credit side of BoP,
as these transactions bring foreign exchange to the country. Besides, it also
includes all the investments made by Indian residents in shares of foreign
companies, real estate abroad, etc. These transactions are recorded on the
debit side of the BoP, as they result in the outflow of foreign exchange.
There are two types of investments to and from abroad:
1. Foreign Direct Investment: FDI consists of the purchase of an asset,
which gives direct control to the buyer over the asset.
For example, purchase of land, building, etc.

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2. Portfolio Investment: It consists of the purchase of an asset that does

not give any direct control over the asset to the purchaser.
For example, purchase of shares. Portfolio Investment also consists of FII
(Foreign Institutional Investment).

3. Change in Foreign Exchange Reserves

The financial assets of the government held in the central bank are known as
the Foreign Exchange Reserves. If there is a change in the reserves, it serves as
the financing item in India’s BoP. Hence, any withdrawal from the reserves is
recorded on the credit side of BoP, and any addition to these reserves is
recorded on the debit side of BoP. Also, any change in the reserve is recorded
in the BoP account and not in ‘Reserves’.

11. Briefly explain the functions of World Bank.

There several functions among some of them are important

 It helps the war-devasted countries by granting those loans for

reconstruction.

 Thus, they provide extensive experience and the financial resources of

the bank help the poor countries increase their economic growth, reducing
poverty and a better standard of living.

 Also, it helps the underdeveloped countries by granting development

loans.

 So, it also provides loans to various governments for irrigation,

agriculture, water supply, health, education, etc.

 It promotes foreign investments to other organizations by guaranteeing

the loans.

 Also, the world bank provides economic, monetary, and technical advice
to the member countries for any of their projects.

 Thus, it encourages the development of of-industries in underdeveloped

countries by introducing the various economic reforms.

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12. Briefly explain the features of foreign exchange markets.

This kind of exchange market does have characteristics of its own, which are
required to be identified. The features of the Foreign Exchange Market are as
follows:

1. High Liquidity

The foreign exchange market is the most easily liquefiable financial market in
the whole world. This involves the trading of various currencies worldwide. The
traders in this market are free to buy or sell the currencies anytime as per their
own choice.

2. Market Transparency

There is much clarity in this market. The traders in the foreign exchange
market have full access to all market data and information. This will help to
monitor different countries’ currency price fluctuations through the real-time
portfolio.

3. Dynamic Market

The foreign exchange market is a dynamic market structure. In these markets,

the currency values change every second and hour.

4. Operates 24 Hours

The Foreign exchange markets function 24 hours a day. This provides the
traders the possibility to trade at any time.

13. What are the factors determining spot exchange rates?

The spot exchange rate is very important as it determines the value of cross-
border transactions, such as international trade and investment. In addition, it
provides a basis for calculating the value of one currency in terms of another
currency, which is necessary for conducting business across borders.

1. Balance of Payments:

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Balance of payments is a statement which shows the total demand and supply
of a foreign currency which helps in determining the value of the currency.
Various exports (whether of goods or services) and the imports, affect the
balance of payment continuously.

2. Inflation:

Inflation rate means the rate at which the cost of living of people of a country
is increasing. Putting it in different words, the inflation rate depicts the rates at
which the cost of various goods and services under its scope are increasing.
The case where they are reducing it is known as deflation. The relative changes
in the inflation rates of different countries results into different value of the
local or domestic currency.

3. Interest Rates:

The interest rates on various deposits and on loans are different across the
countries of the globe. This is due to the economics concept of demand and
supply. If the capital is available in abundance in a country, then the rate
offered on deposits will be low. And if the requirement of capital is more than
its supply, the rates of which loans will be given will be high.

4. Money Supply:

The total money quantum available in a country during a period is known as

money supply. The money supply shows the total money available in an
economy during a period, which helps in determining the rates of interest,
inflation, etc.

5. National Income:

National income shows the total income of the residents of an economy. The
increase in national income results into increase in supply of money and in turn
results into increase in production or creation of production capacities.

6. Resource Discoveries:

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When a country discovers resources, and starts exporting them, it results into
their strong position in exchange market. A good example can be of the oil,
which plays a significant role in foreign exchange market through its export
and import in the International market, through International Trade Thus,
when the supply of oil, in raw or finished form from its major suppliers, such as
Middle East, becomes insecure, the demand of the currencies of this countries
increase.

7. Capital Movements:

Short-term movement of capital from one country to another is normally

influenced by the interest rates in a country. As seen in the discussion of
interest rates, the country with higher rate of interest will get more capital
supply in comparison to the countries providing lower rate of interest.

8. Political Factors:

The look out of government towards the foreign market and international
trade and commerce define their policies. A steady government of a country
provides more time to investors of different countries to decide their strategies
and take steps of investing.

16. Briefly explain the functions of monetary fund.

The functions of the International Monetary Fund are as follows:

• Stability in Foreign Exchange Rate:
IMF helps to achieve stability in foreign exchange rates. The rates of exchange
under the IMF had not fluctuated as much as they used to before the
establishment of the IMF.
• Currency Reservoir:
IMF serves as a repository for all of the member countries’ currencies, from
which a borrowing nation may borrow funds from other countries. All member
countries can park their surplus funds with the IMF. These parked funds are

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then utilized to extend credit to the members, which need funds the most at a
given point of time.
• Advisory and Technical Assistance:
IMF helps its member countries through its policy advice and technical
assistance in formulating sound policies and building strong institutions.
• Support for Low-Income Countries:
IMF provided help to its low-income members with policy advice, technical
assistance and loans for poverty reduction and reducing the debt burden.
• Establishment of a Monetary Reserve Fund:
IMF helps to establish monetary reserve by accumulating a sizeable stock of
the national currencies of different countries. It is out of this stock that the
Fund meets the foreign exchange requirements of the member countries.

• Setting up of a Multilateral Trade and Payment System:

IMF helps to set up multilateral trade and payment system. Member countries
were allowed to impose exchange control on commercial transactions, but it
was hoped that these restrictions on foreign trade would be eliminated.
• Check on Competitive Currency Devaluation:
For boosting exports, different countries of the world would often resort to
competitive currency devaluation before the establishment of the IMF. IMF
helps to keep a check on competitive currency devaluation.

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