Neel Narsinghani

18/11/2014

2014RBI and Foreign Exchange Management

SVKM’S

NMIMS SCHOOL OF LAW

A PROJECT SUBMITTED ON;

RBI and Foreign Exchange Management

IN COMPLIANCE TO PARTIAL FULFILLMENT OF THE MARKING SCHEME, FOR TRIMESTER II OF 2014-2015, IN THE SUBJECT OF

ECONOMICS – II

SUBMITTED TO FACULTY:

Ms. BHAKTI KULKARNI

SUBMITTED BY:

Neel Narsinghani

BBA LLB (HON’S) ROLL NO – A059

RECEIVED BY: ____________________________

ON DATE: __________ TIME: _________

Page 1 of 34

INDEX

Sr.No Topics Page. No

Chapter 1.

Research Methodology Relevance of Topic Scope of Study Objective of Study Hypothesis Limitation of Research

04-05

Chapter 2.

Introduction Origin and Evolution Origin and evolution in India Contemporary position Contemporary position in India Role Of RBI in Foreign Exchange Management

06-10

Chapter 3.

Macro Economics Analysis Analysis in Macroeconomics

Theories Exchange rate determination Diagrams

11-16

Chapter 4.

Relationship between Economics and Law Interdisciplinary Linkage Constitutional Provisions

17-22

Chapter 5.

Comparative Study India and US Between Different aspects of economics

23-27

Chapter6.

Summary 28-29

Chapter7.

Suggestions 30-31

Chapter8.

Bibliography 32

Page 2 of 34

Table of Abbreviations used

Sr.No Abbreviation Full Form1. Govt. Government2. FY Financial Year3. GOI Government of India4. IT Income Tax5. GDP Gross Domestic Product6. Prof. Professor7. US United States8. SC Supreme Court9. UK United Kingdom10. SGD Singapore Dollar11. AUD Australian Dollar12. FERA Foreign exchange regulation Act13. FEMA Foreign Exchange Management Act14. LERMS Liberalized exchange rate management system

15. MFER Managed Flexible Exchange Rate

Table of Statutes Referred

Statute YearConstitution of India 1950FERA 1973FEMA 1999Reserve Bank Of India Act 1934

CHAPTER 1

Page 3 of 34

Research Methodology:

Relevance of the topic:

The topic being “Foreign exchange management and RBI” is highly relevant in

today’s world is related to sеvеral aspеcts of еconomics and law, this at thе samе timе

makеs it a grеat topic to rеsеarch on. This system of exchange management has been

gaining importance from the last one century as international trading is on the rise and

each economy has realised that it can no longer be self-reliant. Due to this, this topic

has started gaining importance, without which a national will be impaired from its

ability to trade in the international market. As it plays with the value of the currency in

the international market, it has to be given prime importance, because it is the value of

a currency in the international market that affects the whole of the economy within the

country.

Scope of the study:

The study is focusing to reveal the insights of the Foreign Exchange Management.

This ‘looking so simple task’ is actually a hericulan and one of the most complex tasks

carried out by the Reserve Bank of India. The study attempts to give the utmost

insight needed to simplify the understanding of this management. It also compares the

management done by the RBI than that of the Foreign banks, and how the US$ dollar

is managed in quite a different manner than that of rupee.

Objective of the Study:

The objective of the study is to research on the topic of Foreign Exchange

management by RBI in detail, and globally in brief. Although, the main objective of

the study to gain personal knowledge on topic but there are other objectives too. With

the rising importance of trading in the international market, it has become one the

main object of the study to focus on the trading aspect that is related to foreign

exchange management.

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Research Question/Hypothesis:

Why is it the need of the hour to study foreign exchange management?

What different aspects of economy are affected by foreign exchange

management?

Why is it considered so complex?

Does US$ have an edging advantage over the other of having a globally

accepted currency?

How does the RBI manage this process?

LIMITATIONS:

Thеrе arе sеvеral limitations of this projеct too bеcausе I am not ablе to covеr thе

еntirе topic and dеpth study of all thе arеas. Somе portions of thе Foreign Exchange

Management arе not covеrеd undеr this study duе to thе lack of undеrstanding of thе

topic. Thе projеct fails to conduct a primary rеsеarch thorough еxamination,

intеrviеws and survеys duе to lack of timе. Thе rеsеarch of thе projеct limits to books

and intеrnеt contеnt.

Chapter 2

IntroductionPage 5 of 34

Foreign exchange is the “The exchange of currency from one country for currency

from another country.”1 Or it may also be defined as “System of trading in

and converting the currency of one country into that of another.”2

Origin and Evolution:

Before the system of money, barter system was prevalent. In the barter system, the

commodities were exchanged between people to fulfil the needs of the entire

population. But with the passage of time this system of trading faced many challenges,

for eg. The need of everyone could not be satisfied with the rise in population. The

system of printed money had to come into existence because of the drawbacks of the

barter system. With the emergence of the new exchange system, the problems of the

old barter system were solved but with the passing time, it also had to face a few

challenges.

With the formation of new countries, each one of these started developing their own

currency to trade in. In the initial stage, this did not cause any problem, for trading

within the country the printed money proved very useful. Difficulties arose when there

was a question of exports and imports. Each country with its own currency was

trading within its boundaries, but the question was, how the payment will be done

when there are exports and imports. This question arose because each country had a

different currency and did not recognise other currency. So the currency of one

country was totally worthless in the other. This made trading between the countries

difficult as there was no proper medium of exchanging the money. Finally, each

country had to maintain other countries currency reserves so as to continue trading

between the two.

Origin and evolution in India:

1 http://en.wiktionary.org/foreign_exchange2 http://www.businessdictionary.com/definition/foreign-exchange-Forex-or-FX.html

Page 6 of 34

Under the Bretton woods system India declared the par value of rupee in terms of gold

as equivalent of 0.268601 rams of fine gold. Historically, rupee was linked to rupee

sterling. In terms of pound sterling, the parity was Rs 1= 1 shilling and 6 pence.3

In September 1949, the pound sterling was devalued and there was a corresponding

devaluation of the rupee. The gold content of the rupee was reduced to 0.186621

grams. In June 1966 India devalued rupee by 37.5 per cent and the parity rate of the

rupee was fixed at US$ 0.133333 equivalent to a gold parity of 0.118489 grams.(Note-

There was free convertibility of US dollars into gold at the official rate of US$ 35 per

ounce. In 1971, the fixed parity system, or what was better known as the Bretton wood

parity system broke down, the major currencies started floating. The US suspended

the convertibility of US dollar into gold. Then it was decided to peg the rupee to dollar

at Rs 7.50. The RBI however retained pound sterling as the currency for intervention.4

The rate of pound sterling was determined on the basis of the rate of US dollar to

pound sterling in the London market. In September 1975, Rupee was delinked from

the pound sterling and linked with a basket of currencies. The value of rupee was

determined by the value of currencies that constituted the basket.

Contemporary position:

The subject of foreign exchange reserves has received renewed interest in recent times

in the context of increasing globalisation, acceleration of capital flows and integration

of financial markets. Each nation has its own official currency, which is normally

issued by the central bank of the country.

The two basic questions that arise out of this are:

How is the value of rupee, that is, the rate of exchange determined?

Is the rupee convertible?

The answer to the first question is fully determined by market forces. TO answer the

second question, the concept of convertibility should be understood. ‘Convertibility

means the conversion of a currency by his holder into any currency of his choice at

3 Pg 171; Foreign Exchange Markets;Dun & Bradstreet4 Pg 61; Foreign Exchange Simplified;B.Srinivasan

Page 7 of 34

market determined rates.’5 The rupee today is convertible on all current account

transactions, though therer are a few restrictions the capital account. The classification

of a transaction into current account or capital account is based on the classification

the balance of payment. Current account transactions are those that relate to the trade

in goods and services. Capital account transactions are those which bring about a

change in the assets and liabilities position of a country, such as external debts,

investments etc. India with its huge forex reserves is progressively moving towards

making the rupee convertible on capital market too.

The Indian Contemporary position:

In 1973, FERA was amended and it came in force on January 1st, 1974. It gave wide

powers to RBI to administer exchange control mechanism properly. With effect from

March 1992, the US dollar was adopted as the intervention currency is place of

sterling and rupee was partially floated. This System was known as liberalized

exchange rate management system (LERMS). The 1993-94 Budget made Indian

Rupee fully convertible on trade account. LERMS was withdrawn. Developing

countries allowed market forces to determine the exchange rate. Under flexible

exchange rate system, if demand for foreign currency is more than that of its supply,

foreign currency appreciates and domestic currency depreciates and vice versa. To

minimise the disadvantages of flexible exchange rate, most of the developing

countries including India have adopted the concept of managed Flexible Exchange

Rate (MFER).

Under MFER, the Central bank intervenes to bring stability in exchange rate. RBI’s

intervention involves purchase of foreign currency from market or release (sale) of

foreign currency in the market, to bring stability in exchange rates.

ROLE OF RBI IN FOREIGN EXCHANGE MARKET

The role of RBI in the foreign exchange market is revealed by the provisions of

FERA (1973):

5 Pg 150;Foreign Exchange simplified;B Srinivasan.

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Administrative Authority

 The RBI is the administrative authority for exchange control in India. The

RBI has been given powers to issue licences to those who are involved in

foreign exchange transactions

Authorised Dealers

The RBI has appointed a number of authorised dealers. They are permitted to

carry out ail transactions involving foreign exchange. The above provision is

laid down in Section 3 of FERA.

Issue Of Directions

The 'Exchange Control Manual' contains all directions and procedures given

by RBI to authorised dealers from time to time.

Fixation Of Exchange Rates :- The RBI has the responsibility of fixing the exchange value of home currency in terms of other currencies. This rate is known as official rate of exchange. All authorised dealers and money lenders are required to follow this rate strictly in all their foreign exchange transactions.

Foreign Investments :- Non-residents can make investments in India only after obtaining the necessary permission from Central Government or RBI. Great investment opportunities are provided to non-resident Indians.

Foreign Travel :- Indian residents can get foreign exchange released from RBI up to a specified amount for travelling abroad through proper application.

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Import Trade:- The RBI regulates import trade. Imports are permitted only against proper licenses. The items of imports that can be imported freely are specified under Open General Licence.

Export Trade:- The RBI controls export trade. Export of gold and jewellery are allowed only with special permission from RBI.

  Gold. Silver. Currency Notes Etc. :- In recent years, the limits fixed for bringing gold, silver, currency notes etc. has been relaxed considerably.

Submission Of Returns:- All foreign exchange transactions made by authorised dealers must be reported to RBI. This enables the RBI to have a close watch on foreign exchange dealings in India. Thus, from above points we can say that RBI is the apex bank that intervens, supervises, controls the foreign exchange markets in order to create an stable and active exchange market.

Page 10 of 34

CHAPTER 3

MACRO ECONOMICS ASPECT

Analysis in Macroeconomics:

Foreign Exchange, which is a study of macroeconomics, holds high importance even

in the Microeconomic aspects. Foreign exchange is affected by all the important

factors of Macroeconomic study, such as GDP, GNP etc, thus becomes a very

important subject to study because of its effects at the Micro level. There are no two

opinions about its importance as a Macroeconomic study, but at the micro level too, it

is very important for its effect on the People. For eg-Travellers.

Understanding the role of banks:

Banks play a vital role. They perform many functions,. But the most important one is

that they are intermediaries through whom documents are exchanged for money

between exporters and importers. They are also the extended arms of the RBI and the

administration of FEMA. Every commercial bank deals in foreign exchange since it is

an activity with good potential for profits. But broadly we could classify the functions

into:

a) Finance of exports

b) Finance of imports

c) Misc. services like traveller’s cheques, currency encashment, etc.

d) Dealings, Rates of exchange etc.

To facilitate dealings in foreign exchange, a bank in India maintains account with

banks abroad. Similarly, some foreign banks may maintain the bank account in India.

In Banking terminology, these are known as Nostro account and Vostro account.6

Nostro account:- Nostro account means our account with you. For example, BOI

maintains an account with Natwest bank London. Obliviously, this account will be

maintained in pound sterling. When corresponding with the Natwest bank, BOI will

refer to its account with Natwest bank as nostro account, meaning our account with

you.

6 http://www.slideshare.net/anujzeal4u/rbi-intervention-in-foreign-exchange-market

Page 11 of 34

Vostro account:- The account pended by a foreign bank in Indian rupee with an

Indian bank would be referred in all the correspondence by the Indian bank as Vostro

account, meaning your account with us. For eg- Bank of Middle East, sharjah

maintains a rupee account with Syndicate bank, Mumbai. Syndicate bank in all its

correspondence with bank of middle east would refer to this account as vostro

account.

While analysing the Macro-economic point, the question arises of how does a

trade in currencies?

Any trading has two aspects: purchase and sale. So, going by this rule, the bank would

either purchase the commodity (Foreign currency) or sell the commodity (Foreign

currency). Banks would thus be paying Indian rupees for purchase of currency and

would accept Indian rupees and deliver foreign currency in a sale transaction. What

must be kept in mind is that the transaction classification, that is, a purchase or sale is

always referred to as banks point of view and the item referred to is the foreign

currency.

Purchase transaction means bank purchases/acquires foreign cuurency and pays the

home currency (Indian Rupees).

Sale transaction means bank sells/parts with foreign currency and accepts the home

currency (Indian rupees).

The Following chart best depicts the purchase and sale of transaction:

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Following can the examples of the purchase and sale transaction:

The bank issues a demand draft on London for £ 5000 on behalf of XYZ –

Sale transaction.

A telephonic transfer from Unilever Ltd. London in favour of Pilmur

enterprise for US$ 25000- purchase transaction.

A traveller enchases a traveller cheque for US$ 100 and currency notes of

US$ 200- sale transaction.

A customer comes with demand draft of Jap¥ 200000 to the bank for

encashment.

Theories:

Foreign Exchange management and markets are solely based on exchange rates. In

Finance, an exchange rate between two currencies is the rate at which one currency

will exchanged for another. It is also regarded as the value of one countries currency

in terms of another currency. While discussing international trade and foreign

exchange, two types of exchange rates are used:

Real Exchange rate

Nominal Exchange rate

Real exchange rate describes how many of a good or service in one country can be

traded for one of that good or service in another country. For example, a real exchange

rate might state how many European bottles of wine can be purchased for one US

bottle of wine. The real exchange rate abstracts away these issues, and it can be

thought of as comparing the cost of equivalent goods across countries. The real

exchange rate is the relative price of the goods of two countries. That is the real

exchange rate tells us the rate at which we can trade the goods of one country for the

goods of another. This real exchange rate is sometimes called the Terms Of Trade.

The Formula to calculate the real exchange rate is7

7 http://www.businessdictionary.com/definition/foreign-exchange-Forex-or-FX.html

Page 13 of 34

Real Exchange rate= (Nominal Exchange rate x domestic price) / (foreign price)

Nominal exchange rate is simply the price of one currency in terms of the number of

units of some other currency. It is nominal because it measures only the numerical

exchange value, and does not say anything about other aspects sch as the purchasing

power of that currency. An increase in the value of domestic currency against other

currency is called an appreciation and a decrease in value is called depreciation.

Usually, in practical world, to find the current exchange rate of a currency, it is

generally expressed in Nominal Terms. To calculate the Nominal Exchange rate,

simply measure, how much of one currency will be necessary to acquire one unit of

another. Formula:

Exchange Rate Determination:

The Price of any commodity is dependent on its supply and on its demand. In the

Foreign exchange market, the commodity is the foreign currency, i.e. the US dollar,

Japanese yen, euro, Swiss francs, pound sterling, and a host of other currencies. The

price of these currencies is called the exchange rate. The demand for, and supply of

these currencies would determine the rate of exchange. Now One of the basic question

that arises out of this is:

Who creates the demand and who Supplies?

The importer of goods and services, people wanting to remit money abroad for

whatever purpose, persons intending

to travel abroad and a host of other

people create a demand for currency

which could be US dollars, pound

sterling, etc. They need these

currencies since they have to make

payment to the overseas suppliers of

goods and services. To keep it simple,

it could be stated as if you are an

Page 14 of 34

Nominal Exchange Rate= (Real Exchange rate x foreign price) / (Domestic price level)

importer you operate on the demand side and if you are an exporter; you are on the

supply side.

But, Demand and supply are not the only factors affecting exchange rate; there are a

few others too.

For Example

a) Balance of Payments

It is a record of the value of all the transactions between residents of a country with

outsiders. In other words it represents the demand for and supply of foreign exchange

which will determine the value of the currency. Exports represents the supply side;

while imports create demand for the currency.

b) Inflation

This means rise in the prices of the domestic commodities. With increase un price the

exports maybe affected as it will cease to be competitive. To give an example, if both

India and US experience 7% inflation, the rate of exchange will not change. If on the

other hand India has 15% inflation and US has 5% inflation, then obviously the Indian

rupee will depreciate by 10%.

c) Money Supply:

An increase in the money supply in the country increases the supply of currency in the

foreign market and its value declines.

d) Political factors

Political stability induces confidence in the investors and encourages capital inflow

into the country. This would strengthen the currency and it would appreciate. In

likewise fashion where the political situation is volatile there the value of currency

will decline.

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Page 16 of 34

Diagrams:

Below is the example of Foreign exchange reserves of India in US$ dollars(Million)

Date 30th

Sept 2011

31st Oct 2011

30th

Nov 2011

31st Dec 2011

31st Jan 2012

29th Feb 2012

31st

March 2012

Foreign Exchange Reserves

311,428 316,210 307,976 296,470 292,670 295,325 294,149

Page 17 of 34

CHAPTER-4

REALTIONSHIP BETWEEN ECONOMICS AND LAW

Interdisciplinary Linkage:

Economics and Sociology

According to Thomas, “Economics is a branch of comprehensive science of

sociology.” The fact that society is influenced by economic factors while environment

processes are largely determined by the social environments clearly proves that

relation between sociology and economics is very intimate. Economic Sociology is the

study of cause and effect of various economic phenomena.

Coming to the topic of the foreign exchange management, it is quite a way related to

the society at large. The activities carried out during the process of this management

ultimately have an impact on the general public. This management affects the value of

rupee in the Global market. Thus, due to this the value of rupee appreciates or

depreciates. This appreciation or depreciation ultimately affects the citizen or the

people of the country and thus has an impact on the society.

Economics and Political Science

Political Science and Economics are social sciences. Political science is the study of

politics in theory and practice, while economics is the study of how resources are

produced, assigned, and circulated. Political science is the science of governance.

Foreign exchange management is important for all the governments to that have to

work at the centre. It is through proper foreign exchange management that they will

have the enough foreign reserves to pay for the imported goods and services that

suffice the needs of the people in the country. Without this, the country has to be self-

reliant, that in today’s world is a herculious task. So, it is the government that has to

take utmost care while formulation the norms for such a task that effects on all the

sections of the economy.

Page 18 of 34

Present Legal framework:

The subject of Foreign Exchange Management is quite related to Law. All the

happenings needed to carry out foreign exchange management are backed by law.

The head of such management in any country is its central bank, that itself is a

legal body. For eg In the case of India, it is the RBI (Reserve Bank Of India), that

itself is recognised by Law. The Functions carried out by this Bank are related to

Foreign exchange management are codified properly and have various laws

governing it.

Foreign Exchange Management being very complicated process requires various

laws to govern the complete process. The laws govern day to day activities of the

management of currencies. Various statues governing such trading of currency

have become an integral part of any economy in the world. Foreign exchange

management is quiet a lengthy subject which comprises of many stages right from

acquiring foreign exchange to Selling it off, and there have to be laws governing

each aspect. As there are different problems that each country has to face regarding

the management, the remedies, i.e. the laws, also have to be home grown. There

cannot be a single set of laws that can be applicable on all the countries. Thus such

framing of laws even though makes the process more complex, but at the same

time helps towards making the system effective. With Laws falling into place, it is

only the system and method of the trading that has to take place effectively so as to

make profits during the deal.

Without Law governing all these happenings, there is no way that such a complex

management could have worked effectively and bring about a positive change in

the economy. But, it is not only the laws that have to be implemented to get

results, laws only come into force only when the guidelines are not adhered to. But

Page 19 of 34

for gaining efficiency I the process, it is the management that will make the

difference.

As explained above, Laws are guiding each and every process of foreign exchange

management. In India, the RBI that is the central bank undertakes this management.

All this management has to be according the predetermined codes, rules, and

regulations. Such rules are codified into FEMA (Foreign exchange management Act).

Following are the details about the Foreign exchange management Act of India:

FEMA 1999, the acronym for Foreign Exchange Management Act 1999, was notified

by the government of India8, Ministry of Finance vie notification No. GSR (371)(E)

dated May 1, 2000, and has been in force since June 1,2000. This act replaced Foreign

Exchange Regulation Act (FERA) 1973. FEMA consists of 49 sections spread over

seven chapters9

Section 46 confers power to the government to make rules to carry out the

provisions of the act and broadly defines the area in which it may make rules.

Section 5 provides that the central Govt. may in the public interest and in

consultation with the RBI impose such reasonable restrictions for current

account transactions. So you could say that section 5 is an inclusive portion of

section 46.

Section 6 confers power to RBI to regulate, prohibit, restrict through

regulations and broadly defines its area of operation.

Administration of the Act

8 http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/VMBPW121212.pdf9 Pg 279;Foreign Exchange simplified;B Srinivasan.

Page 20 of 34

Foreign Exchange Management Act (FEMA) 1999

Government of India

Reserve Bank of India

(Note- This study has mainly focused on the Current account transactions and not the capital account ones.)

Current Account Transactions and Its Rules

What is meant by current account transactions?

Current account transaction means a transaction other than a capital account

transaction and includes

Payments, due in connection with foreign trade, other current business, services,

and short-term banking and credit facilities in the ordinary course of business.

Payments due as interest on loan and as net income from investments.

Remittances for living expenses of parents ,spouse and children residing abroad

and.

Expenses in connection with foreign travel, education, and medical care of parents,

spouse and children.

Who is an authorised person under FEMA?

Authorised person means an authorised dealer, a moneychanger, offshore banking

unit or any other person for time being authorised in writing by RBI to deal in foreign

exchange10. And you as a person would have to deal only with the authorised person

and no one else when you

Deal or transfer any foreign exchange or foreign exchange or foreign security.

Make any payment to or to the credit of any person outside India, in other

words remitting money out of India.

Receive any money or payment by order in any manner from abroad.

What are the rules regarding account transactions?

In terms of the provisions of FEMA any person may sell or draw foreign exchange to

or from an authorised dealer if such sale or drawal is a current account transaction.

Which means there are hardly any restrictions.

10 http://www.bis.org/publ/bppdf/bispap73l.pdf

Page 21 of 34

But there are a few restrictions mentioned as under:

Those prohibited by the FEMA Act-transactions listed in Schedule I.

Transactions which require the prior permission of the govt- transactions

listed in the schedule II.

Transactions which require the prior approval of the RBI-transactions

listed in schedule III.

Schedule I (prohibited transactions)

There are certain restrictions, drawal of exchange for the following transaction is

prohibited

Travel to Nepal or Bhutan.

Transactions with a person resident in Nepal or Bhutan.

Remittance of income from racing/riding, etc, or any other hobby.

Remittance for purchase of lottery tickets, banned/proscribed magazines,

football, pools, sweepstakes, etc.

Payment of commission on exports made towards equity investment in joint

ventures/wholly owned subsidiaries abroad of Indian companies.

Remittance of dividend by any company to which the requirement of dividend

balancing is applicable.

Payment of commission on exports under Rupee State Credit Route.

Payment related to call back services of telephones.

Remittance of interest income on funds held in Non-Resident Special Rupee

Scheme.

Schedule II (Prior Permission of the govt.)11

No person shall draw foreign exchange for a transaction included in the schedule II

without prior approval of the govt. of India; provided that this rule shall not apply

where the payment is made out of funds held in Resident Foreign Currency(RFC)

account of the remitter.

11 http://www.rbi.org.in/scripts/statistics.aspx

Page 22 of 34

Schedule III (Prior Approval of Reserve Bank)

No person shall draw foreign exchange for a transaction included in the schedule III

without prior approval of the RBI; provided that this rule shall not apply where the

payment is made out of funds held in RFC (Resident Foreign Currency) account of the

remitter.12

Another question that may arise in the minds of reader is that why are drawal of

exchange for travel and transactions with Nepal/Bhutan prohibited?

This is because for exchange control purposes, rupee accounts maintained in India

By citizens of India, Nepal, and Bhutan.

Residents in Nepal and Bhutan.

Indian, Nepalese, and Bhutanese firms, companies or other organisations.

Banks functioning in these countries.

are regarded as resident accounts and rupee transfers to such accounts, for imports

into India (or for any other purpose), may be made freely, without reference to the

RBI. Hence sale of foreign exchange for current account transactions with persons

residents in Nepal and/or Bhutan, or against import into these countries made by

residents in India is prohibited.

12 http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14350#int

Page 23 of 34

CHAPTER-5

Comparative study:Comparison between India and the US:

The role of Rupee as a currency and how the exchange is done in the international

market has been explained above. Rupee, like every other currency has to face the

challenges as faced by every other currency. Rupee, like every other currency, has to

see the appreciation and depreciation based on the economic conditions of the

country. This section will be primarily analysing the Merits and Demerits of having

a Global Currency – “US$”

It is usually believed that America is having an edge over the other due to the

advantage of having a global currency. So, this section will compare that if there are

any such advantages to America.

In the following we will recall the determinants of an international currency. From

these

relationships we derive a simple graphical model which highlights some of the

benefits for an economy with a currency with reserve currency status. This model

exhibits the relationship between the foreign exchange market as well the capital

market. The supply of US dollars on the foreign exchange market has a positive

upward slop – with an increasing exchange rate (dollars become more expensive

relative to other currencies) more dollars will be supplied to the market. The US

dollar supply curve can be shifted by a change in liquidity – for instance increasing

the amount of US Treasuries (or other dollar assets) by the Federal Reserve. For the

purpose of this model, liquidity remains the only variable of the US dollar supply

curve. The US dollar asset demand curve has a negative downward slope: When the

exchange rate rises, the demand for US dollar assets declines. Liquidity and network

effects increase the international demand of US dollars by private and public actors,

due to its international currency status. The variable initiating a shift in the US dollar

demand curve is therefore liquidity, which would not be the case for currency

without international currency status. If the variable liquidity is altered, the US

supply as well as the US demand curve is shifted.

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America, never had the problem of acquiring foreign exchange, as there is the

currency universally accepted. Here’s what that means…

Let’s say you’re from England and you want to buy oil from Russia.  You can’t just

pay for your oil in British Pounds, because the oil is priced in dollars as are all

commodities.

So you have to buy dollars first, and then buy your oil.

This is partly why a gallon of gas in England is $7.75, more than double the average

price of gas here in the states.

And so, the value of the Pound is of great importance to the British government.   In

order to maintain the value of its currency, the British must produce at least as much

as they consume from around the world — otherwise the value of its currency will

begin to fall, causing prices to rise and its standard of living to decline.

But in America, they able to consume as much as they want without worrying about

acquiring the money to pay for it, because their dollars are accepted everywhere

around the world.   In short, for decades now, they haven’t had to produce anything or

export anything to get all the dollars they needed to buy all the goods our country

wants.

In the end, if all you need is dollars to buy things, then just make more dollars.   And

if you live in the country where dollars are produced, then you’re on easy street.

It is widely believed that the dollar is overvalued.It is difficult to be precise about

what proportion of this overvaluation is due to the reserve currency status of the

dollar. According to the statistical estimates in an EPI Briefing Paper by Robert

Blecker, the rise in the dollar exchange rate up to 2002 caused the following negative

effects on the US economy:

• A loss of three-quarters of a million U.S. manufacturing jobs;

• A decline in profits on U.S. manufacturing operations of about $100 billion per

year;

• A reduction in capital expenditures at U.S. manufacturing plants of over $40 billion

at an annual rate.

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This is a clear advantage of the reserve currency issuer. But the large accumulation

in recent

years of foreign-held US debt has created a potentially significant responsibility that

could increasingly limit US policy autonomy. An argument could be made that the

reserve currency status is increasingly creating larger costs to the US economy by

forcing the United States to run significant current account deficits and accumulate

debt. This is similar to Triffin’s Dilemma, first identified in the 1960s. Triffin’s

Dilemma is the idea that because the reserve currency issuer must provide liquidity

to the global system by issuing debt denominated in its currency, at some point the

pressure to provide additional debt will endanger the sustainability of the reserve

currency issuer. This could possibly place the system under great strain and cause it

to fall apart.

Cost and benefit in crisis years

What has been stated thus far about costs and benefits relates to normal economic

conditions. We will now consider how the distribution of costs and benefits changes

in an economic downturn. The net benefit as a result of reserve currency status is $40

billion to $70 billion in a normal year (0.3 to 0.5 percent of GDP).These figures

reduce in a bad economic conditions to the range of a net cost of $5 billion to a net

benefit of $25 billion (0 to 0.2 percent of GDP) annually. This decline in the size of

the net benefit occurs due to substantial inflows of foreign capital into the American

economy during a crisis year. There is a subsequent rise in foreign purchases of US

Treasuries which significantly increases the capital cost advantage in early 2009.

However, this larger benefit was outdone by a sharp appreciation of the dollar, which

had negative consequences on the competitiveness for the exporting industry as well

as companies in competition with imported goods and services. In the US Dollar

Index for the past decade, the dollar appreciated considerably during the financial

crisis, which had a highly negative effect on company’s competitive position. The

incurred cost for trade increased from $30 billion to $60 billion in a normal year to

between $85 billion and $115 billion during the financial crisis in 2009 (a negative

impact on GDP of 0.5%).This exhibits some of the problems that a reserve currency

issuer faces in global economic downturns. The overall benefit of reserve currency

status diminishes to negligible levels.

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Comparison between different aspects of economics:

Foreign exchange is a concept that is related to the majority of economic activities.

In this study it will be compared with the trading aspect of macroeconomics, i.e.

Imports and Exports.

These economics concepts form a circle of relations, i.e. both the topics are affected

by each other. There is effect of foreign exchange on the exports and imports of the

country, and on the other hand, the exports and imports also have impacts on the

Foreign exchange in the country. This is will be explained in detail in the following:

Exports: Exports are usually believed to be good for an economy, which to some

extent is quite true. They are good till the extent the residents of the country do not

face the lack of goods due to over-exporting. Coming to the effects of exporting on

foreign exchange, they are usually positive. With the rise in exports we get to earn

more foreign exchange. This helps us to pay for the imports we do. Now coming to

what is the effect of foreign exchange on exports- A country can only trade when it

has reserves of the currency it wants to trade in. Thus is the country with which one

wants to trade is not having enough reserves of the currency that has to be

exchanged, then the trading cannot take place.

Imports- Imports, in general are not believed to be a good sign of an economy. It has

negative effects on the economy and the currency. With the rising imports, we have

to pay more to the other countries. For this we require more foreign exchange to pay

for. This is the reason, each economy lays high duties on the imports, so that due the

high duties on imports, there can be less of imports. There are two possibilities that

may happen in the case of imports:

i) The currency to be traded in is a foreign currency

ii) The currency to be traded in is the local currency

Well, both of these have negative impacts. When the currency to be traded in is the

foreign currency, we will have to acquire more of that currency, and this process we

have to sell our exchange that we had earned through the exports. In this process, the

demand of that currency rises and it appreciates in comparison to ours. The second

possibility, when the currency of exchange is our currency, then we will have to shell

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out our currency to get the desired services, In this process, we create additional

supply of our currency in the global market and the value of our currency depreciates.

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CHAPTER-6

CONCLUSION

Summarization of the chapters:

The Reserve Bank, as the custodian of the country’s foreign exchange reserves, is

vested with the responsibility of managing their investment. The legal provisions

governing management of foreign exchange reserves are laid down in the Reserve

Bank of India Act, 1934.

The Reserve Bank’s reserves management function has in recent years grown both in

terms of importance and sophistication for two main reasons. First, the share of

foreign currency assets in the balance sheet of the Reserve Bank has substantially

increased. Second, with the increased volatility in exchange and interest rates in the

global market, the task of preserving the value of reserves and obtaining a reasonable

return on them has become challenging.

The basic parameters of the Reserve Bank’s policies for foreign exchange reserves

management are safety, liquidity and returns. Within this framework, the Reserve

Bank focuses on:

a) Maintaining market’s confidence in monetary and exchange rate policies.

b) Enhancing the Reserve Bank’s intervention capacity to stabilise foreign exchange

markets.

c) Limiting external vulnerability by maintaining foreign currency liquidity to absorb

shocks during times of crisis, including national disasters or emergencies.

d) Providing confidence to the markets that external obligations can always be met,

thus reducing the costs at which foreign exchange resources are available to market

participants. e) Adding to the comfort of market participants by demonstrating the

backing of domestic currency by external assets.

The Reserve Bank’s approach to foreign exchange reserves management has also

undergone a change. Until the balance of payments crisis of 1991, India’s approach to

foreign exchange reserves was essentially aimed at maintaining an appropriate import

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cover. The approach underwent a paradigm shift following the recommendations of

the High Level Committee on Balance of Payments chaired by Dr. C. Rangarajan

(1993). The committee stressed the need to maintain sufficient reserves to meet all

external payment obligations, ensure a reasonable level of confidence in the

international community about India’s capacity to honour its obligations, and counter

speculative tendencies in the market. After the introduction of system of market-

determined exchange rates in 1993, the objective of smoothening out the volatility in

the exchange rates assumed importance.

India’s exchange rate policy has evolved in tandem with the domestic as well as

international developments. The Reserve Bank’s exchange rate policy focuses on

ensuring orderly conditions in the foreign exchange market. For the purpose, it closely

monitors the developments in the financial markets at home and abroad. When

necessary, it intervenes in the market by buying or selling foreign currencies. The

market operations are undertaken either directly or through public sector banks.

In addition to the traditional instruments like forward and swap contracts, the Reserve

Bank has facilitated increased availability of derivative instruments in the foreign

exchange market. It has allowed trading in Rupee-foreign currency swaps, foreign

currency-Rupee options, cross-currency options, interest rate swaps and currency

swaps, forward rate agreements and currency futures.

Foreign exchange being such a complex process for involving too many economics

concepts requires too much of expertise to deal with. But, at the same time, it has

become a subject of prime importance in today’s times. In this era of globalization,

trading is a very important factor that no economy can ignore. No economy is so self-

reliant that it does not needs to export or import something from the other. This is

where the need of foreign exchanges arises. And, in times when trading is of such

prime importance, no economy can ignore this fact of requiring assistance by the best

formulators to make plans for a flourishing economy. This plan of flourishing

economy cannot be achieved without the proper management of foreign exchange. It

is because of this that a country can have a good currency and satisfy the needs of the

people that it itself is unable to do, by the process of importing. Proper foreign

reserves help a country to recover from various economic problems and thus hold very

high importance.

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CHAPTER-7

Suggestions/Recommendations

The policy formulation process is not difficult on the surface. It is the thorny issues

and debates that emerge that tend to scuttle development and implementation of a

sound foreign exchange management policy. The basic development process can

be summarized as follows:

A. Examine current practices and past experience with regard to foreign

exchange management.

B. Define and evaluate exposures, both actual and projected. Evaluate

effectiveness of past hedging actions if feasible.

C. Formulate policy guidelines:

1. Establish priorities for managing exposures.

2. State corporate objectives clearly.

3. Ensure compatibility with other corporate goals and philosophies.

4. Obtain senior management mandate.

D. Develop operational structure:

1. Decide on degree of centralization.

2. Evaluate reporting systems and implement needed changes.

3. Specify approved hedging techniques.

4. Specify key decision makers/authorized traders.

5. Develop performance evaluation standards.

6. Establish transaction reporting requirements and procedures.

7. Provide for management review of outstanding contracts and

activity.

D. Establish a procedure for regular reviews of foreign exchange policies and

guidelines. A good policy provides positive framework for action, with

room for appropriate modifications and changes over time.

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F. Utilize policy review, goal setting, and policy implementation to encourage

the integration of foreign exchange management into the broader corporate

decision-making process. This will lead to more informed decision-making

and result in fewer surprises in the future.

G. The Study of Foreign Exchange Management unlike many other Social

Sciences is not a theoretical one. It is one of the most practical ones from

beginning to end.

H. Wee, the most important goal should be to keep it as transparent and as less

complicated as possible, as it already has enough layers of functions to make it

a complex one.

I. When the process is kept as transparent as possible, even a layman can

understand the topic with great ease.

H. RBI publishes each and every report on ‘rbi.gov.in’. People should be made

aware about it, so that they themselves can view the latest statistics and the

current standing of the country in terms of other counties.

In the proper context, a foreign exchange management policy serves several

important functions in addition to the critical control function.

An effective policy also helps in assessing treasury performance, providing a

framework for analysis, and involving the foreign exchange function in broader

corporate decision-making. These benefits can be just as important as the control

issues addressed by a formalized policy.

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BIBLIOGRAPHY

Books Referred:

Foreign Exchange Markets-Dun & Bradstreet

Foreign Exchange Simplified-B. Srinivasan

Forex Markets: Exchange Rate Dynamcs- G R K Murty

Websites Referred:

http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12251

http://rbidocs.rbi.org.in/rdocs/Content/PDFs/

FUNCWWE080910.pdf

http://dor.gov.in/fem

http://www.slideshare.net/anujzeal4u/rbi-intervention-in-foreign-

exchange-market

http://business.gov.in/doing_business/fema.php

http://www.investopedia.com/terms/f/foreign-exchange.asp

http://www.businessdictionary.com/definition/foreign-exchange-

Forex-or-FX.html

http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14350#int

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