evolution and future of forex

7/29/2019 Evolution and Future of Forex

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1. Executive SummaryThe Project is titled Foreign Exchange MarketsEvolution and Future.

The objective behind the project is to study and understand the global foreign exchange market

and Indian foreign exchange market in particular.

The project begins with an understanding of the basics of the Foreign Exchange markets and then

moves on to understand how the exchange rates among different currencies are determined. An

overview of the global foreign exchange market and the major currencies that have a significant

contribution to the turnover of the global foreign exchange market is provided.

In order to get an in-depth understanding of the Indian foreign exchange markets, the evolution,

structure and functioning of the market is studied. Subsequently the various rules and regulations

that guide the operation of the market are studied.

The project looks into and analyzes various events that have occurred over the past few years and

how they have impacted the foreign exchange markets as a whole and more specifically the

USD/INR exchange rate movement.

The various risks involved in Foreign Exchange Dealings and the current status of Capital

Account Convertibility in India along with the pros and cons of full capital account convertibility

are explained.

Finally the project analyses the future of the Indian Forex market for the corporates as well as

financial institutions.


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FOREIGN EXCHANGE MARKETS EVOLUTION & FUTURE

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2. Research Design2.1 Objective of the Study:

To study and understand the global foreign exchange market and Indian foreign exchangemarket in particular.

To understand how the exchange rates among different currencies are determined. To study and understand the evolution, structure and functioning of the market & the various

rules and regulations that guide the operation of the market.

To analyze various events that have occurred over the past few years and how they haveimpacted the foreign exchange markets as a whole and more specifically the USD/INR

exchange rate movement.

To study and understand the risks involved in Foreign Exchange Dealings and the currentstatus of Capital Account Convertibility in India along with the pros and cons of full capital

account convertibility.

To analyze the future of the Indian Forex market for the corporate as well as financialinstitutions.

2.2 Scope of the study:In this project I have studied evolution and future of foreign exchange market.

I have tried to explain the nitty-grittys of foreign exchange market in general; containing

foreign exchange basics, global foreign exchange markets, foreign exchange market in India,

risk involved in foreign exchange etc.

Further my emphasis was on to explain in particular USD/INR movement and its correlation

with other factors. I have also mentioned outlook for the future which focused on scope for

fuller capital account convertibility, currency future-the South African experience and Indian

perspective.


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2.3 Research Methodology:Primary Data:

Secondary Data:

For this project secondary data has been collected from various reports, journals, Policy

documents etc. Apart from this other sources of information include Internet, various books,

magazines & some leading financial dailies.

3. Introduction to Foreign Exchange

Foreign Exchange

Foreign exchange simply means foreign money. It is the value of one currency expressed in terms of

another. It involves the simultaneous sell and purchase of one currency for another.

Foreign exchange commonly referred to as Forex or FX, gives us an idea of how well an economy is

doing as compared to another.

Need for Foreign Exchange

In todays world no country is self-sufficient; consequently there is need for exchange of goods

and services amongst different countries. However unlike the primitive age, the exchange of

goods and services is no longer carried out on barter basis. Every sovereign country in the world

has a currency that is legal tender in its territory and this currency does not act as money outside

its boundaries. Therefore whenever a country buys or sells goods and services from or to another

country, the residents of two countries have to exchange currencies.

Hence, Forex markets acts as a facilitating mechanism through which one countrys currency can be

exchanged i.e. bought or sold for the currency of another country.

Features of Foreign Exchange Market

The foreign exchange market is unique because of:

Its trading volume (Average daily turnover of around $ 3.98trillion )


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The extreme liquidity of the market The large number and variety of traders in the market Its geographical dispersion Its trading hours - 24 hours a day (except on weekends) The variety of factors that affect exchange rates

4. Foreign Exchange Basics

The foreign exchange market is a global network of buyers and sellers of currencies.

4.1 Understanding Foreign Exchange Terminology

Reading a Quote

USD/INR = 53.83

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while

the currency on the right is called the quote or counter currency. The quote indicates the number of

units of quoted currency that can be bought for 1 unit of base currency. The quote means that US$1 =

53.83 Indian Rupees. In other words, US$1 can buy 53.83 Indian Rupees.

Direct Quote vs. Indirect Quote

There are two ways to quote a currency pair, either directly or indirectly.

A direct quote is simply a currency pair in which the domestic currency is the base currency;

E.g. 100 INR = 1.86 USD (where INR is the domestic currency)

An indirect quote is a currency pair where the domestic currency is the quoted currency.

E.g. 1 USD = 53.83 INR (where INR is the domestic currency)

In the forex spot market, the U.S. dollar is frequently the base currency in the currency pair.

However, not all currencies have the U.S. dollar as the base. The Queens currencies - those

currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar

and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro, which


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is relatively new, is quoted the same way as well. Most currency exchange rates are quoted out to

four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out

to two decimal places.

Cross Currency

A cross-rate is the rate of exchange between two currencies that do not involve the domestic

currency. In the international market, cross rates have come to mean rates that do not involve the

American dollar. The most common cross currency pairs are the EUR/GBP, EUR/CHF and

EUR/JPY.

Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair there is a bid

price (buy) and an ask price (sell). Again, these are in relation to the base currency.

When buying a currency pair (going long), the ask price refers to the amount of quoted currency that

has to be paid in order to buy one unit of the base currency, or how much the market will sell one

unit of the base currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted

currency will be obtained when selling one unit of the base currency, or how much the market will

pay for the quoted currency in relation to the base currency.

The quote before the slash is the bid price, and the two digits after the slash represent the ask price

(only the last two digits of the full price are typically quoted). Note that the bid price is always

smaller than the ask price.

Whichever currency is quoted first (the base currency) is always the one in which the transaction is

being conducted. You either buy or sell the base currency

Lets look at an example:

USD/CAD = 1.2000/05

Bid =1.2000

Ask=1.2005


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If you intend to buy the base currency, you will look at the ask price to see how much (in Canadian

dollars) the market will charge for U.S. dollars. According to the ask price, you can buy one U.S.

dollar with 1.2005 Canadian dollars.

However, in order to sell this currency pair, or sell the base currency in exchange for the quoted

currency, you would look at the bid price. It tells you that the market will buy US$1 base currency

(you will be selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars,

which is the quoted currency.

Spreads and Pips

The difference between the bid price and the ask price is called a spread. If we were to look at the

following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known aspoints.

The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar,

euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would

be 0.01, because this currency is quoted to two decimal places.

Currency Quote Overview

USD/CAD = 1.2232/37

Base Currency USD Currency to the left

Quote/Counter Currency CAD Currency to the right

Bid Price 1.2232

Price for which the market

maker will buy the base

currency. Bid is always smaller

than ask.

Ask Price 1.2237

Price for which the market

maker will sell the base

currency.

Pip

One point move, in USD/CAD it

is .0001 and 1 point change

would be from 1.2231 to 1.2232

The pip/point is the smallest

movement a price can make.

Spread 5 pips/points;Difference between bid and ask

price (1.2237-1.2232).


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4.2Types of Transaction

A foreign exchange transaction is a contract to exchange one currency for another currency at an

agreed rate on an agreed date.

Cash: Where the transaction and the settlement take place on the same day of the date of thetransaction itself, then such transaction is said to have taken place on Cash or Today value

basis.

TOM: It refers to the transaction wherein the settlement takes place one working day afterthe date of the transaction. The term TOM stands for Value Tomorrow.

Spot: Spot transaction refers to the transaction wherein the settlement takes place twoworking days after the date of transaction. This is the standard basis on which majority of FXtransactions are concluded.

Forward: Any transaction in respect of which the settlement takes place beyond the spot dateis a Forward transaction. The Forward Market requires a more complicated calculation - a

forward rate is based on the prevailing spot rate plus (or minus) a premium (or discount),

which are determined by the interest rate differential between the two currencies involved.

The important thing to remember is that a forward rate is not a guess as to what the spot rate

is going to be in the future; it is purely a mathematically driven calculation. A forward rate

will protect you against unfavorable movements, but will not allow gains to be made should

the exchange rate move in your favor in the period between entering the contract and final

settlement of the currency.

Outright transaction: An Outright transaction is one in which a particular currency isbought against another currency that is being sold for a given value date at a mutually agreed

exchange rate.

Swap: Swap transaction refers to purchase and sale of a given pair of currencies against eachother for different maturity/ value dates. In effect, it is a combination of two outright deals of

varying maturity dates.

Future: Futures are the market-traded counterparts of currency forwards. With standardizedcontract size and maturity dates, they make for a liquid hedging instrument and aid price

discovery in the currency market.


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Models of Exchange Rate Determination

The movements of exchange rates are indeed fascinating, thus it is very important that one

understands the factors influencing exchange rates. Along with the factors such as interest rates and

inflation, the exchange rate is one of the most important determinants of a country's relative level of

income

Purchasing Power ParityThe Purchasing Power Parity (PPP) theory states that exchange rates are determined by the

relative prices of similar baskets of goods. Changes in inflation rates are expected to be offset

by equal but opposite changes in the exchange rate. For example, if a bottle of Coke costs $2

in America and 1 in England, then, according to PPP, the pounddollar exchange rate must

be 2 dollars per 1 British pound. If the prevailing market exchange rate is $1.7 per British

pound, then the pound is said to be undervalued and the dollar overvalued. The theory then

assumes that the two currencies will eventually move towards the 2:1 relation. PPPs major

weakness is that it assumes goods are easily tradable, with no costs to trade such as tariffs,

quotas or taxes.

Interest Rate ParityThis states that an appreciation or depreciation of one currency against another currency must

be neutralized by a change in the interest rate differential. For example, if American interest

rates exceed Japanese interest rates, then the American dollar should depreciate against the

Japanese yen by an amount that prevents riskless arbitrage.

Balance Of Payments ModelThis model holds that a foreign exchange rate must be at its equilibrium level, i.e. the rate

that produces a stable current account balance. For example, a nation with a trade deficit will

experience a reduction in its foreign exchange reserves, which ultimately lowers (depreciates)

the value of its currency. The cheaper currency renders the nations exports more affordable

in the global marketplace while making imports more expensive. After an intermediate

period, imports are forced down and exports rise, thus stabilizing the trade balance and the

currency towards equilibrium.


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Asset Market ModelEconomic variables such as growth, inflation and productivity are no longer the only drivers

of foreign exchange movements. The proportion of foreign exchange transactions stemming

from cross-border trading of financial assets has dwarfed the extent of currency transactions

generated from trading in goods and services. The asset market approach views currencies as

asset prices traded in an efficient financial market. As a result, currencies are increasingly

demonstrating a strong correlation with asset markets, particularly equities.

Monetary ModelThe Monetary Model focuses on a country's monetary policy to help determine the exchange

rate. A country's monetary policy deals with the money supply of that country, which is

determined by both the interest rate set by central banks and the amount of money printed by

the treasury. Countries that adopt a monetary policy that rapidly grows its monetary supply

will see inflationary pressure due to the increased amount of money in circulation. This leads

to a devaluation of the currency.

Factors affecting Foreign Exchange Rates

The movements of exchange rates are indeed fascinating, thus it is very important that oneunderstands the factors influencing exchange rates.

Apart from factors such as interest rates and inflation, the exchange rate is one of the most important

determinants of a country's relative level of economic health. Exchange rates play a vital role in a

country's level of trade, which is critical to most free market economy in the world. For this reason,

exchange rates are among the most watched analyzed and governmentally manipulated economic

measures. But, exchange rates matter on a smaller scale as well: they impact the real return of an

investor's portfolio. Here we look at some of the major forces behind exchange rate movements.

1. Supply and Demand in the foreign exchange marketThe major sources of supply of foreign exchange in the Indian foreign exchange market are

receipts on account of exports and invisibles in the current account and inflows in the capital

account such as:

Foreign direct investment (FDI) Portfolio investment


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External commercial borrowings (ECB) and Non-resident deposits

On the other hand, the demand for foreign exchange emanates from imports and invisible

payments in:

Current account, Amortization of ECB (including short-term trade credits) and external aid, Redemption of NRI deposits and Outflows on account of direct and portfolio investment.

2.

Inflation Rate differentials: As a rule of thumb, a country with a consistently lowerinflation rate exhibits a rising currency value, as its purchasing power increases relative to

other currencies. Those countries with higher inflation typically see depreciation in their

currency in relation to the currencies of their trading partners. This is also usually

accompanied by higher interest rates.

3. Interest Rate Differentials: Interest rates, inflation and exchange rates are all highlycorrelated. By manipulating interest rates, central banks exert influence over both

inflation and exchange rates, and changing interest rates impact inflation and currency

values. Higher interest rates offer lenders in an economy a higher return relative to other

countries. Therefore, higher interest rates attract foreign capital and cause the exchange

rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the

country is much higher than in others, or if additional factors serve to drive the currency

down. The opposite relationship exists for decreasing interest rates - that is, lower interest

rates tend to decrease exchange rates

4. Current-account deficits: A deficit in the current account shows the country is spendingmore on foreign trade than it is earning, and that it is borrowing capital from foreign

sources to make up the deficit. The excess demand for foreign currency lowers the

country's exchange rate until domestic goods and services are cheap enough for

foreigners, and foreign assets are too expensive to generate sales for domestic interests.

Trade Deficit
http://www.investopedia.com/terms/c/centralbank.asphttp://www.investopedia.com/terms/c/centralbank.asp


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5. Public debt: Countries will engage in large-scale deficit financing to pay for publicsector projects and governmental funding, etc. Nations with large public deficits and

debts are less attractive to foreign investors since large debt encourages inflation.

In the worst-case scenario, a government may print money to pay part of a large debt, but

increasing the money supply inevitably causes inflation. Moreover, if a government is not

able to service its deficit through domestic means (selling domestic bonds, increasing the

money supply), then it must increase the supply of securities for sale to foreigners.

Finally, a large debt may prove worrisome to foreigners if they believe the country risks

defaulting on its obligations. Foreigners will be less willing to own securities

denominated in that currency if the risk of default is great. For this reason, the country's

debt rating (for example as determined by Moody's or Standard & Poor's,) is a crucial

determinant of its exchange rate.

6. Terms of trade: A ratio comparing export prices to import prices, the terms of trade isrelated to current accounts and the balance of payments. If the price of a country's exports

rises by a greater rate than that of its imports, its terms of trade have favorably improved.

An increase in terms of trade shows greater demand for the country's exports. This, in

turn, results in rising revenues from exports, which provides increased demand for the

country's currency (and an increase in the currency's value). If the price of exports rises

by a smaller rate than that of its imports, the currency's value will decrease in relation to

its trading partners.

7. Balance of PaymentsIndias current account turned negative in fiscal 2004-05 and has remained so ever since.

This has been offset by capital account surpluses with the exception of fiscal 2008-09 during

which the balance of payments (BOP) actually turned negative (Table 6). Even though the

BOP has once again turned positive, the global financial crisis has exposed vulnerabilities in

Indias foreign currency position and prospects for future growth.

A positive balance of payments indicates an accumulation of forex to the existing forex

reserves and aide the RBI to maintain the exchange rate at desired levels.

8. Political stability and economic performance: Foreign investors inevitably seek outstable countries with strong economic performance in which to invest their capital. A


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country with such positive attributes will draw investment funds away from other

countries perceived to have more political and economic risk. Political turmoil, for

example, can cause a loss of confidence in a currency and a movement of capital to the

currencies of more stable countries.

5. Global Foreign Exchange Markets

5.1 History of events in Global Foreign Exchange Markets

The Evolution of money

Primitive societies used various commodities as a medium of exchange. The marketability of a

commodity determined its acceptance and use as a means of exchange. Marketability of a

commodity was determined by the familiarity with the commodity and its quality, divisibility,

uniformity and ease of transportation and storage.Over time, with the introduction of metals and

coins, another important quality of the commodity emerged. It became a medium of exchange,

having a value much greater than its intrinsic value. It was no longer used for consumption, but for

acquiring other commodities for consumption. This was the evolution of money.

The Gold Standard

Under the gold standard,a currency would be backed by gold. Over time, the difference in price of an

ounce of gold between two currencies became the exchange rate for those two currencies. This

represented the first standardized means of currency exchange in history. This also came to be

known as the mint parity theory of exchange rates. The main types of gold standard were:

1. The Gold Specie Standard2. The Gold Bullion Standard3. The Gold Exchange Standard

The Gold Specie Standard18801914

Under the Gold Specie Standard, gold was recognized as a means of settling domestic as well as

international payments. Import and export of gold was freely allowed and Central Banks guaranteed


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the issue or purchase of gold at a fixed price, on demand. The price of gold varied according to the

supply of the metal in the market and the value of gold coins was based on their intrinsic value.

The Gold Bullion Standard- 1922 - 1936

The Gold Bullion Standardstarted after the First World War, as increased expenditures to fund the

war effort exposed the weaknesses of the gold standard. Under the gold bullion standard, paper

money was the main form of exchange. It could however be exchanged for gold at any time.

The gold bullion standard too could not last long as many major currencies were highly over or

under valued leading to a distortion in balance of payment positions.

The Gold Exchange Standard- 1944- 1970

During the Second World War, international trade suffered with runaway inflation and devaluation

of currencies. A need was felt to bring out a new monetary system that would be stable and

conducive to international trade. The new system aimed to bring about convertibility of all

currencies, eliminate exchange controls and establish an international monetary system with stable

exchange rates.

5.2 Summary of events since 1944

Figure 3: Summary of events in global foreign exchange markets since 1944

Year Event

1944Bretton Wood Accord is established to help stabilize the global economy after Wolr War II

1971Smithsonian Agreement established to allow for greater fluctuations band for currencies

1972

European Joint Float established as the European community tried to move away from its

dependency on the US dollar

1973

Smithsonian Agreement and European Joint failed and signified the official switch to a free-

floeating system

1978Free floating system officially mandated by the IMF

1993European Monetary System fails making way for a world-wide free floating system


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Bretton Wood System

The IMF was set up in 1946 under the Bretton Woods agreement and the new exchange rate system

also came to be known as the Bretton Woods system. Under the Bretton Woods system, member

countries were required to fix parities of their currencies to gold or the US dollar and ensure that

rates did not fluctuate beyond 1% of the level fixed. It was also agreed that no country would effect a

change in the parity without the prior approval of the IMF.

Stated purposes and goals:

The main terms of this agreement were:

Formation of theInternational Monetary Fundand theInternational Bank for Reconstructionand Development(presently part of the World Bank).

Adjustable peg Foreign exchange market rates system: The exchange rates were fixed, withthe provision of changing them if necessary.

Currencies were required to be convertible for trade related and other current accounttransactions. The governments, however, had the power to regulate capital flows.

As it was possible that exchange rates thus established might not be favourable to a country'sBalance of payments position, the governments had the power to revise them by up to 10%.

All member countries were required to subscribe to the International Monetary Fund's capital.Encouraging open markets

The seminal idea behind the Bretton Woods Conference was the notion of open markets. The

establishment of the International Monetary Fund and the World Bank marked the end of

economic nationalism. This meant that countries would maintain their national interest, but

trade blocks and economic spheres of influence would no longer be their means. Another idea

behind the Bretton Woods Conference was joint management of the Western political-

economic order. Meaning that the foremost industrial democratic nations must lower barriers

to trade and the movement of capital, in addition to their responsibility to govern the system.

5.3 Turnover


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5.4 Timing

Forex is the only 24-hour market It starts from Sunday 5pm EST through Friday 4pm EST. Forex

trading begins each day in New Zealand, Sydney (Australia,) and moves around the globe as the

business day begins in each financial center, to Tokyo (Asia), the Middle East, London (Europe), and

New York (America).

Foreign exchange market is in fact misnomer as there is no market place as such which can be called

as foreign exchange market. It is a facilitating mechanism through which one countrys currency can

be exchanged i.e. bought or sold for the currency of another country.

5.5 Major CurrenciesEUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD and USD/CADare the most liquid and

widely traded currency pairs in the world. Trades involving them make up about 90% of total Forex

trading. GBP/USD is the only currency pair with its own name. It is known as Cable.

6. Foreign Exchange Market in India

6.1 History of Events shaping the Foreign Exchange markets in India

The exchange rate regime in India has undergone significant changes since independence and

particularly during the beginning of 1990. The following provides a bird's eye view of major

changes.


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Figure 5: History of Events shaping the Foreign Exchange markets in India

6.2 Development of Foreign Exchange Markets

Market players in forex became active in the seventies, consequent upon the collapse of Bretton

Woods Agreement. However, India was somewhat insulated since stringent exchange controls

prevailed and banks were required to undertake only cover operations and maintain a square or

near square position at all times. In 1978, the RBI allowed banks to undertake intra-day

trading in foreign exchange and as a consequence, the stipulation of maintaining `square' or

`near square' position was to be complied with only at the close of business hours each day.

This perhaps marks the beginning of forex market in India.

Year Type of Change

1966 The rupee was devalued by 57.5% against the sterling on June 6th.

1967 Rupee-sterling parity changed as a result of devaluation of sterling

!971

Bretton woods system broke down in August. Rupee briefly pegged to the US

dollar at rupee 7.5 before repegging to sterling at Rs.18.967 with a 2.25 %

margin on either side.

!972

Sterling was floated on June 23rd. Rupee sterling parity revalued at Rs.18.95

and then in October to Rs.18.80

1975

Rupee pegged to an undisclosed currency basket with margins of 2.25% on

either side. Intervention currency was sterling with a central rate of Rs

18.3084

1979 Margins around basket parity widened to 5% on each side in January

1991

Rupee devaluead by 22% between July 1st and July 3rd. Rupee-Dollar rate

depreciated from Rs.21.20 to Rs 25.80

1992

LERMS(Liberalised Exchange Rate Management System) introduced with 40-

60 dual rate for converting export proceeds, market determined rate for all

specified imports and market rate for approved capital transaction

1993

Unified market determined exchange rate introduced for all transactions.

RBI would buy spot US dollar and sell US dollars for specified purposes. It

will not buy or sell forward, though it will enter into dollar swaps


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As opportunities to make profits began to emerge, the major banks started quoting two-way prices

against the rupee as well as in cross currencies and gradually, trading volumes began to increase.

During the period, 1975-92 the exchange rate regime in India was characterised by daily

announcement by the RBI of its buying and selling rates to Authorized Dealers (ADs) for merchant

transactions. Given the then prevalent RBIs obligation to buy and sell unlimited amounts of the

intervention currency arising from the banks merchant purchases, its quotes for buying/selling

effectively became the fulcrum around which the market was operated. The RBI performed a

market-clearing role on a day-to-day basis, which naturally introduced some variability in the size of

reserves. Incidentally, certain categories of current and capital account transactions on behalf of the

Government were directly routed through the reserves account.

FERA

Soon after independence, complex webs of controls were imposed for all external transactions

through legislation, i.e., Foreign Exchange Regulation Act (FERA), 1947. These were put into a

more rigorous framework of controls through FERA, 1973. The Foreign Exchange Regulation Act,

1973, (hereinafter referred to as FERA) was drafted with the object of introducing the changes felt

necessary for the effective implementation of the Government policy and removing the difficulties

faced in the working of the previous enactment. The control framework was essentially transaction

based in terms of which all transactions in foreign exchange including those between residents and

non-residents were prohibited, unless specifically permitted.

The prevailing mood then was one of preserving and consolidating the freedom and not to permit

once again any type of foreign domination, political or economic. Initial approach on foreign

capital was negative to a not-interested attitude.Any offence under FERA was a criminal offence

liable for imprisonment.

From Regulation to Management (FERA to FEMA)

As the country came to be endowed with sizeable reserves of foreign exchange, the basic aim of

foreign exchange policy shifted from one of control and conservation to that of effective

management, to facilitate external trade/payment and promote the orderly development and

maintenance of the forex market in India.


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FERA had become incompatible with the pro-liberalization policies of the Government of India. In

order to remove the special restrictions in respect of companies registered in India and to simplify the

regulations in regard to foreign investment, to attract better flow of foreign capital and investment a

change in the policy was necessary.

Hence Foreign Exchange Regulation Act of 1973 (FERA) in India was repealed and was replaced by

the Foreign Exchange Management Act (FEMA) 1979.

The new legislation reflected the economic realities and was far more pragmatic in its approach. The

objective of the earlier Act (FERA) as contained in its preamble was the conservation of foreign

exchange and its utilization for economic development of the country whereas the objective of the

new Act (FEMA) is "facilitating external trade" and "promoting the orderly development and

maintenance of foreign exchange market in India". The most significant feature of the new Act is that

it provides legal basis to the current account convertibility.

Foreign Exchange Management Act, 1979 (FEMA)

The Act was thoroughly revised and replaced by the by the Foreign Exchange Management Act,

1999. The latter has dropped many of the stringent provisions of the older Act, in the area oftransactions involving foreign exchange. The FEMA 1999 took effect from June 1, 2000.

This Act extends to the whole of India and also applies to all branches, offices and agencies outside

India owned or controlled by a person resident in India. It is also be applicable to any contravention

committed outside India by any person to whom this Act is applicable.

Objectives and Extent of FEMA

The object of the Act is to consolidate and amend the law relating to foreign exchange with the

objective of facilitating external trade and payments and for promoting the orderly development and

maintenance of foreign exchange market in India. FEMA extends to the whole of India.

Broad Scheme of the Foreign Exchange Management Act, 1999

Prohibits dealings in foreign exchange except through an authorized person. Restrains any person resident in India from acquiring, holding, owning, possessing or

transferring any foreign exchange, foreign security or any immovable property situated

outside India except as specifically provided in the Act.


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Allows a person to draw or sell foreign exchange from or to an authorized person for a capitalaccount transaction. RBI in consultation with Central Govt. has issued various regulations on

capital account transactions.

Every exporter is required to furnish to the RBI or any other authority, a declaration etc.regarding full export value.

Establishment of Directorate of Enforcement and the powers to investigate the violation ofany provisions of Act, rule, regulation, notifications, directions or order issued in exercise of

the powers under this Act.

6.3 Recommendations of various Committees

LERMS

After the Gulf crisis in 1990-91 and the official devaluation of the rupee in July 1991, the broad

framework for reforms in the external sector was laid out in the Report of the High Level

Committee on Balance of Payments (Chairman: Dr. C. Rangarajan).

Following the recommendations of the Committee to move towards the market-determined exchange

rate, the Liberalized Exchange Rate Management System (LERMS) was introduced in March 1992

initially involving a dual exchange rate system.

Under this system all foreign exchange receipts on current account transactions were required to be

submitted to the Authorized dealers of foreign exchange in full, who in turn would surrender to RBI

40% of their purchases of foreign currencies at the official exchange rate announced by RBI. The

balance 60% could be retained for sale in the free market.

As the exchange rate aligned itself with market forces, the $/Re rate depreciated steadily from 25.83

in March 1992 to 32.65 in February 1993. Consequently, in March 1993, India moved from the

earlier dual exchange rate regime to a single, market determined exchange rate system.

The unification of the exchange rate of the Indian rupee was an important step towards

current account convertibility, which was finally achieved in August 1994.

Sodhani Committee:

The Report is widely regarded as an enlightened blue-print for the development of the Indian

Foreign Exchange Market.Summary of Major Recommendations aimed at developing the Foreign

Exchange Market:


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Recommendation Implication Acceptance

Open positions limits tobe decided by banks

subject to their

earmarking capital to the

extent of 5% of Open

Exposure Limit.

Cap of Rs 15 Crores onopen exchange position

may be withdrawn

Banks decide their own Overnight OpenPosition limits according to the capital

base, volume of merchant transactions,

dealing expertise and infrastructure.

Banks earmark their capital to the extentof 5% of the open position limit to cover

market risk. Limits are approved by RBI

Ceiling of Rs 15 Crores was removed on1st Jan, 1996.

Accepted

Banks should be permittedto fix their own Gap limits

based on capital, risk

bearing capacity etc

Banks are permitted to fix their own Gaplimits, subject to a daily ceiling of $ 100

million or 6 times the net owned funds

of a bank.

Accepted.

Banks may, on applicationto RBI, be permitted toinitiate Cross Currency

positions overseas

Permissions granted on basis ofinfrastructural capabilities and dealingexpertise and experience.

Accepted.

Market intervention byRBI should be selective

rather than continuous.

Forex swaps may be usedas a tool by RBI to control

the forward margins

The RBI no longer quotes two wayprices on a daily basis.

RBI intervenes in both Spot and Forwardmarkets.

Accepted

Banks should have thefreedom to determine the

interest rates and maturity

period of FCNR (B)

deposits subject to a cap

being put in place by RBI.

Interest rates on FCNR (B) deposits arefixed by RBI and are uniform across all

banks.

Accepted in

part


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Exporters should, subjectto liquidation of

outstanding advances, be

permitted to retain 100%

of export earnings in

foreign currency in India.

Exporters are allowed to retain 50% oftheir export earnings in foreign currency

accounts (EEFC Accounts - Exchange

Earners Foreign Currency Accounts).

However,exporters can lend upto $ 3

million abroad out of their EEFC

accounts. Another move towards Capital

Account Convertibility.

Not accepted

as yet

The proposed ForexClearing House in

Bombay may be set up

early considering the

substantial benefits this

could offer to banks.

CCIL was set up in 2001. As a clearing agency

for transactions improved the stability in the

market by mitigating the settlement risk.

Accepted

Tarapore Committee:

Tarapore-I committee report on Capital Account Convertibility (CAC), which came out in May1997, wanted CAC to be phased in over three years. Some of the parameters recommended by the

Tarapore Committee on CAC such as

Reduction in the combined fiscal deficit Inflation between 3 and 5 percent Further reduction in the gross NPAs of the banking sector

were to be achieved for creating an enabling environment for further liberalization in the forexmarkets.


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Tarapore-II noted that two of the three milestones the inflation rate and a reduction in non-

performing assets (NPA) had been substantially reached.

Observations

The perspective on CAC has, however, undergone some change following the experiences of

emerging market economies (EMEs) in Asia and Latin America which went through currency and

banking crises in the 1990s. A few countries backtracked and re-imposed some capital controls as

part of crisis resolution. It was argued that extensive presence of capital controls, when an economy

opens up the current account, creates distortions, making them either ineffective or unsustainable.

The link between capital account liberalisation and growth is yet to be firmly established by

empirical research.

Meaning of Account Convertibility

Current account convertibilityrefers to freedom in respect of payments and transfers for current

international transactions.

Capital account convertibility (CAC) would mean freedom of currency conversion in relation to

capital transactions in terms of inflows and outflows.

The cross-country experience with capital account liberalization suggests that countries, including

those which have an open capital account, do retain some regulations influencing inward and

outward capital flows. Thus the Committee recommended the definition of CAC to be as follows:

CAC refers to the freedom to convert local financial assets into foreign financial assets and vice

versa. It is associated with changes of ownership in foreign/domestic financial assets and liabilities

and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC can be, and

is, coexistent with restrictions other than on external payments.

6.4 Participants of Market

Following are the major participants of the foreign exchange market:

1. Banks


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The interbank market caters to both the majority of commercial turnover and large amounts of

speculative trading every day. Some of this trading is undertaken on behalf of customers, but

much is conducted by proprietary desks, trading for the bank's own account.

Only Authorized Dealers (ADs) licensed by the RBI can participate directly in the FX market.

Customers approach ADs to get the best value for their FX requirements. Factors like customer

relationship, execution capability and post trade service quality also has a bearing on which AD

gets the deal. The competitiveness of the quote offered by the AD to the customer depends on

how active that AD is in the inter-bank FX market.

An exporter would sell foreign currency to an AD while an importer would purchase foreign

currency. Apart from trade transactions there are remittances which could be inward remittances,

involving the sale of foreign currency to an AD, and outward remittances involving purchase of

foreign currency. Customer's requirements for purchase or sale of foreign currency also arise

from capital account transactions such as Foreign Currency Borrowings or their repayment, issue

of ADRs/GDRs, acquisition of domestic companies by an overseas entity or vice-versa etc.

Apart from merchant transactions ADs also take proprietary positions i.e. positions on their own

account. These positions are subject to daylight and overnight limits. The net overnight position

which is termed as the Net Overnight Open Position Limit (NOOPL) is approved by the RBI foreach AD after the latter's Board of Directors has approved the same.

2. Commercial companiesCommercial companies often trade fairly small amounts compared to those of banks or

speculators, and their trades often have little short term impact on market rates. Nevertheless,

trade flows are an important factor in the long-term direction of a currency's exchange rate. An

important part of this market comes from the financial activities of companies seeking foreign

exchange to pay for goods or services. Some multinational companies can have an unpredictable

impact when very large positions are covered due to exposures that are not widely known by

other market participants.

3. Central banksNational central banks play an important role in the foreign exchange markets. They try to

control the money supply, inflation, and/or interest rates and often have official or unofficial


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target rates for their currencies. They can use their often substantial foreign exchange reserves to

stabilize the market.

The mere expectation or rumor of central bank intervention might be enough to stabilize a

currency, but aggressive intervention might be used several times each year in countries with a

dirty floatcurrency regime. Central banks do not always achieve their objectives. The combined

resources of the market can easily overwhelm any central bank.

4. Hedge fundsHedge funds have gained a reputation for aggressive currency speculation since 1996. They

control billions of dollars of equity and may borrow billions more, and thus may overwhelm

intervention by central banks to support almost any currency, if the economic fundamentals are

in the hedge funds' favor.

5. Investment management firmsInvestment management firms (who typically manage large accounts on behalf of customers such

as pension funds and endowments) use the foreign exchange market to facilitate transactions in

foreign securities. For example, an investment manager with an international equity portfolio will

need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreignequities. Since the forex transactions are secondary to the actual investment decision, they are not

seen as speculative or aimed at profit-maximization.

Some investment management firms also have more speculative specialist currency overlay

operations, which manage clients' currency exposures with the aim of generating profits as well

as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a

large value of assets under management (AUM), and hence can generate large trades.

6. Retail forex brokersThey provide the currency conversion or credit-depositary processes between the foreign

currency purchaser and seller. Forex brokers don't charge a commission, difference between the

price at which a currency can be purchased and the price at which it can be sold at any given

point in time is how they make money. Forex brokers are usually tied to large banks or lending

institutions because of the large amounts of capital required.

7. Other


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Non-bank foreign exchange companies offer currency exchange and international payments to

private individuals and companies. These are also known as Foreign Exchange Brokers but are

distinct from Forex Brokers as they do not offer speculative trading but currency exchange with

payments. i.e. there is usually a physical delivery of currency to a bank account.

6.5 Institutional Framework

Foreign Exchange Market is governed underForeign Exchange Market Act 1999

1. Foreign Exchange Dealers Association of India (FEDAI):FEDAI frames rules governing the conduct of inter-bank foreign exchange business among

banks vis--vis public and liaison with RBI for reforms and development of forex

market.Some of the current functions of FEDAI are as follows:

Guidelines and Rules for Forex Business Training of Bank Personnel in the areas of Foreign Exchange Business Accreditation of Forex Brokers Advising/Assisting member banks in settling issues/matters in their dealings Represent member banks on Government/Reserve Bank of India/Other Bodies Announcement of daily and periodical rates to member banks

FEDAI plays a catalytic role for smooth functioning of the markets through closer co-

ordination with the RBI, other organizations like FIMMDA, the Forex Association of

India and various market participants. FEDAI also maximizes the benefits derived from

synergies of member banks through innovation in areas like new customized products,

bench marking against international standards on accounting, market practices, risk

management systems, etc.

2. Clearing Corporation of India Limited (CCIL):It was set up in 2001 in pursuance of theSodhani Committees recommendations. CCIL as a clearing agency for transactions has

improved the stability in the market by mitigating the settlement risk. CCIL is the first

institution in India to offer centralized clearing and settlement services to players in the

financial services sector. The Corporation has been promoted by the country's major banks

and financial institutions and conducts its operations via modern computer and

telecommunication systems, leading to efficiency in operations, lower cost, and mitigation ofrisks, particularly the systemic risk. CCIL's intermediation has gone a long way towards


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facilitating the deepening of India's debt markets by bringing in all classes of investors -

wholesale, semi-wholesale and retail.

3. Reserve Bank of India (RBI) :The RBI is the constant monitoring authority of Indian financial markets. The RBIs primary

aim when it comes to foreign exchange management is to ensure safety and liquidity, with

higher returns figuring lower in the hierarchy of preferences. RBIs parking of reserves is

consistent with the best practices laid down for central banks by the International Monetary

Fund (IMF). This includes parking part of the reserves as cash deposits with foreign central

banks and multilateral agencies such as IMF and the Bank for International Settlements

(BIS). It also invests in the deposits of foreign commercial banks and bonds, generally the

highest-rated sovereign bonds of leading economies and occasionally in top rated corporate

bonds. Indias foreign exchange reserves are spread across a variety of currencies including

the dollar, euro and yen. But, the precise currency composition of reserves is generally not

released by most countries including India, going by global practice.

6.6 Foreign Exchange Derivative Instruments in India

1. Foreign Exchange ForwardsAuthorised Dealers (ADs) (Category-I) are permitted to issue forward contracts to persons

resident in India with crystallized foreign currency/foreign interest rate exposure and based

on past performance/actual import-export turnover, as permitted by the Reserve Bank and to

persons resident outside India with genuine currency exposure to the rupee, as permitted by

theReserve Bank. The residents in India generally hedge crystallized foreign currency/foreign

interest rate exposure or transform exposure from one currency to another permitted

currency. Residents outside India enter into such contracts to hedge or transform permitted

foreign currency exposure to the rupee, as permitted by the Reserve Bank.

2. Foreign Currency Rupee SwapA person resident in India who has a long-term foreign currency or rupee liability is

permitted to enter into such a swap transaction with ADs (Category-I) to hedge or transform

exposure in foreign currency/foreign interest rate to rupee/rupee interest rate. A currency

swap (or cross currency swap) is a foreign exchange agreement between two parties to

exchange a given amount of one currency for another and, after a specified period of time, to


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give back the original amounts swapped.Currency swaps can be negotiated for a variety of

maturities up to 30 years.

3. Foreign Currency Rupee OptionsADs (Category-I) approved by the Reserve Bank and ADs (Category-I) who are not market

makers are allowed to sell foreign currency rupee options to their customers on a back-to-

back basis, provided they have a capital to risk weighted assets ratio (CRAR) of 9 per cent or

above. These options are used by customers who have genuine foreign currency exposures, as

permitted by the Reserve Bank and by ADs (Category-I) for the purpose of hedging trading

books and balance sheet exposures.

4. Cross-Currency OptionsADs (Category-I) are permitted to issue cross-currency options to a person resident in India

with crystallized foreign currency exposure, as permitted by the Reserve Bank. The clients

use this instrument to hedge or transform foreign currency exposure arising out of current

account transactions. ADs use this instrument to cover the risks arising out of market-making

in foreign currency rupee options as well as cross currency options, as permitted by the

Reserve Bank.

5. Cross-Currency SwapsEntities with borrowings in foreign currency under external commercial borrowing (ECB) are

permitted to use cross currency swaps for transformation of and/or hedging foreign currency

and interest rate risks. Use of this product in a structured product not conforming to the

specific purposes is not permitted.

6.7 Foreign Exchange Derivative GuidelinesThe Reserve Bank has issued comprehensive guidelines on derivatives laying down broad generic

principles for undertaking all derivative transactions, management of risks and sound corporate

governance requirements as adoption of suitability and appropriateness policy. Banks and their

clients, who scrupulously follow the extant guidelines, including the Regulations framed under the

FEMA, would be well equipped to meet any potential consequences.

However, there are four main modifications to the instructions contained in the extant guidelines

issued by Foreign Exchange Department, RBI with regard to the above instruments, viz;


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Users, such as importers and exporters having crystallized (evidenced by firm order, openingof LC or actual shipment), un-hedged foreign exchange receivables and payables in respect of

current account transactions may write covered call and put options in both foreign currency/

rupee and cross currency and receive premia.

Market-makers may write cross currency options. Market-makers may offer plain vanilla American foreign currency-rupee options. A person resident in India, who has a foreign exchange or rupee liability, is permitted to enter

into a foreign currency rupee swap for hedging long-term exposure. For purposes of clarity,

the term long-term exposure may be defined to mean exposure with residual maturity of

three years or more.

In respect of foreign exchange derivatives, market participants may be guided by the instructions

issued by Foreign Exchange Department, RBI from time to time to the extent indicated in the

guidelines.


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7 Foreign Exchange RisksEach company has a different approach to foreign exchange based on industry, trade volumes,markets, etc. To develop a strategy its important to know whether the company is risk-averse, the

levels of risk for the currencies one deals with, and how well one understands financial services.

Credit risk/exposure: The risk that counterparty will not settle an obligation for full value,either when due or at any time thereafter. This risk can be effectively managed through fixing

of counter party limits, appropriate measurement of exposures, ongoing credit evaluation and

monitoring and following sound operating procedures.

Replacement risk/replacement cost risk: The risk that counterparty to an outstandingtransaction for completion at a future date will fail to perform on the settlement date.

This failure may leave the solvent party with an unhedged or open market position or deny

the solvent party unrealized gains on the position. The resulting exposure is the cost of

replacing, at current market prices, the original transaction.

Systemic risk: The risk that the failure of one participant in a transfer system, or in financialmarkets generally, to meet its required obligations when due will cause other participants or

financial institutions to be unable to meet their obligations (including settlement obligations

in a transfer system) when due. Such a failure may cause significant liquidity or credit

problems and, as a result, might threaten the stability of financial markets and confidence in

the market.

Legal risk: The risk that counterparty will incur damage because laws or regulations areinconsistent with the rules of the settlement system, settlement arrangements or other

interests entrusted to the settlement system. Legal risk is also created by unclear or

unsystematic application of laws and regulations. To avoid this risk one should insist on

internationally accepted Master Agreements between the two parties to be supported by other

relevant documents.

Liquidity risk: The risk that a counterparty (or participant in a settlement system) will notsettle an obligation for full value when due. Liquidity risk does not imply that a counterparty


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or participant is insolvent since it may be able to settle the required debit obligations at some

time thereafter. The following limits are fixed for managing the above risk:

Individual Gap Limits (IGL)

Aggregate Gap Limits (AGL)

Total Aggregate Gap Limits (TAGL)

Market risk:The risk that an institution or other trader will experience a loss on a trade owingto an unfavorable exchange rate movement.

Foreign exchange settlement exposure:The amount at risk when a foreign exchangetransaction is settled. This equals the full amount of the currency purchased and lasts from the

time that a payment instruction for the currency sold can no longer be cancelled unilaterally

until the time the currency purchased is received with finality.

Operational risk: The risk of incurring interest charges or other penalties for misdirecting orotherwise failing to make settlement payments on time owing to an error or technical failure.

Foreign exchange settlement risk: The risk that one party to a foreign exchange transactionwill pay the currency it sold but not receive the currency it bought. This is also called cross-

currency settlement riskorprincipal risk.


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8.USD/INR movement and its correlation with other factors

8.1 Explaining USD/INR movement

Figure 7: USD/INR movement

1995-96 - Depreciation of Rupee

During 1993-94, India saw relatively large inflows on account of portfolio investments,which were regularly picked up by the Reserve Bank of India, keeping the Rupee steady at

around 31 levels (or else the currency would have appreciated in nominal terms).

The Indian Rupee depreciated sharply against the Dollar, from Rs 31.40 to the USD in June'95 to approximately 38 levels in February '96 (down 22.1%), regained to 34.20 by March

1996 before falling again to 35.70 by June-July 1996.

Over September 1995 to February 1996, the Government's net foreign debt and interestrepayments worth about $ 4 billion hit the market which, coupled with increased covering of

capital liabilities by corporates and a dramatic slowdown in foreign portfolio investments, led

to around 22% fall in the Rupee, from 31 levels to 38 levels.

199697 - Stagnant

Thereafter the currency had been steady in a broad range of 35.60 to 36.00.

After currency falling in 1995-96, FII and FDI flows picked up in 1996-97, making up forsizeable debt repayments.


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Trade, which had grew at a rate in excess of 20% over 1994-96, stagnated in Financial Year1996-97(April to March), due to both, credit squeeze induced slowdown in domestic growth

as well as a downturn in India's major export markets.

Capital inflows during 1996-97 roughly matched capital outflows and, together with subduedimports and trade, led to a relatively stable Rupee.

1997-98 to 2000-01 - Depreciation of Rupee

In 1997-98 the rupee depreciated by 9.1 per cent, in 1998-99 by 6.9 per cent, and again itcontinued to depreciate by 6.5 per cent in 2000-01.

The increase in prices of crude oil internationally which impacted on Indias trade and it hadan effect on the exchange rate. Since 1998, increase in the prices of imported oil had been

high. This resulted in increase in import bill substantially.

The other point was the higher rate of inflation on the value of the rupee. The major reasonfor increase in the rate of inflation during that period in India was the increase in the prices of

petroleum products, including mineral oils, etc.

2001-04 - Rupee Appreciation

India recorded a current account surplus since financial year 2001-02, also liberalization encouraged

and attracted large inflows on its capital account. This pressure on the rupee lead to its appreciation.

The principal sources of current account inflows have been buoyant remittance flows andinflows under the ''software services'' head. Inflows on account of software services rose from

$5.75 billion in 2000-01 to $6.88 billion in 2001-02, $8.86 billion in 2002-03 and $9.09

billion over the first nine months of 2003-04, while private transfers (mainly remittances)

were $12.8 billion and $12.13 billion in 2000-01 and 2001-02 respectively, and it touched$14.81 billion in 2002-03 and $14.49 billion during April-December 2003.In an

intensification of this trend, during the first nine months of the financial year 2003-04, net

inflows on account of invisibles stood at around $18 billion, well above the $15 billion deficit

on the trade account.

Even while India's current account was relatively healthy on account of the foreign exchangelargesse from Indian workers abroad, the country's liberalized capital markets have attracted

large inflows of capital amounting to a net sum of $10.57 billion in 2001-02, $12.11 billion

in 2002-03 and a at around massive $18 billion during the first nine months of 2003-04.


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20062010 - Rupee Appreciation

The trend of steady month-on-month appreciation began in September 2006. The Indianrupee had appreciated by nearly 10% since late 2006, posing an acute dilemma for Indian

policymakers. The average rupee-US dollar rate in November 2007 was the lowest since

1999/2000.

It suggests that the country's attractiveness to foreign investors had been increasing andsignals optimism about the Indian economy more generally.

Performance of Indian rupee against dollar has improved significantly in the year 2009-2010.The rupee has shown tremendous strength against the US$ as the rupee US$ exchange rate

appreciated to Rs. 46.64 per dollar on January 1, 2010, which was Rs. 50.95 per dollar in

end-March 2009. Overall the rupee has appreciated by 9.2 per cent over its March 31, 2009

level, according to Economic Survey 2009-10.

Explaining the rupee's appreciation

The main reason for the rupee's appreciation since late 2006 has been a flood of foreign-exchange

inflows which was primarily due to the strong fundamentals of the economy which includes:

High GDP growth Rate - (GDP grew by more than 9 % since FY06) Demographic dividend Low Inflation Reasonable interest rates Strong Corporate earnings Change in FII inflows, continued inflows under FDI and NRI deposits Weakening of the US$ in international markets

The main factors responsible for Rupee appreciation are as follows:

FDI - India's stellar economic growth had created a large domestic market that offeredpromising opportunities for foreign companies. In the current year FDI equity inflows during

the financial year 2009-2010 (from April 2009 to November, 2009) are US $ 19,379 million

(Rs. 93,354 core) compared to US $ 19,791 million (Rs. 85,700 corer) during the

corresponding period in 2008-09. This represents a decrease of 2% in dollar terms and an

increase of 9% in rupee terms. The cumulative amount of FDI equity inflows from April
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2000 to October 2010 stood at US$ 122.68 billion, according to the data released by the

Department of Industrial Policy and Promotion (DIPP)

Foreign portfolio inflows - India's booming stock market embodied the confidence ofinvestors in the country's corporate sector. Foreign portfolio inflows had played a key role in

fuelling this boom. In dollar terms the net equity inflow in 2010 totaled $29.36 billion,

compared to an inflow of $17.45 billion in 2009. The annual inflow in 2010 was at record

level.

External commercial borrowings (ECBs) - Indian companies had borrowed enormousamounts of money overseas to finance investments and acquisitions at home and abroad.

ADR and GDRs: Another major source of portfolio capital inflows had been overseas equityissues of Indian companies via global depositary receipts (GDRs) and American depositary

receipts (ADRs The inflows under ADRs/ GDR increased to US $ 2.7 billion in April-

September 2010 (US $ 1.1 billion in April-September 2009).

Investments and remittances - Indians settled in other countries have also been a majorsource of capital inflows, with many non-resident Indians (NRIs) investing large amounts in

special bank accounts. The attractive interest rates offered on such deposits provided a

powerful incentive.

Impact of Rupee Appreciation on Companies

The RBI's deputy governor, Rakesh Mohan, referred to the effects of the rupee's appreciation as a

case of "Dutch disease" . The term refers to episodes where large inflows of foreign exchange

usually as a result of the discovery of natural resources or massive foreign investment leads to

appreciation of the currency, undermining a country's traditional export industries.

Positive Impact of Rupee Appreciation

The appreciation of the INR helped in bringing down the countrys import bill particularlythat of oil imports which easily accounts for more than a third of all imports. This in turn

helped the country in bringing down the trade deficit.

Major Indian stock indices were able to scale new peaks because of appreciation in the INR.This resulted in wealth creation for the investors.

INR appreciation helped control inflation.


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Sectors that gained from the currency appreciation were auto, engineering, telecom,aviation companies to name a few:

Auto: The biggest gainers in the auto sector are Hero Honda, Maruti, Tata Motors andAshok Leyland as the imported price of their raw materials cost less.

Engineering: Engineering companies like Suzlon also gained on raw material costsavings.

Aviation: Airlines like Jet were gainer on account of its aviation fuel costs. Companies with foreign currency loans: Companies with foreign currency loans or

FCCBs like Reliance Communications, Bharat Forge, Sun Pharma and Ranbaxy are also

gained due to rupee appreciation due to lower debt servicing costs.

Telecom: The telecom companies capital expenditure (capex) mainly goes intoequipment imports for their expansion plans. The rupee appreciation resulted in foreign

exchange gains as the companies were paying in dollars. The two major companies

Bharti Airtel and Reliance Communications were the major Gainers

Negative Impact of Rupee Appreciation

Sectors that lost due the currency appreciation were apparel, IT, BPO, Textile companies toname a few.

The continued appreciation of the rupee by had made it difficult for the manufacturing

exporter, who had to further offer his quotations to match the competitive range of suppliers

from other countries.

Apparel:In the apparel sectorone of India's major export industries--the strongcurrency led to a decline of 3.5% year on year in January-April 2010. During the

same period, apparel exports to the US by China, India's most important competitor,

rose by 57%. Moreover, for India the decline marked the reversal of a positive

trendapparel exports to the US were rising at an average rate of 21% a year after

import quotas were phased out at the beginning of 2005.

IT: Software companies lost on the back of the appreciating rupee as their exports arepriced in foreign currency. Infosys had in the fourth quarter seen an impact of 100 bps

on their operating margins because of the movement of the rupee.
http://www.bharti.com/http://www.rcom.co.in/webapp/Communications/home.jsphttp://www.rcom.co.in/webapp/Communications/home.jsphttp://www.bharti.com/


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BPO: The rise of the rupee against the dollar impacted the Indian outsourcingcompanies, as two-thirds of their business comes from the U.S.A. The rising rupee

had pushed down exporters' rupee revenues, even as their costs locally (staff salaries

etc) went up.

Textile: Textile growth from a healthy export growth rate of 21% in 2005-06plummeted to a mere 4.6% during the 11 months of2009-10. This had also resulted in

a lot of job cuts.

Others: Other sectors like leather and handicrafts, which provide hugeemployment, actually registered a negative growth. These sectors seldom use import

for their production and are mainly depending on export for revenue generation.

Hence the appreciating rupee did not cause any savings in raw material purchases for

leather and handicraft companies on the contrary it resulted in severe pressure on

margins.

Policy dilemma

Given the limited extent to which the RBI can intervene in the foreign-exchange market in the face

of large and sustained capital inflows, policymakers can only stem rupee appreciation substantially

by easing limits on domestic firms' overseas investments or restricting inflows, for instance, through

further controls on ECBs

RBI had stopped aggressive intervention in the currency market because of the adverse effects

noticed as a result of its injection of liquidity by sale of rupees in exchange for forex. The supply of

excess domestic currency leads to inflationary pressures unless offset by sterilisation, which means

the central bank would have to sell debt paper of Government to the banks to suck out the additional

rupees. Unfortunately, sterilisation has its costs. It increases the supply of debt paper leading to a fall

in their price, which is the inverse of interest rate. The net result of successful intervention and

sterilisation is rise of interest rates, which, in turn, leads to further capital inflows,a vicious cycle.

Rise of the rupee: Way out

Following are some of the ways of dealing with the rising rupee:

Japan faced its problem of appreciation of the yen in the 1990s from nearly 230 yen to adollar to around 130. To overcome this appreciation Japan improved its productivity and

introduced product innovations. To emulate Japan, India, perhaps, needs to import low end


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goods from other developing countries and concentrate on value-added products. This is

possible as, with the appreciation of the Rupee, newer technologies become economical and

accessible to Indian manufacturing. This is, of course, a challenge that requires a host of other

enabling factors. Infrastructure, for instance, is an important bottleneck.

As India is home to one-sixth of humanity Indian businesses can ill afford to ignore their ownhome markets? They should focus partly on the domestic markets which will provide and

automatic hedge to rising rupee

9. Outlook for the Future

9.2 Currency FuturesOutlook for India

Currently several stipulations apply to the derivative instruments available in India. In an effort to

ensure that forwards are used only for hedging purposes, resident individuals/firms and FIIs can

book contract in the forward market only against their underlying. Therefore entities outside India

even if having direct or indirect exposures on INR cannot hedge themselves.

An important consequence of these restrictions has been the development of a vibrant offshore

market inNon-Deliverable Forwards (NDF) on the Indian rupee. Based primarily in Singapore and

in operation since the mid-1990s, this is a market where deals are settled by paying in dollars the

difference between the contracted forward price and the resulting spot price of the rupee on the

settlement date. Thus no rupee transaction actually takes place, but the instrument serves as a betting

device on the value of the rupee. In recent times, the NDF market has witnessed explosive growth

with average transaction volumes reportedly exceeding $750 million a day in 2007, from about $100

million a day only three years ago. Most major foreign banks offer NDFs, but Indian banks are

barred from doing so. The NDF market serves currency hedge funds and other offshore entities

interested in speculating on India. Multinationals and foreign portfolio investors who use the P-Note

route to Indian assets also use this hedging device.

Arbitrageurs, including Indian exporters, with access to both onshore and offshore forward markets

help keep the rates close to one another.

The first exchange-traded currency derivative on the rupee was recently launched in Dubai.


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The success of rupee futures in Dubai, without explicit RBI approval, points to two things: that it

were regulations that held back the growth of exchange-traded currency derivatives in India, and that

in todays globalised financial environment, domestic strictures merely shift the trading overseas.

In order to provide the entities that are exposed to currency risk with more hedging instruments the

Indian government is planning to introduce exchange traded currency futures. Once these futures are

introduced the NDF markets in INR will cease to exist.International experiences, albeit of select

countries like South Africa and South Korea, suggest that currency futures could coexist with the

OTC currency markets as well as capital controls.

A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain

underlying instrument on a certain date in the future, at a specified price. Traditionally, the futures

market meets the needs of the three distinct sets of market users

those who wish to discover price information those who wish to speculate and those who wish to hedge

Forward vs. Future

The pros and cons of Future contracts as compared to forward contracts are as follows:

Advantages of Futures

The exchange traded currency futures offer different advantages over OTC market. The

advantages are:

Transparency and efficient price discovery. Elimination of counterparty credit risk. Access to all types of market participants. Standardized products. Transparent trading platform.

Disadvantages of Futures


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The futures are also disadvantageous in a few areas when compared to OTC market. The

major disadvantages are:

Standardization it is not possible to obtain a perfect hedge in terms of amount andtiming.

Cost forwards have no upfront cost, while margining requirements may effectivelydrive the cost of hedging in futures up.

Small lots- not possible to hedge small exposures generally.Risks of possible Dollarization of the economy

Dollarization refers to broad use of foreign currency as a substitute for domestic currency for

transaction or other purposes. Currency futures, however, entail some potential risk of permeating

through the capital controls in place causing dollarization of the economy, as its consequence or

otherwise. Given a choice, many residents might prefer to hold assets denominated in foreign

currencies (US dollar or any other hard currency) in the interest of preserving the value of their

holdings. Such a preference of the economic agents could potentially lead to dollarization of an

economy.

The serious risk emanating from the process of dollarization is that it makes it very difficult for the

domestic monetary authority to conduct an independent monetary policy.

It could be extremely damaging to the domestic economy if, for instance, the domestic demand

shock warrants a monetary policy compression in the domestic economy at a time when the external

monetary authority is pursuing an expansionary monetary policy on the basis of its own

macroeconomic situation, or vice-versa.

The gains likely from the introduction of currency futures in the Indian context could be set

out as below:

Provide an additional tool for hedging currency risk. Further development of domestic foreign exchange market. Permit trades other than hedges with a view to moving gradually towards fuller capital

account convertibility.


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Provide a platform to retail segment of the market to ensure broad based participation basedon equal treatment.

Efficient method of credit risk transfer through the Exchange. Create a market to facilitate large volume transactions to go through on an anonymous basis

without distorting the levels. While theoretically futures prices should reflect similar interest

rate expectations, the real effect on prices remains to be seen.

Framework for Introduction of Currency Futures

Initially only USD-INR currency futures contract may be introduced at the outset The Internal

Working Group of RBI recommends that a single contract of notional value USD 1,000 may beintroduced.

The Group recommends the following:

Initially, the tenors of the contract may largely replicate the tenors of the currency forwardsand to this end, the currency futures maturing in the first 12 calendar months may be offered.

The futures settlement cycle may be co-terminus with the settlement of month end forwardcontracts.

No quantitative restrictions may be imposed on residents to trade in currency futures. This islikely to ensure greater liquidity and wider participation and would be in line with usual

policy where liberalization is done first for residents.

Participation


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In the interest of financial stability, at the inception, the participation in the futures market may be

restricted to residents alone. This will help in evaluating the robustness of various systems such as

surveillance, monitoring, reporting, etc.

Role of Reserve Bank

The introduction of currency futures will not alter the role of Reserve Bank in the domain of

exchange rate management. The Reserve Bank will continue to retain the right to stipulate or modify

the participants and / or fixing participant-wise position limits or any other prudential limits in the

interest of financial stability.

Currency Futures Market: Surveillance and Reporting

A key prerequisite for smooth functioning of the currency futures market at exchanges is to put in

place a state-of-the- art surveillance system and an adequate reporting mechanism. Ideally, the

surveillance system should have the following features:

It should be based on the on-line trading system It should have the capability of generating real time data, if required.

It may also provide exception reporting at a fairly short interval of say every half-an-hour.

Be capable of providing warning mechanisms through alerts at the earliest possible. It should also be able to treat distinctly hedge, arbitrage, and speculative trades.

The surveillance system is of a critical importance, especially in respect of the generation of key

reports on market manipulation. The primary task of the Surveillance Committee should be to ensure

that day-to-day monitoring by the exchange ensures compliance with the best of the surveillance

abilities.


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9.3 Exchange traded Currency Options

Once the currency futures are implemented and the currency future market stabilizes, the

government can go ahead with the implementation of exchange traded currency options.

Transactions can be cleared through the clearinghouses of the exchanges on which currency futures

will be traded.

The option buyer who has no further financial obligation after having paid the premium may not be

required to make margin payments. The option writerwho would have all of the financial risk may be

required to put up initial margin and to make additional (maintenance) margin payments if the

market price moves adversely to his position.

Options on foreign currencies presently are traded on the Philadelphia Stock Exchange(PHLX) and

the Chicago Mercantile Exchange (CME).

Advantages of Currency Options:

Exchange-traded options have many benefits including: flexibility

evolution and future of forex

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