Blog | TheRoughPaper

QUERY? ASK US

FOREIGN EXCHANGE MARKET

27 Sep, 2018 RBI General Studies

.

Part I - Foreign Exchange Market

It is an online network where exchange of different currencies take place. The buyers and sellers exchange the currencies at the exchange Rate. The exchange is always in pair i.e dollar against euro/ pound against rupee etc . Hence there is never an absolute value of a currency. It is always relative to another currency. And hence the term foreign Exchange or Forex.

The exchange takes place through financial centres around the world which facilitate in trading between multiple types of buyers. These exchange centres work everyday except the weekends. By far it is the largest market in the world in terms of volume. Trading is huge coz of the number of people and entities who participate in this exchange. The main attraction of this market is not limited to buying and selling of currencies but the exchange of one currency for another and speculation of the currencies.

This market comprises of the following: central banks, commercial banks, corporates, investment management fund companies, brokers and investors. So let us understand how these entities communicate with each in the market.

 

Choice of exchange rate Regime:

1. Fixed Exchange Rate Regime

2. Fully Floating Exchange Rate Regime

3. Intermediate Exchange Rate Regime

Now who or under what circumstances the exchange rate regime is selected?

1. Fixed Exchange Rate Regime - Small economies. Eg. Nepal Tibet use Indian ruppe exchange rate. African Countries use SA Rand

2. Fully Floating Exchange Rate Regime - No central bank or the government regulates the exchange rates. The currency value is decided by the demand and supply. However developing countries try to resist it as the speculation on a currency can de stabilise the economy and its import export.

3. Intermediate Exchange Rate Regime - The most commonly used exchange rate regime. Most countries follow the "fixed but adjustable" exchange rate regime where the currency can be devalued if the need be. The countries intervene or manage the rates if the movements are expected to destabilise.

Exchange Rate Management in India in chronological Order

  • 1947-1971 : Par value System. Rupees external value was fixed at 4.15 gms of fine gold. In term of currency rupee was pegged against Pound sterling.
  • 1971-1992: Pegged Regime. Exchange rate of Rupee was determined by the RBI in the band of +-5% against the basket of currencies with India traded majorly.
  • The Foreign Exchange Regulation Act (FERA) enacted in 1973, FERA was given the real power by making “any violation of FERA was a criminal offense liable to imprisonment”. It a professed a policy of “a person is guilty of forex violations unless he proves that he has not violated any norms of FERA”.
  • Since 1991: Partial convertibility of rupee known as LIBERALISED EXCHANGE RATE MANAGEMENT SSTEM (LERMS). It was a dual scheme where 40 % of the foreign exchange earning was at the official rate and rest 60 % at the market rate. The foreign exchange surrendered at the official rate was used to import oil, life saving drugs etc.
  • Market determined rate regime since 1993: market determined day to day exchange rates. The 60-40 exchange rate was converted into 100pct exchange rate.

Foreign Exchange Dealer’s association of India (FEDAI), set up in 1958, helped the government of India in framing rules and regulation to conduct forex exchange trading and developing forex market In India.

Need for Accumulation of Foreign Currency

The need for accumulation of foreign currency has increased due to increased globalisation. Under a fully floating exchange system, accumulated currency would have minimal or no role. But mostly countries adopt the INTERMEDIATE exchange policy. The need for maintaining adequate foreign currency can be summed as follows

  • Maintaining confidence in the economy of the country.
  • Limiting external influences
  • Absorbing sudden shocks in the international economy
  • Reducing volatility

So the next question arises is how much stock is sufficient for an economy?

The ans is It is depends on the size of the economy and the current and capital account of the BOP. Based on the size of the economy the stock reserves should be equivalent to a few month imports.

 

The Capital account transactions are also very important.

Among the capital account transactions the most important is the short term external debt.

  • India's foreign exchange reserves comprise foreign currency assets, gold and special drawing rights allocated to it by the International Monetary Fund (IMF) in addition to the reserves it has parked with the fund. Foreign exchange reserves are held and managed by the RBI.
  • The Foreign currency assets are investment mainly in instruments abroad which have the highest credit rating and which do not pose any credit risk. These include sovereign bonds, treasury bills and short-term deposits in top-rated global banks besides cash accounts.
  • The Special Drawing Right (SDR) is an interest-bearing international reserve asset created by the IMF in 1969 to supplement other reserve assets of member countries. The SDR is based on a basket of international currencies comprising the U.S. dollar, Japanese yen, euro and pound sterling. It is not a currency, nor a claim on the IMF, but is potentially a claim on freely usable currencies of IMF members.

From crisis prevention point of view reserves to short term debt ratio has gained prominence. As per the GUIDOTTI rule, the reserves adequacy is that country must be able to meet the external borrowing without additional borrowing for one year.

 

India's Approach : A sterilised Intervention by RBI

  • As discussed, foreign reserves are accumulated for maintaining the confidence on the economy. A high reserve also alleviates liquidity risk. In the current scenario India is maintaining a foreign currency reserve of about 400 billion USD. The question arises what is the policy RBI has taken up to maintain the forex reserves.
  • The built up of capital is due to the inflow of foreign currency from various sources like remittances, FDI, FII. These dollars are not absorbed by the economy fully because of slowed imports. Hence RBI buys these dollars from the market and sells rupee in return. Thus the dollar purchased by RBI added to the foreign reserve. However the rupee injected into the market can create inflation. Hence RBI sells government securities to suck out the extra money.
  • This whole process of removing excess dollar from the economy and releasing rupees and then again absorbing the rupee in the form of Government bond is called Sterlisatiion process to control the economy as well as maintain forex reserves.

Market Stabilisation Scheme

  • Sometimes there is a persistent flow of foreign exchange and this was absorbed through the Liquidity Adjustment Facility (LAF) and the open Market Operations (OMOs) conducted by the Reserve Bank. However, a depletion in the stock of securities hampered the LAF and the Open market operations of the Reserve Bank.
  • To make up for this, the Reserve Bank signed in March 2004, a memorandum of understanding (MOU) with the Government of India for issuance of dated government securities of a maturity of less than two years and treasury bills under the MSS.
  • The scheme came into effect from April 1, 2004.
  • The main purpose of introducing the scheme was to absorb surplus liquidity of a more enduring nature, thus reducing the burden of sterilisation on the LAF window.
  • These bonds have a tenor of two years and the proceeds from them remain in a separate account of the Reserve Bank (not used for govt. spending).
  • This account is utilised solely for redeeming the principal amount of market stabilisation bonds.
  • The liability of the government is restricted to interest payments

 

PART II - Currency convertibility

Currency convertibility in economic parlance refers to the freedom to convert the domestic currency into other internationally accepted currencies and vice versa.

Some of the world’s currencies are accepted in all types of transactions throughout the world. These are called convertible currencies. Examples are US dollar, Swiss franc, French franc, British pound, Germany marc and so on. Other currencies are called inconvertible currencies because these are not accepted by all countries in all types of transactions.

The international status of a country’s currency depends on two things:

(i) The country’s balance of payments position and

(ii) The confidence of the rest of the world in the country’s currency

Currency convertibility is of two types: on current account and on capital account.

  • If a currency is convertible only on current account it is called a partly convertible currency. Such a currency is accepted for all current transactions such as exports of goods and services and unilateral payments and receipts.
  • However, if a currency is convertible on capital account also (along with current Account) it is called a fully convertible currency. Such a currency can be used to repay the external debt. For example if rupee becomes a fully convertible currency India will be in a position to repay her external debt in rupees rather than in foreign exchange. Capital account convertibility is also likely to encourage greater inflow of financial capital from the rest of the world and thus improve the country’s balance of payments position.

Convertibility of the Rupee:

The Indian rupee was made a partly convertible currency in the wake of the liberalisation policy announced in July 1991. Rupee has been linked to a basket of currencies and a new exchange rate system has been introduced since then called liberalised exchange rate mechanism system (LEMS). Now rupee is floating in the international market and its external value is deter­mined by the free play of market forces. But rupee is yet to be made a fully convertible currency.

Capital Account Convertibility

A concept put forward by economists for the following benefits:

1. Liberal capital account directly related to faster economic growth

2. A developing nation will require external capital for its investment than the savings

3. In the era of globalisation where trading is becoming free and open, it is difficult to control the capital account in the long run

4. The government will become more responsible towards the investors as a fiscal deficit will crumble the economy. There will be masssive outflow of money rather than inflow.

India's Approach : 

Tarapore Committee –

3 main conditions:

1. Fiscal consolidation 

2. Fixed inflation target  

3. Strengthening financial sector

The report said that implementing capital account convertibility would increase capital inflows. But, it would make it difficult to implement an effective domestic monetary policy. The report suggested that capital account convertibility should not be fully implemented until weaknesses in the financial systems are completely eliminated. 

Based on the recommendations of the committee, the Foreign Exchange Regulation Act (FERA) was repealed and replaced with Foreign Exchange Management Act (FEMA) in June 2000.

Monitoring of the CAC Convertibility (RBI WEBSITE)

The Committee has also recommended that certain important macroeconomic indicators, i.e., the exchange rate, the balance of payments and the adequacy of reserves should be monitored while determining the appropriate timing and sequencing of CAC. In the conduct of exchange rate policy, the RBI should have a monitoring band of +/- 5 per cent around the neutral Real Effective Exchange Rate (REER) and ordinarily intervene as and when the REER is outside the band. The REER band should be declared, published contemporaneously and changes in neutral REER made public.

What is REER and NEER

  • Nominal Effective Exchange Rate is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies. It is the exchange rate of one currency against a basket of currencies, weighted according to trade with each country (not adjusted for inflation).
  • Real Effective Exchange Rate (REER) is the weighted average of nominal exchange rates, adjusted for inflation.
  • A country's REER is an important measure when assessing its trade capabilities and current import/export situation.

 

Part III – Derivative Instruments in Forex Market

 

Derivative Market Instruments

Derivatives play a crucial role in developing the foreign exchange market as they enable market players to hedge against underlying exposures and shape the overall risk profile of participants in the market.

Banks in India have been increasingly using derivatives for managing risks and have also been offering these products to corporates.

Foreign Exchange Forwards

  • Authorised Dealers (ADs) (Category-I) are permitted to issue forward contracts to persons resident in India with crystallised 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 the Reserve Bank.
  • The residents in India generally hedge crystallised 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.

Foreign Currency Rupee Swap

A 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.

Foreign Currency Rupee Options

  • ADs (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.

Cross-Currency Options

  • ADs (Category-I) are permitted to issue cross-currency options to a person resident in India with crystallised 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.

Cross-Currency Swaps

Entities 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.

Part IV – Money Market and Forex Market

The call money market and the foreign exchange market are also closely linked as there exist arbitrage opportunities between the two markets. When call rates rise, banks borrow dollars from their overseas branches, swap them for rupees, and lend them in the call money market.

At the same time, they buy dollars forward in anticipation of their repayment liability. This pushes forward the premium on the rupee– dollar exchange rate. It happens many a times that banks fund foreign currency positions by withdrawing from the call money market. This hikes the call money rates.

 

Liquidity Changes and Gaps in the Foreign Exchange Market Call rates increase during volatile forex market conditions. This increase is a result of monetary measures for tightening liquidity conditions and short position taken by market agents in domestic currency against long positions in US dollars in anticipation of higher profi ts through depreciation of the rupee. Banks fund foreign currency positions by withdrawing from the inter-bank call money market which leads to a hike in the call money rates.

Global Depository Receipt –

  • GDRs are essentially equity instruments issued abroad by authorised overseas corporate bodies against the shares/bonds of Indian companies held with nominated domestic custodian banks.
  • An Indian company intending to issue GDRs will issue the corresponding number of shares to an overseas depository bank.

American Depository Receipts (ADRs)

  • ADRs enables investors based in the USA to invest in stocks of non-US companies trading on a non US stock exchange.
  • These are negotiable instruments, denominated in dollars, and issued by the US Depository Bank.
  • A non-US company that seeks to list in the US, deposits its shares with a bank and receives a receipt which enables the company to issue American Depository Shares (ADSs).

BASIS FOR COMPARISON

ADR

GDR

     

Meaning

ADR is a negotiable instrument issued by a US bank, representing non-US company stock, trading in the US stock exchange.

GDR is a negotiable instrument issued by the international depository bank, representing foreign company's stock trading globally.

Issued in

United States domestic capital market.

European capital market.

Listed in

American Stock Exchange such as NYSE or NASDAQ

Non-US Stock Exchange such as London Stock Exchange or Luxemberg Stock Exchange.

Negotiation

In America only.

All over the world.

Market

Retail investor market

Institutional market.

 

External Commercial Borrowings

  • ECB is basically a loan availed by an Indian entity from a nonresident lender. Most of these loans are provided by foreign commercial banks and other institutions.
  • It is a loan availed of from non-resident lenders with a minimum average maturity of 3 years.
  • External Commercial Borrowings supplement domestically available resources for expansion of existing capacity as well as for fresh investment.

ECBs can be accessed under two routes, the automatic route and the approval route.

Automatic Route

ECBs for investment in the real sector–the industrial sector, especially the infrastructure sector in India are under the automatic route, i.e., they do not require RBI/government approval.

Approval Route

ECBs that do not come under the automatic route are now considered by an empowered committee of the Reserve Bank for approval.

Foreign Currency Convertible Bonds (FCCBs)

FCCBs are bonds issued by Indian companies and subscribed to by a non-resident in foreign currency.

  • They carry a fixed interest or coupon rate and are convertible into a certain number of ordinary shares at a preferred price.

Foreign Currency Exchangeable Bonds (FCEBs)

Foreign currency exchangeable bond is a bond offered by an issuing company and subscribed to by investors living outside India and exchangeable into equity shares of another company, which is called the offered company, in any manner, either wholly or partly or on the basis of any equity-related warrants attached to debt instruments.

  • For example, Reliance India, a promoter of all Reliance group companies, issues exchangeable bonds to raise funds for Reliance Jio.

Foreign Direct Investment (FDI)

It is the investment through capital instruments by a person resident outside India

(a) in an unlisted Indian company; or

(b) in 10 percent or more of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company.

  • Once the investment is classified as FDI (basis total holding), if the FDI holding comes back to <10% it will continue to remain as FDI.

 

Foreign Portfolio Investment

It is any investment made by a person resident outside India in capital instruments where such investment is

(a) Less than 10 percent of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company or

(b) Less than 10 percent of the paid up value of each series of capital instruments of a listed Indian company.

Foreign Institutional Investor - FII

  • A foreign institutional investor (FII) is any type of large investor who does business in a country other than the one in which the investment instrument is being purchased. In addition to the types of investors above, others include banks, large corporate buyers or representatives of large institutions. All FIIs take a position in a foreign financial market on behalf of the home country in which they are registered.
  • All FIIs are allowed to invest in India's primary and secondary capital markets only through the country's portfolio investment scheme (PIS). This scheme allows FIIs to purchase shares and debentures of Indian companies on the normal public exchanges in India.
  • There is a ceiling for all FIIs that states the max investment amount can only be 24% of the paid-up capital of the Indian company receiving the investment. The ceiling is reduced to 20% of the paid-up capital for investments in public sector banks.

 

YOUR COMMENT

POST

ALL COMMENTS (1)

Govinda S
18 Oct, 2018

Thank u maam