| Exchange Rate Systems: Global Currency, Inflation Rate & Method of Calculation |
Introduction of EXCHANGE RATE SYSTEM
To prepare for INDIAN ECONOMY for any competitive exam, aspirants have to know about the Exchange Rate System. It gives an idea of all the important topics for the IAS Exam and the Economy syllabus (GS-II). Important Exchange Rate System terms are important from Economy perspectives in the UPSC exam. IAS aspirants should thoroughly understand their meaning and application, as questions can be asked from this static portion of the IAS Syllabus in both the UPSC Prelims and the UPSC Mains exams
In this article, you will read about meaning, method, types, importance and other aspects related to the Exchange Rate System.
The exchange rate of any currency is determined by the supply and demand for the country’s currency in the international foreign exchange market.
- For example, the value of Indian rupee with respect to the dollar is determined by the demand of dollars against the Indian rupee. If the demand for dollars increases, its value increases, and the dollar appreciates while the Indian rupee depreciates with respect to the dollar.
- Exchange Rate System: The price of one currency in terms of the other currency is called the exchange rate. E.g. $1 = ₹ 70. Meaning, it costs ₹ 70 to buy one dollar.
- This is also called Nominal Exchange Rate because it does not take into consideration inflation or purchasing power in the respective countries.
- Foreign Exchange Market is a place where currencies are exchanged. Their dealers are called Authorized (Forex) Dealers (AD). They can be banks or non-banks. They have to get registered with RBI under the Foreign Exchange Management Act (FEMA).
- These dealers keep separate prices for buying and selling, to make profit in between e.g. ICICI: $1 Dollar buying price ₹ 67.95 and $1 selling price is ₹ 72.76.
- Exchange Rate System: Such currency transaction service is also subjected to GST, however the rate depends on the quantum of currency exchanged. (e.g. upto ₹ 10 lakh exchanged in foreign currency then only about ₹ 3000 of that 10 lakh will be taxable in GST → 18% of 3000 → ₹ 540 GST Tax.)
American Economist James Tobin had suggested 0.1% to 0.5% Tobin Tax on currency exchange transactions to discourage the speculative trading and volatility in the International Financial Market, but on that logic if ₹ 10 lakhs exchanged then 0.1-0.5% = ₹1,000 to 5,000 should be levied as ‘tax’, but since GST amount is much lower, so in reality it can’t be labeled as ‘Tobin Tax’.
Exploring the Objectives of Exchange Rate Management in India within the Global Exchange Rate System
- To ensure that the economic fundamentals of the Indian economy are correctly reflected in the external value of the Indian rupee.
- To reduce the volatility in exchange rates for ensuring that changes in the exchange rates take place in a smooth and orderly manner.
- To maintain a sufficient level of foreign exchange reserves to deal with any external currency shocks.
- To help in the elimination of market constraints for ensuring the growth of a healthy foreign exchange market.
- To help in the prevention of the emergence of any destabilizing and speculative activities in the foreign exchange market.
The exchange rate system in India has undergone a systematic change since Independence. From the system of the pegged exchange rate to the present form of market determined exchange rate after liberalization in 1993.
Understanding the Rupee: Exploring Key Factors Influencing the Exchange Rate of India
- The Exchange Rate System: Exploring the Intervention of the Reserve Bank of India
- During high volatility in the exchange rate system, RBI intervenes to prevent the exchange rate going out of control.
- For example, the RBI sells dollars when the Indian rupee depreciates too much, while it purchases dollars when the Indian rupee appreciates beyond a certain level.
- Inflation rate:
- The increase in inflation rate can increase the demand for foreign currency which can negatively impact the exchange rate system of the national currency.
- For example, an increase in the inflation level of petroleum oil can increase the demand for foreign currency leading to the depreciation of the Indian rupee.
- Interest rate:
- Interest rates on government securities and bonds, corporate securities etc affect the outflow and inflow of foreign currency.
- If the interest rates on government bonds are higher compared to other country forex markets, it can increase the inflow of foreign currency, while lower interest rates can lead to the outflow of foreign currency. This affects the exchange rate system of the Indian rupee.
- Exports and imports:
- Exports and imports affect the exchange rate system as exports earn of foreign currency while imports require payments in foreign currency.
- Thus, if the overall exports increase, the national currency appreciates, while increases in imports lead to the depreciation of the national currency.
- Apart from above, the Indian foreign exchange market is also affected by factors such as the receipts in the accounts of exports in invisibles in the current account, inflow in the capital account such as FDI, external commercial borrowings, foreign institutional investments, NRI deposits, tourism activities etc.
Understanding Exchange Rate Systems: Analyzing Exchange Rate Regimes in India
It is the set of rules governing the exchange of domestic currency with foreign currencies.
EXCHANGE RATE REGIME: Exploring the Dynamics of the Exchange Rate System
- Floating or Flexible
- Fixed or Pegged
- Managed Float / Dirty Float
- Floating or Flexible
- A floating or flexible exchange rate system is determined by the market forces of demand and supply.
- Under the floating exchange rate regime, the market forces determine the value of domestic currency on the basis of the forces of demand and supply of the domestic currency.
- In this system, neither the government nor the central bank intervenes and the market functions freely to determine the real value of domestic currency.
- The floating exchange rate regime establishes trust among the foreign investors which can help in the increase in foreign investment in the domestic economy.
- This system ensures that a country can get easy access to loans from the IMF and other international financial Institutions.
- So if there are more Indian people wanting to import crude oil, gold, iPhone; Compared to the number of Americans interested to buy Indian goods, services; / coming to vacation in Kerala, then, demand for dollars will be more than that of rupees. So, $1 = 50 → $1=70
- In this system, if rupees weakens, it is called “Depreciation” (e.g. 50 → 70); Makes the export look cheaper to the foreign buyer if ₹ strengthens it is called “Appreciation” (e.g. 70 → 50)
| Challenge | |
| Currency Speculation | When a person buys $ and other foreign currency with the hopes they become more expensive in future so he can sell at a profit to others. In other words, he would be hoping for ₹ to depreciate / $ to appreciate. Such elements distort the exchange rate by hoarding foreign currencies. |
| Interest Rates | If US repo rate / Treasury Bonds are going at 2% whereas in Greece’s bonds going at 4% Then American investors will convert Dollars to invest in Greece. Later, when the US Fed increases their repo rate from 2% to 4% American investors might pull back from Greece. Because America commercial bank loans will become more expensive by about 5%, then there will be American companies willing to borrow by issuing Bond/debentures at 4.5%. |
- Fixed Exchange rate system- IMF would decide for each country
- Floating Exchange rate- Fixed exchange rate system has inherent risk of Payment crisis. Hence many countries started shifting to Floating Exchange Rate system, first being UK in 1973
- Mixed Exchange Rate
- Where the central bank interferes whenever a crisis situation occurs. Otherwise the exchange rate system is market driven on day to day basis
1. Fixed or Pegged
- Under the fixed exchange rate regime, the government or the central bank has complete intervention in the determination of the currency’s exchange rate system. This is achieved by linking the domestic currency to the value of gold or with other major currencies such as the US dollar etc.
- For instance, when the central bank of a country itself decides the exchange rate system of local currency to foreign currency e.g. People’s Bank of China (PBC) $1 = 6 Yuan.
- If excess dollars are entering their market, the central bank will print more Yuan to buy and absorb the excess dollars, to ensure Yuan doesn’t strengthen against Dollar ($1 = 6 → 5 Yuan). As a result their forex reserve will get a large build-up of dollars, due to the central bank’s purchase.
- In future, if less dollars are entering in their market, the central bank will sell the (previously acquired) dollars from its forex reserve to ensure Yuan doesn’t weaken (₹ 1= 6 → 7 Yuan)
- In this system, if Yuan is weakened by Central Bank’s official notification, it is known as ‘devaluation’ (e.g. $1=6 → 7); usually done when it doesn’t have enough dollars in reserve to play the game and / or when it wants to deliberately weaken Yuan to encourage exports.
| Benefit | It ensures stability in the exchange rate system of the domestic currency. |
| It ensures that the domestic currency does not appreciate or depreciate beyond the predetermined level. |
| Challenge | This regime puts a massive burden on the government for maintenance of the exchange rate system and the government may have to infuse a large amount of money for the maintenance of the exchange rates. |
| The foreign investment can reduce under the fixed exchange rate regime as investors may lose their confidence as they believe that the exchange rate system of the domestic currency does not represent the real value of the economy. | |
| If the trade deficit widens or speculators are hoarding dollars or FPIs are pulling their money back to the USA due to higher interest rates. It will create a shortage of $ in the local forex market. Then PBC will have to sell $ from its forex reserve to keep the exchange rate stable. | |
| But since PBC will not have an infinite amount of dollars in its reserve, ultimately it will be forced to devalue the local currency. This will make imports more expensive. | |
| Therefore, most of the countries have abandoned this system after the 70s. China too abandoned it eventually, and shifted to Managed Floating Exchange Rate. |
Understanding the Floating Exchange Rate System in the Global Exchange Rate System
- Under the floating exchange rate regime, the market forces determine the value of domestic currency on the basis of the forces of demand and supply of the domestic currency.
- In this system, neither the government nor the central bank intervenes and the market functions freely to determine the real value of domestic currency.
- The floating exchange rate regime establishes trust among the foreign investors which can help in the increase in foreign investment in the domestic economy.
- This system ensures that a country can get easy access to loans from the IMF and other international financial Institutions.
2. Managed floating exchange rate system
- It is the middle path between the fixed exchange rate regime and the floating exchange rate regime.
- In the system, the exchange rate system of domestic currency is allowed to move freely based on the market forces of demand and supply.
- However, during difficult circumstances, the central banks intervene to stabilize the exchange rate system of the domestic currency.
- RBI will not decide the exchange rate system (unlike the fixed system). In the ordinary days, RBI will let the market forces of supply and demand decide the exchange rate system.
- But if there is too much volatility, then RBI will intervene to buy / sell $ to keep the volatility controlled.
- Similarly, People Bank of China will not intervene in ordinary circumstances. They will intervene during volatility. if $ to Yuan value changes more than “x%” up or down compared to the previous day’s exchange rate.
- It can further be categorized as following:
3. Managed floating exchange rate
- Crawling peg system
- Clean floating
- Adjusted peg system
- Dirty floating
| Adjusted peg system | Under this, the central bank tries to hold the exchange rate system of domestic currency until the foreign exchange reserves of that country gets exhausted. After this, the central bank goes for the devaluation of the domestic currency to move to another equilibrium of the exchange rate. |
| Crawling peg system | Under this, the central bank keeps on adjusting the exchange rate system based on the new demand and supply conditions of the exchange rate market. It follows a system of regular checks and balances and the central bank undertakes small devaluations based on the market conditions. |
| Clean floating system | Under this, the exchange rate of domestic currency is based on the market forces of demand and supply without the government intervention.This system is identical to the floating exchange rate system. |
| Dirty floating system | Under this, the exchange rate system is mainly determined by the market forces of demand and supply but the central banks occasionally intervened to remove excessive fluctuations from the foreign exchange markets. |
| Challenges in Managed Float System | Currency speculation and interest rates |
| Currency Manipulation: usually occurs when a central bank keeps buying dollars to create artificial scarcity of $ in the forex markets. This makes dollars more expensive. This makes local currency weak and helps in boost to exports. | |
| The US Department of the Treasury publishes a semi-annual report to track such nations. 2018: China, Germany, Japan, Switzerland, South Korea and India have been kept in (‘Watch list’) citing the (alleged) lack of transparency and consistency in their respective Central banks operations. The USA has not officially labeled anyone as “Currency Manipulator”, since 1994. |
Q. The price of any currency in international market is decided by: (CSE-2012)
Answer codes:
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Exploring Exchange Rate Systems and Regimes
- Gold Standard (1870-1914)
- Bretton Woods System (1946-1971)
- Pegged regime(1971-1992):
- Towards Managed Floating Exchange Rate: 1995 onwards
Fixed exchange rate system à Gold Standard (1870-1914)
- The USA would issue a $1 note, if only it has 14 grams of gold in reserve, whereas England would issue one pound note if only it has 73 grams of gold in its reserve. Accordingly, their exchange rate will be 1 Pound =73/14 = about 5 USD.
- And, each Central Bank Governor has promised to convert their currency into gold at a fixed amount. So, a person could walk with paper currency and demand the gold coins or gold bars in return.
- When the gold mining production declined, nations gradually shifted to ‘bimetallism g. $1 promised with 14 gm gold or 210 gm of silver whichever available with their Central Bank.
- This system collapsed during the First World War (WW1) because the nation’s currency printing capacity was limited by their gold reserve, but their governments were more eager to print more money to finance the war (soldiers’ salaries, rifles, ammunition etc.)
Fixed exchange rate system à Bretton Woods System (1946-1971)
- Here, the USA agreed to fix the price of its $1 = (1/35) ounces of gold. [1 ounce = 28 grams]. The USA allowed free convertibility of Dollar to Gold. So if a person walked into the US Federal Reserve with $35, their chairman (Governor) will give him one ounce of gold.
- Then the IMF fixed the exchange rate system of every country’s currency against the USA. e.g.₹ 1= $0.30 = about 0.24 grams of Gold. So, that implies India can’t issue more currency if RBI does not have proportionately sufficient gold reserves of its own. Still if RBI issues more ₹ currency, the International Monetary Fund (IMF) will order India to devalue its rupee exchange rate against dollar.
- Robert Triffin (American Economist) claimed this system will collapse eventually because gold is a finite commodity and its price will continue to rise (from 1 ounce of gold = $35 to $40). So there is always danger of people converting the local currency into dollars and then converting dollars into gold at $35, then selling it in the open market at a profit, then the US Feds Chairman can’t continue honoring his promise. It was called the “Triffin Dilemma”. He therefore suggested an alternative SDR (Paper gold) system for the IMF.
- USA President Robert Nixon, in 1971 pulled out of Bretton Woods gold convertibility system, mainly because he wanted freedom to print more dollars to finance the Cold War and arms race against the USSR.
- Thus, the USA shifted to the “Floating Exchange System”. Eventually most of the nations also shifted in that either floating / managed-floating system.
- Ecuador adopted Dollarization in 2000.e. it abandoned the domestic currency and adopted the US dollar as their official currency.
Rupee Realities: Understanding India’s Currency Exchange System
Towards Fixed Exchange Rate System
| 1860 onwards | Fixed Fiduciary System à i.e. The British Indian Govt can issue Rs.10 crore notes on fiduciary (“trust”) backed by G-Sec. Beyond that every note must be backed by gold / silver. |
| 1935 onwards | Proportional Reserve à RBI must keep about 40% gold to the value of currency issued. British govt fixed exchange rate. |
| 1946 onwards | Bretton Woods / IMF system of fixed exchange rate à Wherein ₹ price was fixed (pegged) against dollar, and dollar price was fixed (pegged) against gold. |
| 1956 onwards | While RBI could issue any amount of Indian currency but that has to be balanced by the Assets of the issue department (Remember M0). If RBI printed too much currency backed by only Indian G-sec but (without adequate Gold / Forex Reserve, then IMF may force devaluation of ₹ against Dollar). So, we adopted “Minimum Reserve System” i.e. RBI must keep ₹ 400 crore of foreign currency/security + ₹ ‘specified’ crore worth gold. |
Towards Managed Floating Exchange Rate System: 1995 onwards
- Post 1995 onwards, “Minimum Reserve System is continued but RBI is required to only keep ₹ ‘specific’ crores of gold. No compulsion for RBI to keep additional 400 crore worth foreign currency or foreign securities. RBI can print as much currency it wants as long as its balanced by the Assets of Issue Dept. (such as Indian G-sec, Foreign Securities, Gold etc.)
Big Mac Index – The Economist magazine’s informal index to measure PPP exchange rate system using the price of one McDonald burger in the USA vs the respective country.
Exchange Rate System Strategies: VRR and FAR Approaches for Attracting Dollars
To prevent weakening of ₹, we have to attract more $ (and other foreign currencies) in India. So, RBI taken following notable measures:
| Voluntary Retention Route (VRR) | Launched in 2019: If an FPI buys Indian Union/State Governments’ G-Sec and Indian Corporates’ Bonds through this route → FPI will be given more freedom in certain technical regulations of RBI & SEBI.
But, with conditions= FPI must remain invested in India for a minimum 3 years. (Hot Money) RBI decides quantitative limits to how much money can FPI invest through this route. |
| Fully Accessible Route (FAR) | Budget-2020 had announced allowing non-resident investors to invest in G-Sec, without any restrictions.
2020-March: RBI announced this window, non-resident individual investors (who’re not FPI) can buy G-Sec. No limits on amount of investment. |
Benefit – Investors will convert $ & other foreign currency into ₹ currency to buy G-Sec. so more $$ coming towards India which will help keep BoP and currency exchange rate system stable during the crisis.
Analyzing Currency Exchange Rate System Amidst the COVID-19 Crisis
| 2020-Feb | Corona Virus Force Majeure àSENSEX dips so FPIs Selling shares from Indian companies= they got ₹₹ → converting them into $ → running back to USA to invest in (AAA rated) US treasury bonds which is the safest investment. So there is a great shortage of dollars in the Indian market. If RBI does not supply dollars → further weakening of rupee ($1=₹75 → ₹80). |
| 2020-March | RBI starts Dollars Swap with Indian banks. i.e. A bank shall buy US Dollars from the Reserve Bank and simultaneously agree to sell the same amount of US Dollars at the end of the swap period (6 months). It is done through auctioning, so, RBI earns some % of profit. |
| COVID-19 | Dollar up-down movements, RBI signing more swap agreements, Indian Government borrowing more $$ from ADB, BRICS Bank etc. |
Q. In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis? (CSE-2019)
Answer Codes:
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Q. Which one of the following is not the most likely measure the Government/RBI takes to stop the slide of the Indian rupee? (CSE-2019)
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IMF Special Drawing Rights (SDR)
- After the collapse of Bretton Woods Exchange Rate System, IMF was converted into a type of ‘deposit bank’, where the members would deposit currencies in the proportion of quotas allotted to them (depending on size of their economy, openness etc).
- The IMF will pay them a small interest rate for their deposits. And the IMF would lend this money to a member facing a balance of payment crisis. To operationalize this mechanism, the IMF would allot an artificial currency / accounting unit called SDR to the members based on their deposits.
- Initially the price of SDR was fixed against the amount of gold but present mechanism:
| Currency Basket | Weightage |
| U.S. Dollar | 41.73 |
| Euro | 30.93 |
| Chinese Yuan (Renminbi *added in 2015) | 10.92 |
| Japanese Yen | 8.33 |
| Pound Sterling | 8.09 |
- By applying a formula involving (weight * exchange rate), IMF will obtain a value of 1 SDR = how many dollars?
- Presently, 1 SDR = $1.40 = ₹ 98 (assuming $1 is trading at ₹ 70).
- SDR is called ‘Paper Gold’ because it’s merely an accounting entry or artificial currency, without any gold involved.
- SDR can be traded among the members, it can be converted into members’ currencies as per above method & be used to settle their Balance of Payment Transactions / Crisis.
- If the BoP crisis is so big that a country’s entire SDR quota exhausts, then member countries may borrow more SDR from IMF (and then convert it into dollars etc. to pay off the import bill), but eventually members will have to repay this loan to IMF with interest.
2016-Reforms: The total quantity of SDR was increased, and India’s quota was increased from 2.44% to about 2.75%, accordingly, we are allotted around 13 billion SDR [25% of it is kept as reserve tranche position (RTP)]
- India is the 8th largest quota holder after the USA (~18%), Japan (~7%), China (~6%)…
- In the IMF, a member’s voting power depends on his SDR quota contribution.
- For India, this voting power is exercised by India’s Finance Minister as the ex-officio Governor in IMF’s Board of Governors.
- If the Finance Minister is absent, then the RBI Governor can vote as the Alternate Governor during the IMF’s meetings.
| Q. Recently, which one of the following currencies has been proposed to be added to the basket of IMF’s SDR? (CSE-2016)
Answer codes:
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Exchange Rate System: Understanding the Power of Currency Convertibility in the Global Financial Landscape
- Presently, India has managed a floating exchange rate system wherein, currency exchange rate is determined by the market forces of supply and demand, however, during high levels of volatility RBI will intervene to buy / sell ₹ or $ to stabilize the exchange rate system.
- But if people are allowed to convert the local and foreign currency in an unrestricted manner, this will lead to so much volatility that RBI will not be able to manage.
- So, RBI puts certain restrictions on the convertibility of Indian rupee to foreign currency using the powers conferred under:
- Foreign Exchange Regulation Act, 1973 (FERA)
- FERA was later replaced by Foreign Exchange Management Act, 1999 (FEMA)
Understanding RBI’s Exchange Rate System: Restrictions on Rupee Convertibility
- CONVERTIBILITY OF RUPEE
- Convertibility on Capital Account Transactions
- Convertibility on Current account transactions
Convertibility on Capital Account Transactions:
| External Commercial Borrowing (ECB) | RBI’s External Commercial Borrowing (BoP → Capital Account → Borrowing → ECB) ceiling is up to $750 million (or equivalent other currency) per year for Indian Companies. That means even if Bank of America was willing to lend $1500 million to Reliance, it can’t bring all those dollars (or its converted rupee equivalent) in India. If he tries through illegal methods like Hawala, then the Enforcement Directorate (ED) will take action for FEMA violation exchange rate system. |
| Foreign Portfolio Investors (FPI) | An Foreign Portfolio Investors (BoP → Capital Account → Investment → FPI) can’t invest in more than 5% of available government securities in the Indian market and more than 20% of the available corporate bonds in the Indian market.
So, even if Morgan Stanley or Franklin Templeton investment fund has billions of dollars they can’t bring them all to India because of the above restrictions. |
| Foreign Direct Investment (FDI) | Similar restrictions on Foreign Direct Investment (FDI) as well. Govt decides FDI policy and RBI mandates the forex dealers accordingly to convert or not convert foreign currency into Indian currency. E.g. Las Vegas’s Flamingo Casino company can’t convert $ int ₹ to invest in Goa’s Casino (Because FDI prohibited in Casino). If they manage to ‘smuggle’ rupees through Hawala / Mafia boats then again ED will take action for FEMA violation. |
| Conclusion | Thus, Indian rupee is not fully convertible on capital account transactions. |
Exchange Rate System: Understanding RBI’s Approach to Convertibility in Current Account Transactions
- During 2013 to 2014, RBI’s 80:20 norms mandated min. 20% of the imported gold must be exported back.
- Exchange Rate System: Until then Jeweller/bullion dealers will not get permission to (convert their rupees into dollars/foreign currency) to import the next consignment of gold.
- However, if we disregard such few rare examples/restriction, Indian rupee is considered fully convertible on current account transactions (i.e. Import and export, remittance, income transfer gift and donations) since 1994.
FCRA 2010 violations:
- If NGO / Universities were allowed to accept foreign donations in an unrestricted manner, they may become puppets of ISI / Pakistan / China / CIA.
- So, the Ministry of Home Affairs (MHA) requires them to ‘register’ and furnish annual reports under Foreign Contribution Regulation Act 2010 (FCRA). Those who fail to comply with it, are prohibited from accepting foreign donations as per the exchange rate system.
- Exchange Rate System: But this angle takes us towards the ‘National security and sovereignty of India’. We need not confuse or mix it up with the ‘Economics concept’ of Rupee convertibility under FEMA ACT.
Full convertibility of Rupee
Meaning – India should permit unrestricted conversion of Indian ₹ to foreign currency for both current account and capital account transactions. This will infuse more FDI investment in India which will help in the resolution of the NPA problem, new factories, jobs, GDP growth, rivers of honey and milk will flow.
Anti-Arguments:
- Before 1997, East Asian “Tiger” economies – (South Korea, Indonesia, Malaysia, Thailand, Vietnam Philippines etc.) allowed full capital account convertibility to attract FDI.
- Exchange Rate System: But 1997: Their automobile & steel companies filed bankruptcy. The foreign investors panicked, sold their shares and bonds and got local currency to convert into $ and ran away. The flight of this ‘Hot Money’ resulted in extreme depreciation of local currency $1 = 2000 Indonesian Rupiah → $1= 18,000 Indonesian Rupiah. All developments resulted in heavy inflation of petrol and diesel, social unrest, riots and political instability. None of their central banks had enough forex reserves to combat this crisis.
- So, in 1998, their GDP growth rates fell in negative territory e.g. Indonesia (-13.7%) Because of their mistake of allowing full currency convertibility.
- Whereas India and China grew at 6-8% because we had not allowed it.
Exchange Rate System: Understanding the S.S. Tarapore Committee’s Vision for Rupee Convertibility (1997)
- In Exchange Rate System-Committee suggested India to allow full Capital Account Convertibility (CAC) only when the fundamentals of our economy become strong enough, such as:
- RBI must have enough forex to sustain 6 months’ import
- Fiscal deficit must not be more than 3.5% of GDP
- Inflation must not be more than 3-5%
- Banks’ NPA must not be more than 5% of their total assets, and among others.
- So, time is not yet ripe for allowing full CAC.
Rupee Convertibility and RBI Reforms (2004-2019) in the Exploring Exchange Rate System
- Exchange Rate System: While RBI has not permitted full convertibility of Indian rupee (on Capital Account), but over the years it has liberalized the norms, such as:
| 2004 | Liberalized Remittance Scheme (LRS) for each financial year, An Indian resident (incl. minor) is allowed to take out upto $2,50,000 (or its equivalents in other currencies) from India. He may use it for either a current account or capital account transaction as per his wish. (e.g. paying for college fees abroad, buying shares, bonds, properties, bank accounts abroad.)
Exchange Rate System – Controversy à Panama papers allege certain Bollywood celebrities used LRS window to shift money from India in their shell companies in tax havens. Later used those shell companies for tax avoidance. |
| 2016 onwards | RBI began relaxing the norms for External Commercial Borrowing (ECB), mainly to soften the NPA problem e.g. Software firms can bring up to $200 million in ECB, Micro-finance $500 mill, Infrastructure companies $750 million etc. |
| 2018-19 | When ₹ started to depreciate heavily against dollars ($1 → ₹ 63 → ₹ 74), RBI had to encourage the flow of dollars into the Indian economy. So, aforementioned sector- specific limits streamlined → all eligible companies automatically allowed to borrow upto $750 million via ECB route. (Although prohibited in certain categories e.g. purchase of farm house, tobacco, betting, gambling, lottery etc.) |
| 2019 | RBI allowed ECB even for working capital & repayment of rupee loans. |
Twin Deficit – It’s the term used when both Current Account Deficit and Fiscal Deficit are high.
Money Clash 2018: Understanding Exchange Rate System in the Currency Battle
- 2015: Chinese authorities announced they don’t manipulate/control Yuan exchange rate. They only intervene if Yuan’s exchange rate system varies more than +/- 4% from the previous day.
- During 2018, People’s Bank of China pursued ‘Cheap (Dovish) Money Policy’ to inject more Yuan (renminbi) in the system to make loans cheaper in the domestic market and boost the consumption, demand, and growth.
- But, on the other side, US Feds pursued Dear (Hawkish) Money Policy, so dollar supply is shrinking, so dollars are becoming more expensive against other currencies.
- Results à Increased supply of Yuan vs. reduced supply of $: resulted in $1=6.20 Yuan weakening to almost $1= 7 Yuan.
- Trump alleges Yuan was deliberately weakened (due to PCB increasing Yuan supply) to make Chinese products more cheaper in global trade. He even accused Russia and Japan of playing a similar ‘Currency War’ against him.
Exchange Rate System: Understanding the 2018 Currency War and the Depreciation of the Indian Rupee
2018: Turkey was suffering from high Inflation, current account deficit and political turmoil.
- Exchange Rate System: US Feds was pursuing Hawkish (Dear) monetary policy, so dollar supply shrinking and resultantly dollar is becoming more expensive against other currencies. In this atmosphere, foreign investors feared Turkish companies (who had previously borrowed a lot of money from the American financial market) would not be able to repay their loans in dollar currency.
- So foreign investors began selling their shares and bonds from Turkey’s market. They got Lira currency and exchanged it for dollars and ran away from Turkey.
- Because of this rush, demand for dollars strengthened even further and resultantly, other currencies became even weaker. (Including India: $1=₹ 63 in January → $1= ₹ 74 in Oct ’18).
- Exchange Rate System: In 2019-20 also, India rupee continued to weaken towards $1=75₹ because of Corona Force Majure which led to dip in SENSEX. Foreign investors pulling out money from India.
- While such depreciation is good for our exporters but bad for our importers.
Strengthening the Rupee: Government and RBI’s Exchange Rate System Interventions in Response to the Currency
- FPI’s investment limits in the Bond market were relaxed. (So they feel encouraged to convert their Dollars into Rupees and invest in Indian bond market)
- External commercial borrowing (ECB) norms were also relaxed.
- RBI sold about 25 billion dollars from its forex reserve to calm down the demand for dollars.
- Further, to attract NRIs dollar savings into India:
- RBI could announce more interest rates on Foreign Currency (Non-Resident) Account (Banks) [FCNR (B) Account] & then pay interest subsidy to Indian Banks, like they had done in 2013.
- Govt could also tell RBI to issue NRI bonds to attract their $ savings to India.
- But, Urjit Patel avoided doing 4A and 4B solutions because eventually such borrowed dollars have to be returned back to NRI with interest, which could result in an exchange rate crisis in future.
- RBI could also pursue Hawkish Monetary Policy to reduce rupee supply in the market (so that ₹ can also become expensive just like dollars). But, because the RBI act mandates inflation control within 2-6% CPI, and by December 2018 the CPI has been falling towards 2% so RBI’s MPC had to actually reduce the policy rate (2019 Feb to August) to combat deflation.
| 2018-Oct | The central banks of India and Japan signed Currency Swap Agreement of $75 billions i.e. either party can use that much dollar currency from the other party’s forex reserve during the crisis. Even in 2008 and 2013 too they had signed similar agreements but lower amounts were involved. |
| 2019- March | RBI’s $5 bn Currency Swap with Indian banks → RBI gains dollar reserve to fight future volatility in currency exchange rate, whereas Indian banks got extra rupee liquidity → (Hopefully) cheaper interest rates to combat deflation. |
| 2018-Dec | India signed a pact with Iran to pay crude oil bills in rupee currency. National Iranian Oil Co (NIOC) will open a bank account in India’s UCO Bank (a PSB). Indian oil companies will make payments there in ₹ currency. This will help curbing the demand for dollars in India. |
| Budget – 2019 | Nirmala S. announced various measures to attract more FPI and FDI investment in India |
| 2020-Feb | Corona Virus Force Majeure = dip in SENSEX so FPIs Selling shares from Indian companies= they got ₹₹ → converting them into $ → running back to USA to invest in (AAA rated) US treasury bonds which is the safest investment. So there is a great shortage of dollars in the Indian market. If RBI does not supply dollars → further weakening of rupee ($1=₹75 → ₹80). |
| 2020-March | RBI starts Dollars Swap with Indian banks. i.e. A bank shall buy US Dollars from the Reserve Bank and simultaneously agree to sell the same amount of US Dollars at the end of the swap period (6 months). It is done through auctioning, so, RBI earns some % of profit. |
Exploring the Impact of Quantitative Easing and Federal Tapering on Exchange Rate Systems
| Quantitative Easing | In Exchange Rate System – Subprime crisis in USA (2007-08 → Borrowers unable to repay the home loans → American Banks and NBFCs’ bad loans / NPA / toxic assets increased → to help them, the US Federal Reserve printed new dollars & used it to buy those toxic assets → increased dollar supply in the system. Known as “Quantitative Easing”. |
| Fed Tapering | 2013: US Federal Reserve gradually cut down its toxic asset purchasing program → less new dollars issued → called “Fed Tapering” |
Result
- shortage (perceived) of dollars in USA → Loans % become more expensive in the USA so American investors began selling shares/bonds in other countries, and took their dollars back to the USA (to lend to local businessmen).
- This phenomenon was called “Taper Tantrum”. It resulted in weakening of other currencies against USD.
Money from the Sky and No Interest: How They Affect Exchange Rate Systems
- Exchange Rate System – Economist Milton Friedman (1969) introduced the concept of ‘Helicopter Money’ to combat recession, a central bank should supply large amounts of money to the public at near zero interest rate, as if the money was being showered on them from a helicopter. It will encourage consumption, demand which will result in more factories, jobs and economic growth.
- Exchange Rate System: In the aftermath of the subprime crisis and global financial crisis, there was a fall in consumption, demand and so the deflation & recession scenario.
- So, the Central Banks of Sweden, EU and Japan cut their deposit interest rates into negative figures (-0.1%) so if a commercial bank parked/deposited its surplus money into the central bank (through a reverse repo like mechanism), its money will be deducted in penalty instead of earning deposit interest as er the exchange rate system.
- Exchange Rate System: Result à Commercial banks will proactively try to give away more loans to customers to boost demand in the economy.
Understanding Exchange Rate Systems : The Power of Purchasing Power Parity (PPP)
- Hypothetical concept that tries to compare two currencies’ exchange rate through their purchasing power in respective countries.
- So, If 1 cup of coffee in India = ₹ 20 whereas 1 cup of coffee costs $2 in USA then Dollar to Rupee exchange rate (PPP) should be $1 = ₹ 10. (According to OECD, the exact figure is $1=₹ 17 at PPP).
- This (hypothetical) exchange rate can happen in real life, if both the countries have Floating Exchange Rate System without any intervention of the respective Central banks; and if the bilateral trade is free of protectionism (i.e. without tariff or non-tariff barriers).
- GDP is the total market value of all goods and services produced in a country within a year. When we convert these GDP values from local currencies into PPP $ exchange rate system, the largest economies of the world (GDP, PPP wise) are: USA⇒China⇒India⇒Japan⇒Germany
Q. Find correct statement(s) (CSE-2019)
Codes:
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Yuan as global currency
- In 2015, Yuan was added to an SDR basket of currency. It increases the acceptance of Yuan in the global economy.
- Exchange Rate System China is also loaning Yuan to other nations for infra. development in One Belt One Road Initiative (OBOR), via AIIB and BRICS bank, and even via Panda Bonds.
- In future, China may have to be less dependent on dollars while importing oil, missiles, metal and food commodities- as other nations begin to happily accept Yuan.
- Such in the exchange rate system Yuan dominance may pose strategic challenges to the USA and India.
Exploring Effective Exchange Rate systems in the Global Currency System
Effective Exchange Rate systems
1. Nominal effective exchange rate (NEER)
- Weighted average of 36(6) currencies
2. Real effective exchange rate (REER)
- Weighted average of 36(6) currencies adjusted to respective domestic inflations
Exchange Rate System: Understanding NEER and REER in the Global Economic
- Nominal Effective Exchange Rate System (NEER) and Real Effective Exchange Rate (REER) are the indicators of external competitiveness.
- Five-country and thirty six-country indices are being constructed by the Reserve Bank of India to help the researchers and analysts.
| NEER is the weighted average of the bilateral nominal exchange rate system of the home currency in terms of foreign currencies. | REER is the weighted average of nominal exchange rate systems adjusted for relative price differential between the domestic and foreign countries, related to the purchasing power parity (PPP) hypothesis. |
- In real life we are not just trading with the USA but other countries, using foreign currencies other than US dollars (such as Euro, Pound, Yen, Yuan etc).
- Therefore, only tracking $1=60 or $1=70 will not give a full picture. So, RBI also calculates the geometric average of the rupee’s exchange rate system against upto 36 types of foreign currencies.
- The formula will give weightage to each of those 36 foreign currencies depending on their trade-volume with India. The result is called “ Nominal effective exchange rate (NEER)”.
- Exchange Rate System: When NEER is mathematically adjusted as per the CPI-inflation levels in India and those foreign countries, it’s called “Real effective exchange rate (REER)”.
- REER interpreted as the quantity of domestic goods required to purchase one unit of a given basket of foreign goods.
- NEER vs REER values help analyze whether a currency is really weakening (depreciating) against the foreign currencies or not, thus helping to know our international competitiveness in exports in the exchange rate system.
Devaluation of a currency: Understanding the Impact on Exchange Rate Systems
- Under the fixed rate regime, the central bank or the government decides the value of the currency with respect to other foreign currencies. The central bank or the government purchases or sells its currencies to maintain the exchange rate system. When the government or the central bank reduces the value of its currency, then it is known as the devaluation of the currency.
- For instance, in 1966 when India was following the fixed exchange rate regime, the Indian Rupee was devalued by 36 %.
Exploring Currency Devaluation: Reasons and Objectives within the Exchange Rate System
- To increase Exports: countries go for currency devaluation to boost their exports in the international market. Devaluation of currency makes its goods cheaper compared to its International competitors.
- Exchange Rate System Competitive devaluation (race to the bottom):if one country devalues its currency other countries are also incentivized to devalue their own currency to maintain their competitiveness and the international export market.
- To reduce trade deficits:currency devaluation makes a country’s exports cheaper, while imports become more expensive. This leads to an increase in exports and decrease in imports. This situation favors the improved balance of payment and reduces trade deficits in the exchange rate system.
- To reduce the sovereign debt burden:If the debt payments are fixed, devaluation of currency will make the domestic currency weaker and will ultimately make the payments less expensive over time.
Disadvantages of Currency Devaluation in the Exchange Rate System
- Inflation: it can lead to increase in the inflation rate as essential imports such as oil etc will become more expensive. It can also lead to demand-pull inflation.
- It reduces the purchasing power of the country’s citizens and foreign goods and foreign tours become expensive for them as per the exchange rate system.
- Large and quick devaluation of currency may reduce the faith of international investors in the domestic economy. Foreign investors would be less interested in holding the government debt as devaluation reduces the value of their holdings.
- Devaluation of currency negatively impacts the corporates and individuals who hold debt in the foreign currency.
The Simple Story of Currency Depreciation in Exchange Rate System
- In the floating exchange rate regimes, the value of a country’s currency is determined by the market forces of demand and supply. The exchange rate system of the currency changes on a daily basis as per the demand and supply of that currency with respect to foreign currencies. A currency depreciates with respect to foreign currency when the supply of currency in the market increases while its demand falls.
Exploring Reasons Behind Devaluation in Exchange Rate Systems
- Exchange Rate System-Decline in exports: The decline in a country’s overall exports leads to a decline in export revenues. This reduces the demand for the country’s currency and leads to its depreciation.
- Large increase in imports:A large increase in the demand for imported goods and services can lead to a trade deficit. Increase in the current account deficit can lead to a net outflow of the currency which can weaken the exchange rate system leading to currency depreciation.
- Monetary policy of the Central Bank:If the central bank reduces its policy interest rates it can lead to the outflow of hot money such as foreign portfolio investment etc. This can lead to the depreciation of domestic currency.
- Open market operations of the central bank:If the Central bank (in Indian case, RBI) undertakes open market operations to buy foreign currency and gold etc. it can lead to the depreciation of domestic currency as per the exchange rate system.
Dollars Going Down: Understanding Devaluation and Depreciation in Money Talk
Both devaluation and depreciation lead to the decline in the value of domestic currency. However, there are certain differences between them in the exchange rate system.
| Devaluation | Depreciation |
| Devaluation is the official reduction in the value of a currency. | Depreciation refers to an unofficial decline in the currency’s value. |
| Devaluation is the phenomena associated with fixed exchange rate regime. | Depreciation of a currency is associated with the floating or managed floating exchange rate regime in exchange rate system |
| Exchange Rate System-Devaluation of the currency is done purposely by the central bank or the government | The market forces of demand and supply are responsible for the depreciation of a currency. |
| The impact of currency devaluation is for short term, | The depreciation of currency can affect the economy for a longer time. |
| Devaluation of currency is done occasionally by the central bank. | Depreciation and appreciation of currency occur on a daily basis. |
Examining the Long-Term Effects of Devaluation and Depreciation in Exchange Rate Systems:
- The long-term impacts of devaluation and depreciation differ.
- Exchange Rate System: The depreciation of the domestic currency in a floating exchange rate regime can increase its exports, boost spending and can make the economy look better for the foreign investors.
- This can increase the flow of foreign investment which can cancel out some of the effects of depreciation.
- However, this is not possible in a fixed rate economy as only the government or Central bank changes the exchange rate systems.
Exploring the Dynamics of Currency Revaluation in Exchange Rate Systems
- Revaluation refers to an upward adjustment to the country’s official exchange rate system relative to either the price of gold or any other foreign currency.
- Revaluation increases the value of the domestic currency with respect to the foreign currency.
- Revaluation is a feature of the fixed exchange rate regime, where the exchange rate system is determined by the central bank or the government.
- Revaluation is opposite to devaluation, which is a downward adjustment.
Exchange Rate System: Simple Reasons Behind Revaluation in Money Matters
- Exploring Exchange Rate System: Current account surplus: the government can go for currency revaluation for reducing the current account surplus. This happens for economies where exports are higher than imports.
- To manage inflation: the government may go for currency revaluation in order to manage that inflation rate. Revaluation can lead to either higher inflation or even lower inflation. Currency revaluation can make imports cheaper which can reduce the inflation rate in the domestic economy.
- Exchange Rate System: Changes in the interest rates of other countries and changes in the global economic environment can also lead to currency revaluation in order to manage its impact on the domestic economy.
In Exchange Rate System : Currency Appreciation
- Currency appreciation refers to the increase in the value of one currency with respect to other foreign currencies.
- Currency appreciation is the unofficial increase in the value of any currency.
- It is a feature associated with floating or managed floating exchange rate regimes.
- Appreciation of a currency takes place when the supply of the currency is lesser than its demand in the foreign exchange market.
Exploring the Causes of Currency Appreciation in Exchange Rate Systems
- Increase in the policy interest rate by the central bank: It would make the investors attractive to invest in the government bonds and domestic securities which can lead to inflow of foreign investment in the form of hot money.
- Current account surplus:current account surplus can cause an inflow of foreign exchange in the economy leading to appreciation in the exchange rate system of the domestic currency.
- Exchange Rate System Increase in exports:it increases the demand for the domestic currency leading to its appreciation with respect to foreign currencies.
- Intervention by the central bank through open market operations:buying of domestic currency from the foreign exchange market by the central bank can lead to an appreciation of the domestic currency.
- Higher economic growth can increase foreign investment in the economy which can cause appreciation in the exchange rate system.
Appreciation of a currency associated with a floating or managed floating exchange rate system. Whereas revaluation of a currency is associated with the fixed exchange rate regime.
Previous Year Questions
| GSM3-2016 | Exchange rate system justifies the need for FDI for the development of the Indian economy. Why is there a gap between MOUs signed and actual FDIs? Suggest remedial steps to be taken for increasing actual FDIs in India. |
| GSM3-2015 | Craze for gold in Indians has led to a surge in import of gold in recent years and put pressure on balance of payments and external value of rupee. In view of this, examine the merits of the Gold Monetization Scheme as per the exchange rate system. |
| GSM3-2015 | Exchange Rate System-There is a clear acknowledgement that Special Economic Zones (SEZs) are a tool of industrial development, manufacturing and exports. Recognizing this potential, the whole instrumentality of SEZs requires augmentation. Discuss the issues plaguing the success of SEZs with respect to taxation, governing laws and administration. |
| GSM2-2014 | Though 100 percent FDI is already allowed in non-news media like a trade publication and general entertainment channel, the Government is mulling over the proposal for increased FDI in news media for quite some time. What difference would an increase in FDI make? Critically evaluate the pros and cons. |
| GSM3-2014 | Exchange Rate System-Foreign direct investment in the defense sector is now said to be liberalized. What influence is this expected to have on Indian defense and economy in the short and long run? |
Conclusion
The exchange rate system serves as a dynamic lens through which we understand the intricacies of currency movements. The causes of currency appreciation, explored within this context, shed light on the economic forces shaping global financial landscapes. As we navigate the exchange rate system, recognizing the factors influencing currency value becomes crucial for informed decision-making and economic stability.
