FOREIGN EXCHANGE MARKET IN INDIA

Chapter 1

International Foreign Exchange

Foreign Exchange Market:

The need for a foreign exchange market therefore arises out of the fact that the power of domestic legal tender, circulating in the form of currency notes, to redeem commercial liabilities legally, is limited by national boundaries. Both the seller and buyer want to receive and make payments in their respective domestic currencies. The task of fulfilling this requirement is handled by international commercial banks.

All the countries have their own currencies. Any economic transaction that takes place between residents of two countries involves exchange of some currency between those two residents. This may involve import/ export of goods or services, investments or redemptions, borrowing or lending, or personal transfers such as family maintains, tourism etc. in all these cases, the source of purchasing power is available in one currency whereas its utilisation after conversation is in another currency. When these transactions get executed through the intermediation of banks, one currency gets converted into another. This process is called “Foreign Exchange”.

International Foreign Exchange:

The foreign exchange market is the largest and the most liquid financial market in the world. Traders include large banks, central banks, currency speculators, corporations, governments, foreign currency remittance companies and other financial institutions.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by the anticipation of changes in monetary flows caused by changes in GDP growth, inflation ( purchasing power parity theory), interest rates ( interest rates parity theory), budget and trade deficits or surpluses , large cross border deals and other macroeconomic developments.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several in different proportions. These elements generally fall into 3 categories: economic factors, political conditions and market psychology.

Fact File on International Market:

• Average daily turnover is USD3trillion with an additional USD2 trillion turnover in foreign currency derivatives major component of this turnover is speculative.

• This market is predominantly made up of day-traders which means that positions build up in currencies are mostly squared off during the day and there is very little carry forward of open speculative positions.

• US dollar is the most heavily traded currency. The most heavily used currency pairs are EUR/USD, GBP/USD (called CABLE) and USD/JPY.

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FOREIGN EXCHANGE MARKET IN INDIA• London, New York, Tokyo are the biggest foreign exchange canters and Deutsch Bank (Germany) is the single largest trading entity in international foreign exchange markets.

• Unlike a stock market, the foreign exchange market is divided into levels of access which means that all participants cannot operate in all segments of the market and are subject to different categories of exchange rates. At the wholesale level (banks transact with each other), generally called ‘the interbank market’, interbank rates are used between participants whereas, at the retail level (banks transact with customers) the rates uses are called ‘Merchant rates’. Each localized market is governed by the domestic exchange control regulations which determine the different levels of access.

• Generally, for a given currency pair, either currency can function as the base currency while the other acts as the variable or quoted currency. By convention the LHS currency is stronger than the RHS currency at the time of creation of the pair. However the euro was created, the European Central bank mandated that EUR be the base currency in any pairing. Similarly GBP has traditionally been the base currency in all cases.

Characteristics of the international foreign exchange market:

The primary objective of the foreign exchange market is to facilitate international trade and investment, by allowing end-users to convert one currency into another. The conversion rates between currencies are called as foreign exchange rates. The market also facilitates speculation, arbitrage and lending/borrowing of currencies for financing different transactions. Therefore this market connects exchange rates with interest rates. The modern foreign exchange market started with the introduction of the “Flexible exchange rate system” during 1970s.

The principle characteristics of this market are:

• It is decentralised, over the counter market, engaged in negotiated transactions.

• In comparison to all other markets, it enjoys the highest trading volume, which results in high liquidity.

• International foreign currency transactions do not involve transfers of currencies in physical cash form. All settlements, receipts and payments are conducted through demand deposit accounts with commercial banks and since only banks

provide such accounts it follows that all transactions in this market get routed through the banking system.

• The actual settlement of transactions is done through a network of NOSTRO and VOSTRO accounts maintained by banks worldwide.

• It is geographically dispersed across all countries which makes it universal market. However in each country there is a domestic foreign exchange market governed by individual regulations.

• It operates 24 hours a day, except weekends, across all time zones.

• It operates on very fine (low) profit margins compared to other markets (fixed income securities, commodities, etc.)

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FOREIGN EXCHANGE MARKET IN INDIA• It provides for a ‘Barter’ of currencies. If a person A wants to sell USD to get INR, there must be person wanting to sell INR for the USD, at the same exchange rate. Therefore, as in the case of Barter there has to be double coincidence of wants. The foreign exchange market thus functions as an international clearing mechanism or a ‘Currency Exchange’ bringing together participants wishing to exchange currencies at mutually agreed exchange rates.

• It has no physical existence and operates as an electronically connected network of end-users, banks, brokers, and service providers.

• The most modern communication systems are used thereby reducing transaction cost, eliminating interest loss factor and the problem of idle funds. Settlement systems worldwide have been synchronised so that participants are able to shift from one market to another and from one currency into another without settlement gaps.

Chapter 2

Exchange rates

The foreign exchange market includes end-users (individuals and corporate) commercial banks, brokers, central banks and service providers such as SWIFT (messaging service providers), etc.

The foreign exchange market provides the environment for establishing the demand supply equilibrium between currencies based on which the rate of conversion is established. These conversion rates are called ‘Foreign exchange rates’ or ‘Exchange rates’. Thus the rate of exchange for a currency is known from the quotation in the foreign exchange market.

Classification of rates:

1. Direct Rate: A foreign exchange rate which provides a relationship between fixed number of units of foreign currency against variable number of units of domestic currency is called a Direct Rate.( This format of expressing exchange is operative in India since 1993). In such rates the foreign currency acts as the base currency whereas the domestic currency acts as the variable currency.

2. Indirect Rate: A foreign exchange rate which provides a relationship between fixed number of units of domestic currency against variable number of units of foreign currency is called an Indirect Rate.( this form of expressing rates prevailed in India prior to August 1993). In such rates the domestic currency acts as the base currency whereas the foreign currency acts as the variable currency.

3. Cross Currency Rate: A foreign exchange rate which provides a relationship between two non domestic currencies is called a cross currency rate.

Characteristics of exchange rates:

1. Foreign exchange rates are quoted by banks on a two-way basis. Eg: USD/INR 41.0625- 41.0675

2. The LHS rate in the quotation is called bid rate and represents the rate at which the bank would buy one unit of the base currency.

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FOREIGN EXCHANGE MARKET IN INDIA3. The RHs rate in the quotation is called ASK or OFFER rate and represents the rate at which the bank would sell one unit of the base currency.

4. The difference between the Ask and the Bid rates, in a given quotation is called spread. Therefore spread is denoted as (Ask-Bid). Since Ask > Bid, the spread is always positive.

5. Foreign exchange rates are normally quoted upto two or four decimals. In India, the general practise in the interbank market is to quote rates upto four decimal places.

6. Foreign exchange rates are always expressed to the base of 1, 10, 100 or 1000 units of base currency. In India, rates are expressed either to the base of 1 unit or 100 units of base currency.

7. Unless otherwise specified, an interbank quotation in India is usually valid for USD 1 million.

VEHICLE CURRENCY:

The international foreign exchange market is an aggregate of individual markets operating in each country.

At the start of every trading day, the value of the domestic currency in each country is locally established against each one, major, universally accepted, international/ foreign currency such as USD, GBP, EUR, etc. this currency is called the vehicle currency for the domestic currency.

In India, effective from August 1991, the USD is considered as vehicle currency for INR. This means the Indian Foreign Exchange Market establishes only the USD/INR quotation.

Since the vehicle currency is normally a universally traded currency, quotations of this currency against most international currencies are easily available, this currency therefore acts as a vehicle to help establish value of the domestic currency against any desired international currency.

The factors which influence the choice of vehicle currency are composition of foreign currency reserves of the country, pattern of invoicing import export trade of the country, ready acceptability of the vehicle currency, ready availability of cross currency quotations against the vehicle currency, proportion of use of the vehicle currency in invoicing of international trade.

CROSS RATES:

The cross currency rates are used in combination with the vehicle currency rate against the domestic currency to establish the value of the domestic currency against all international currencies. This process is called ‘crossing’ and the resultant exchange rates are called ‘cross rates’.

INTERBANK RATES:

All the exchange rates that are exchanged and dealt with between banks are called as Interbank Rates. Interbank contracts are settled at interbank rates. Interbank foreign exchanges do not involve any pre/post payment of either currency.

MERCHANT RATES:

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FOREIGN EXCHANGE MARKET IN INDIARates quoted by banks for their customers are called merchant rates and involve an addition or subtraction of Exchange Margin which represents the profit margin, transaction handling commission and overhead expenses.

Factors affecting foreign exchange rates:

Foreign exchange rates are influenced by several factors in the international market. All tangible factors are captured in the Balance of Payments Account and the net disequilibrium in the BOP is the single most important demand-supply element affecting an exchange rate. However there are other tangible factors such as Economic indicators, political factors, view of speculators, etc. which influence the exchange rate.

1. Gross domestic Product (GDP): GDP is the broadest measure of aggregate economic activity in a country and represents the total value of final goods and services produced in a country. GDP is the primary indicator of the strength of economic activity. So the growth in the GDP positively influences the foreign exchange price of the currency. A fast growing economy will reflect strength in the exchange rate and vice versa.

2. Trade balance: it represents the difference between imports and exports of tangible goods. The changes in exports and imports are recorded in the current account of the BOP and therefore have immediate effect on the demand- supply equilibrium. This data is widely followed by foreign exchange market. A positive BOP would result in an appreciation in the domestic currency which would make imports cheaper and exports costlier and vice versa.

3. Inflation: inflation is the rate of change in the price level of a fixed basket of goods and services in an economy. Inflation reduces the purchasing power of the currency. This reduction in domestic purchasing power gets reflected internationally through depreciation in the exchange rate of the domestic currency.

4. Employment levels: It reflects the development and stability in the economy. An expanding economy would result in greater investments which would result in more employment generation. Higher employment reflects a growing economy and leads to appreciation in the domestic currency.

5. Interest Rate Differentials: Interest rate applicable to a currency has a dual impact on the currency valuation. If increase in the interest rate is reflection of the strength of the economy then it would have a positive effect on the exchange rate. However if the interest rates increase due to expectations of higher inflation then it would have a negative effect on the value of the currency. In any exchange rate there are two currencies involved. Therefore there are situations when interest rates of both the currencies may rise simultaneously. In such situations the interest rate differential is relevant. Sometimes the interest rates of the two currencies could move in opposite directions thereby increasing the gap between the two. In such cases the effect the exchange rate would be more pronounced.

6. Exchange rate policy: the exchange rate policy is decided by the Finance Ministry while monetary policy is decided by the central bank of the country. The execution of exchange rate policy is always managed by the central bank. The central bank of the country participates in the local foreign exchange market by way of intervention to stabilize the exchange rate or maintain it in a particular range. This also affects the exchange rate of the currency.

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FOREIGN EXCHANGE MARKET IN INDIA7. Political factors: the foreign exchange market can be influenced by political events and changes. These events may be expected or unexpected. Some of the common political developments are elections, public announcements by central bank or government officials, military takeovers, political instability, etc. affect the exchange rate.

8. View of speculators: more than 90% of the turnover in international foreign exchange markets represents speculative activity. The view or perception of the likely value of the currency of these participants in the market has a critical effect on the exchange rate. The forces of demand and supply determine the prices of commodities (foreign currency) in a free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand then price will fall.

The Exchange Rate Systems

The history of foreign exchange can be traced back to the time moneychangers in the middle-east would exchange coins from all over the world. Foreign exchange dealings with gold as the standard of value started around 1880 after more than a hundred years of bimetallism where both gold and silver were commonly used as a measure of value.

The Gold Standard

Under the gold standard, the exchange rate of two currencies was based on the intrinsic value of gold in the unit of each currency. This also came to be known as the mint parity theory of exchange rates. Under the gold standard exchange rates could only fluctuate within a narrow band known as the upper and lower gold points. A country, which had a balance of payments deficit had to part with some of its gold and transfer it to the other country. The transfer of gold would reduce the volume of money in the deficit country and lead to deflation while the inflow of gold in the surplus country would have an inflationary impact on that economy. The country which was in deficit would then be able to export more and restrict its imports as a result of the fall in domestic prices and reduce its BOP deficits. A lowering of the discount rates in a country with a surplus and a hike in discount rates in the deficit country also aided in reducing the imbalance in the BOP.

The main types of gold standard were:

• The gold specie standard.

• The Gold Bullion standard.

• The Gold Exchange standard.

The Gold Specie Standard – 1880 – 1914

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FOREIGN EXCHANGE MARKET IN INDIAUnder the gold specie standard, gold was recognized as a means of settling domestic as well as international payments. There were no restrictions on the use of gold and it could be melted down or be sent to a mint for conversion to coins. Import and export of gold was freely allowed and Central Banks guaranteed 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 standard started after the first world war, as increased expenditures to fund the war effort exposed the weaknesses of the gold standard. It was decided at an international conference in Brussels in 1922 to reintroduce the gold standard but in a modified form. Under the gold bullion standard, paper money was the main form of exchange. It could however be exchanged for gold at any time. As it was unlikely that there would be a great demand for converting currency notes to gold at any given time, the banks could issue currency notes in excess of the value of gold they were holding. 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. In 1925, the sterling was overvalued against the dollar by nearly 44% and necessitated devaluation. This devaluation had an impact on other currencies too and led to an exchange rate war. England withdrew from the gold standard in 1931, America in 1933 and Italy, France, Belgium, Switzerland and Holland remained. It finally collapsed in 1936 with the devaluation of the French franc and the Swiss franc.

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 process was started in 1943 by Britain and the US and finally in July 1944 the American proposal was accepted at the Bretton Woods conference. The new system aimed to bring about convertibility of all currencies, eliminate exchange controls and establish an international monetary system with stable exchange rates.

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.

Flexible Exchange Rate System

There are two primary models of currency management used to maintain the exchange rate under the flexible exchange rate system. They are clean float or free float and managed or dirty float.

Clean float or free float:

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FOREIGN EXCHANGE MARKET IN INDIAIt is a model under which there is no official participation in establishing currency values. The central bank does not set any target range or price and the value of a currency is determined by market forces of demand and supply. The central bank or the government does not participate in the establishment of exchange rate. The disadvantage of this system was that currencies of weaker economies became vulnerable to speculative attacks but most major economies floated their currencies.

Managed or dirty float:

Most medium and small economies adopted the system of pegging their currency either to one of the major international currencies or SDR’s (special drawing rights) or a basket of currencies. The disadvantage of this mechanism was that the exchange rate of a country did not reflect the economic fundamentals of the home country, but its value depended upon the economic performance of the country to whose currency the domestic currency was pegged. This resulted in several adverse effects such as imported inflation, etc. gradually most such economies adopted the managed float concept.

A managed float or a dirty float is a form of exchange rate management where the country’s central bank does not set a target price nor does it set a target range. Whenever the currency exhibits volatility the central bank intervenes by participating in the domestic foreign exchange market. It does so in order to ensure stability and also to ensure that the exchange rate reflects the underlying status of the economy.

Essentially, in this concept the currency is floated but the central bank participates in the domestic market to influence the exchange rate movement in such a way as to reflect the true fundamentals of the currency. The central bank does not announce any target rate but take suitable intervention action, as and when necessary. Intervention under the managed float system does not involve reversing the trend set by the market forces but controls the rate of depreciation or appreciation of the domestic currency.

India adapted this model for controlling the exchange rate of INR under the flexible exchange rate system. In India the Reserve Bank of India intervenes when the value of INR depreciates or appreciates against the foreign currencies.

Advantages:

The managed float attempts to combine the advantages of both the fixed and flexible exchange rate systems, depending on the degree of instability. The less instability, the less intervention is necessary by central banks and they can pursue quasi-independent domestic monetary policies to stabilize their own economies. The greater the instability, the more intervention is necessary by central banks and the less free they are to pursue independent domestic monetary policies because they are frequently required to use their money supplies to calm disturbances in the foreign exchange markets.

Disadvantages

The big problem with a managed float comes in determining the timing and magnitude of the instability and the necessary intervention. If the central banks are too quick to respond or if the amount of intervention is inappropriate, their actions may be further destabilizing. This increased instability has a tendency to dampen international flows and contract world trade. If they wait too long, permanent damage may be done to some countries' trade and investment balances.

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FOREIGN EXCHANGE MARKET IN INDIA

Chapter 3

Foreign Exchange Market in India

History of Foreign Exchange Market in India

The foreign exchange currency trading in India is growing at a really good pace however it is said that the forex market is still in the early phase in India. Nevertheless there are already several big players in the Indian forex market.

The history of forex market in India owes its origin to an important decision taken by the Reserve Bank of India (RBI) in the year 1978 which allows banks to undertake intra-day trading in foreign currency exchange. As a result of this step, the agreement of maintaining ‘square’ or ‘near square’ position was to be complied with only at the close of business every day. The history of currency trading in India also clearly shows that during the initial period when these economic reforms started, the exchange rate of national currency i.e. Indian rupee used to be determined by the RBI in terms of a weighted basket of currencies of India’s major trading partners. Moreover, there were some fairly significant restrictions on the current account transactions.

Then again during early nineties, more economic reforms were introduced which witnessed the important two-step downward adjustment in the exchange rate of the Indian rupee in order to place it at a suitable level in line with the inflation differential so that the competitiveness in exports could be maintained. With these economic reforms which resulted in the unification exchange rate of the rupee heralded the commencement of the new era of market determined forex currency rate regime of rupee in the Indian forex history which was based on the demand and supply principle in the forex market.

Another landmark in Forex history of India came with the appointment of an Expert Group committee on Forex currency in 1994. This committee was made to study the forex market in detail so that step can be taken out to develop, deepen and widen the forex market in India. The result of this exercise was that banks were significant freedom in many of its market operations related to like forex market development and liberalization. The freedom was granted to banks in term of fixing their trading limits, allowed to borrow and invest funds in the overseas markets up to specified limits, accorded freedom to make use of derivative products for asset-liability management purposes.

The corporate were granted the flexibility to book forward cover based on previous turnover and were given freedom to make use of financial instruments like interest rates and currency swaps in the international currency exchange market. The other feature of forex history in India is that a large sum of foreign exchange in India came through the large Indian population working in foreign countries.

However, the common man was not much interested in forex trading. the things are changing now and with the growing economy more and more people are showing interest in forex trading and are looking out for hedging currency risks.

National Stock Exchange of India popularly known as NSE was the first recognized exchange in Indian forex history to launch forex currency futures trading in India. These currency futures are beneficial over overseas forex trading especially to comparatively small traders and retail investors. Another

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FOREIGN EXCHANGE MARKET IN INDIAimportant point to know is that before discussing the history of forex market in India, it is important to know the central government of India has the powers to control transactions in foreign exchange and hence forex transactions in India are managed by the government authorities

Evolution of the forex derivatives market in India:

This tremendous growth in global derivative markets can be attributed to a number of factors. They reallocate risk among financial market participants, help to make financial markets more complete, and provide valuable information to investors about economic fundamentals. Derivatives also provide an important function of efficient price discovery and make unbundling of risk easier. In India, the economic liberalization in the early nineties provided the economic rationale for the introduction of forex derivatives. Business houses started actively approaching foreign markets not only with their products but also as a source of capital and direct investment opportunities. With limited convertibility on the trade account being introduced in 1993, the environment became even more conducive for the introduction of the hedge products. Hence, the development in the Indian forex derivatives market should be seen along with the

steps taken to gradually reform the Indian financial markets.

Developments in the capital inflows:

Since early nineties, we are on the path of a gradual progress towards capital account convertibility. The emphasis has been shifting away from debt creating to non-debt creating inflows, with focus on more stable long-term inflows in the form of foreign direct investment and portfolio investment. In 1992, foreign institutional investors were allowed to invest in Indian equity & debt markets and the following year, foreign brokerage firms were also allowed to operate in India. Non-Resident Indians (NRIs) and Overseas Corporate Bodies (OCBs) were allowed to hold together about 24 percent of the paid up capital of Indian companies which was further raised to 40 percent in 1998. In1992, Indian companies were also encouraged to issue ADRs/GDRs to raise foreign equity, subject to rules for repatriation and end use of funds. These rules were further relaxed in 1996 after being tightened in 1995 following a spurt in such issues. Presently, the raising of ADRs/GDRs/FCCBs is allowed through the automatic route without any restrictions. FDI norms have been liberalized and more and more sectors have been opened up for foreign investment. Initially, investments upto 51 percent were allowed through the automatic route in 35 priority sectors. The approval criteria for FDI in other sectors was also relaxed and broadened. In 1997, the list of sectors in which FDI could be permitted was expanded further with foreign investments allowed upto 74 percent in nine sectors. Ever since 1991, the areas covered under the automatic route have been expanding. This can be seen from the fact that while till 1992 inflows through the automatic route accounted for only 7 percent of the total inflows; this proportion has increased steadily with investments under the automatic route accounting for about 25 percent of total investment in India in 2001. In 2000, the Indian Government permitted the raising of fresh ECBs for an amount upto US$ 50 million and refinancing of all existing ECBs through the automatic route. Corporates no longer had to seek prior approval from the Ministry of Finance for fresh ECBs of upto US$ 50 million and for refinancing of prevailing ECBs.

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FOREIGN EXCHANGE MARKET IN INDIADevelopments in capital outflows:

Thus, while the inflows from abroad have been freed to a large extent, outflows associated with these inflows like interest, profits, sale proceeds and dividend etc. are completely free of any restriction. All current earnings of NRIs in the form of dividends, rent etc. have been made fully repatriable. But convertibility in terms of outflows from residents, however, still remains more restricted although these restrictions are gradually reduced. Residents are not allowed to hold assets abroad. However, direct investment abroad is permissible through joint ventures and wholly owned subsidiaries. An Indian entity can make investments in overseas joint ventures and wholly owned subsidiaries to the tune of US$ 100 million during one financial year under the automatic route. At the same time investments in Nepal and Bhutan are allowed to the tune of INR 3.50 billion in one financial year. Units located in Special Economic zones (SEZs) can invest out of their balances in the foreign currency account. Such investments are however subject to an overall annual cap of US$ 500 million. Indian companies are also permitted to make direct investments without any limit out of funds raised through ADRs/GDRs. Recently mutual funds have been allowed to invest in rated securities of countries with convertible currencies within existing limits. A deep and liquid market for the underlying is necessary for the development of an efficient derivative market. The easy movement of capital between different markets and currencies is essential to eliminate pricing discrepancies and efficient functioning of the markets. The steps mentioned above to increase convertibility on the capital account and the current account aided the process of integration of the Indian financial markets with international markets. These reforms set in motion the process of the development of the forex derivatives markets by gradually opening the Indian financial markets and developing the foreign exchange and the money markets.

Growth of Foreign Exchange markets in India:

Presently the Indian Forex market is the 16th largest Forex market in the world in terms of daily turnover as per the BIS Triennial Survey report. As per this report the daily turnover of the Indian Forex market is around US$ 100 billion including the OTC derivative segment.

The growth of the Indian Forex market owes to the tremendous growth of the Indian economy in the last few years. Today India holds a significant position in the Global economic scenario and it is considered to be one of the emerging economies in the World. The steady growth of the Indian economy and diversification of the industrial sectors in India has contributed significantly to the rapid growth of the Indian Forex market. The main centre of Foreign Exchange in India is Mumbai, the commercial capital of the country and other centers including the major cities like Kolkata, New Delhi, Chennai, Bangalore and Cochin. All these Foreign Exchange Markets of India work collectively deploying latest technology. The Foreign Exchange Market in India is a flourishing ground of profit and initiatives taken time to time by the Indian Central Government also strengthen the foundation.

It is during the year 2008 that Indian Forex market has seen a great advancement that took the Indian Forex trading at par with the global Forex markets. It is the introduction of future derivative segment in Forex trading through the largest stock exchange in country – National Stock Exchange. This step not only increased the Indian Forex market volume too many folds also gave the individual and retail investor a chance to trade at the Forex market, that was till this time remained a forte of the banks and large corporate. Indian Forex market got yet another boost when the SEBI and Reserve Bank of India permitted

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FOREIGN EXCHANGE MARKET IN INDIAthe trade of derivative contract at the leading stock exchanges NSE and MCX for three new currency pairs. In its recent circulars Reserve Bank of India accepting the proposal of SEBI, permitted the trade of INRGBP (Indian Rupee and Great Britain Pound), INREUR (Indian Rupee and Euro) and INRYEN (Indian Rupee and Japanese Yen). This was in addition with the existing pair of currencies that is US$ and INR. From inclusion of these three currency pairs in the Indian Forex circuit the Indian Forex scene is expected to boost even further as these are some of the most widely traded currency pairs in the world.

Structure of Indian Foreign Exchange Market

Regulatory framework:

Foreign currencies cannot be created domestically and hence every country tries to balance their inflow and outflow. This process is called Exchange Control. The term exchange control thus essentially deals with quantitative control. Effectively, any directive or regulation which restricts the free play of demand supply forces, in the foreign exchange market can be described or deemed as exchange control. It was introduced in India in 1939 and various regulations made in regard were consolidated into the ‘Foreign Exchange Regulation Act (1973)’. In 1991, the LPG model was introduced in India. FERA was replaced by “foreign exchange management act (1999)”. The objectives of FEMA were

1. To facilitate international trade and investments. This means both domestic and foreign operators were to be provided greater freedom in international operations.

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FOREIGN EXCHANGE MARKET IN INDIA2. To promote an orderly development and maintenance of the domestic foreign exchange market. The RBI focuses on providing a competitive environment through exchange rate management and on dismantling controls to provide operational ease to all market participants.

Sections 41, 46 and 47 of the foreign exchange management act, 1999 collectively provide the RBI with the powers as well as the responsibility to administer foreign exchange business in the country. However the RBI does not transact with private entities and therefore has delegated this function as provided in the act.

The Foreign Exchange Management Act (1999) or in short FEMA has been introduced as a replacement for earlier Foreign Exchange Regulation Act (FERA). FEMA became an act on the 1st day of June, 2000. FEMA was introduced because the FERA didn’t fit in with post-liberalisation policies. A significant change that the FEMA brought with it was that it made all offenses regarding foreign exchange civil offenses, as opposed to criminal offenses as dictated by FERA.

The Foreign Exchange Management Act, 1999 is focused towards consolidating and amending the law relating to Foreign Exchange utilisation with the objective of facilitating external trade and payments. It was also formulated to promote the orderly development and maintenance of foreign exchange market in India.

The FEMA head-office, also known as Enforcement Directorate is situated in New Delhi and is headed by a Director. The Directorate is further divided into 5 zonal offices in Delhi, Mumbai, Kolkata, Chennai and Jalandhar and each office is headed by a Deputy Director. Each zone is further divided into 7 sub-zonal offices headed by the Assistant Directors and 5 field units headed by Chief Enforcement Officers.

The important features in the new Act as compared with previous Act are:

A) The classification of current account and capital account transactions has been clearly defined;

B) The new enactment is positive, that is, all current account transactions not specifically restricted can be freely carried on;

C) The FERA provided for criminal proceedings against violations whereas the FEMA provides for only civil liabilities against violations;

D) The definitions of residents and non-residents now takes into account the duration of their stay in India as in the case of Income Tax Act;

E) The FERA dealt with ‘Demand side’ management whereas the FEMA deals with ‘Supply side’ management of foreign currency resources of the economy.

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FOREIGN EXCHANGE MARKET IN INDIAAuthorised Persons:

Although the RBI has the sole authority to administer foreign exchange business in India, it does not deal with individuals and other private entities and therefore cannot undertake this function by itself. Foreign exchange is received or required by a large number of individuals, exporters and importers in the country spread over a vast geographical area. It is not possible for RBI to deal with them individually. The Reserve Bank provides licences to three categories of persons called Authorised Dealers, Money Changers and Offshore Banking Units (OBUs) to transact with the public at all different levels. All such transactions, with end-users are governed by the Exchange Control Regulations provided by the Reserve Bank of India.

Authorised persons are mandatorily required to comply with the directions or orders of the RBI in all the foreign exchange dealings undertaken by them. Before undertaking any transactions in foreign exchange, necessary declarations and information should be obtained from the customer so as to ensure that the provisions of the Act are not violated.

Authorised dealers:

The bulk of the foreign exchange transactions undertaken in the country involve end-users and banks. Banks and selected entities licensed by the RBI to undertake these transactions are called Authorised Dealers (Ads). They are permitted to undertake all categories of transactions pertaining to both the Current and Capital Accounts of the Balance Of Payments.

An authorised dealer is required to comply with the directions and instructions of the RBI. Such instructions are collectively called ‘Exchange Control Regulations’ and are contained in the ‘Exchange control Manual’. All amendments to the exchange control manual are intimated to authorised dealers by the Reserve Bank in the form of its AD (MA series) circulars. Further, directions pertaining to general procedures are given in the form of its AD (GP series) circulars.

With regard to the operational of foreign exchange transactions such as charging of commission, methods of quotation of rates etc., the authorised dealer is required to comply with the rules of the Foreign Exchange Dealers Association of India (FEDAI).

Authorised Money Changers:

Money changers are licensed entities permitted to provide facilities for encashment of foreign currency denominated travel related instruments such as foreign currency notes and traveller’s cheques. Licences to operate as money changers are normally provided to hotels, travel agencies, etc. Authorised money changers are sub-classified as full-fledge money changers and restricted money changers. A full fledged money changer is permitted to undertake both purchase and sale transactions with the public such as Travel agencies. A restricted money changer is permitted only to purchase foreign currency notes and traveller’s cheques e.g. five star hotels. All collections need to be surrendered to an authorised dealer in foreign exchange through a back to back arrangement.

Offshore Banking Units:

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FOREIGN EXCHANGE MARKET IN INDIABranches of banks in India established in Special Economic Zones (SEZ’) are accorded the status of Offshore Banking Units (OBUs). The OBUs are allowed to undertake banking operations only in designated foreign currencies essentially with non-residents. Each such OBU has a minimum start up capital of USD 10 million and its balance sheet is prepared in designated foreign currencies.

Classification

The foreign exchange market in India may be broadly classified into:

1. The Retail Market, and

2. The Wholesale Market

RETAIL MARKET:

1. In this segment end-users of foreign currencies which includes individuals who receive and make remittance, exporters and importers who sell or buy their foreign currency requirements from commercial banks and travellers and tourists who exchange one currency for another in the form of currency notes and ‘foreign currency’ traveller’s cheques approach Ads for their requirements.

2. Ads provide committed rates for such transactions. Therefore this is the segment in which exchange rates are used. These rates are called ‘merchant rates’.

3. Total turnover and individual transaction size is very small. Transactions are customised in terms of amount and maturity to meet the requirement of individual customers.

4. All transactions undertaken in this segment are governed by the Exchange Control Regulations of RBI. ADs also need to maintain tariffs and commissions as per FEDAI guidelines.

5. Brokers and other intermediaries are not allowed in this segment.

WHOLESALE MARKET:

1. The wholesale market is also referred to as inert-bank market. It includes the transactions between ADs as also operations between ADs and the RBI.

2. Transactions in this segment are conducted in standard market lots and the average transaction size is large.

3. Transactions are conducted at ‘inter-bank rates’. This is the segment in which exchange rates are determined. The external value of the domestic currency as a function of market demand and supply gets established in this segment.

4. A large portion of inter-bank transactions are conducted through approved / authorised foreign exchange brokers.

5. All transactions are conducted in accordance with the code of conduct established by RBI and FEDAI in this regard.

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FOREIGN EXCHANGE MARKET IN INDIAParticipants in the Indian Foreign Exchange Market:

END – USERS:

End-users represented by individuals, business houses, international investors, and multinational corporations operate in the market to meet their genuine trade or investment requirements. They also buy or sell currencies to speculate or trade in currencies to the extent permitted by the exchange control regulations. They operate by replacing orders with the commercial banks. The deals between the banks and their clients represent the retail segment of foreign exchange market. Speculative and arbitrage transactions constitute a major portion of market turnover.

COMMERCIAL BANKS:

Commercial banks are the major players in the market. They buy and sell currencies for their clients. They may also operate on their own account. This is called proprietory trading. When a bank undertakes transactions to adjust a sale or purchase position in a foreign currency arising from its deals with its customers, such transactions are called cover operations. Such transactions constitute only 15% of the total transactions done by a trading bank. A major portion of the volume is accounted by proprietary trading in currencies to gain from exchange rate movements. All foreign exchange transactions are conducted through the banking system and thus banks are ideally situated to establish demand-supply equilibrium. Thus, banks actively participate in establishing the exchange rates between currencies. Banks may deal directly among themselves, or use the services of foreign exchange brokers. Foreign exchange (and derivatives)

trading profits are a very important source of revenue for major international banks.

FOREIGN CURRENCY BROKERS:

Foreign exchange brokers function as intermediaries between Authorised Dealers transacting in the wholesale interbank market. Banks place orders with the brokers indicating the amount and rate at which they would be interesting in buying or selling specified currencies. These orders enable the brokers to create very fine combination quotes. When market makers or users approach them, the brokers are able to provide these ready quotes and match their requirements. The details of counter parties are conveyed to complete the transaction.

Brokers in India are not permitted to maintain ‘open positions’ or trade on proprietary account. They only act as deal facilitators. The rates of brokerage and general operational aspects are governed by guidelines from the Foreign Exchange Dealers Association Of India (FEDAI).

Foreign exchange brokers in India require licence from the RBI to operate. This licence is renewed based on the periodic review undertaken by FEDAI which makes the necessary recommendations to RBI.

All such entities are required to maintain specifies security deposit with FEDAI.

RESERVE BANK OF INDIA:

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FOREIGN EXCHANGE MARKET IN INDIA

The central bank may intervene in the market to influence the exchange rate or to reduce volatility. The basic intention in such actions is to redefine the demand - supply equilibrium. The central bank may transact in the market on its own for the above purpose or on behalf of the government, when undertaking transactions which may involve foreign currency payments and receipts. Under the Flexible Exchange Rate System currently in operation, Central banks are under no obligation to defend any particular exchange rate but still intervene to change market sentiment.

The role of RBI in the exchange market is as follows:

• Monitoring and management of exchange rates without a pre-determined target rate or range with intermittent intervention as and when necessary has been the basis of the Managed Float system followed in India.

• A policy to build a higher level of foreign exchange reserves, which takes into account not only anticipated current account deficits but also liquidity requirements arising from unanticipated capital outflows.

• A judicious policy for management of capital account transactions, with progressive liberalisation of such transactions.

• Balancing the external economy represented by the exchange rate and the internal economy represented by interest rates, inflation, money supply, etc.

FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA (FEDAI):

Foreign Exchange Dealer's Association of India (FEDAI) was set up in 1958 as an Association of banks dealing in foreign exchange in India (typically called Authorised Dealers - ADs) as a self regulatory body and is incorporated under Section 25 of The Companies Act, 1956. Its major activities include framing of rules governing the conduct of inter-bank foreign exchange business between banks, transactions between banks and public and liaison with RBI for reforms and development of foreign exchange market.

Presently their main functions are as follows:

• Frame guidelines and rules for foreign exchange business.

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FOREIGN EXCHANGE MARKET IN INDIA• Training of bank personnel in the areas of foreign exchange business.

• Accreditation of foreign exchange brokers and periodic review of their operations. They also advise the RBI regarding licensing of new brokers.

• Advising/ assisting member banks in settling issues/matters in their dealings. They provide a standardized dispute settlement process for all market participants.

• Represent member banks in discussions with government / Reserve Bank of India / other bodies and provide a common platform for Authorised Dealer’s to interact with the government and RBI.

• Announcement of daily and periodical rates to member banks. At the end of each calendar month they provide a schedule of forward rates to be used by ADs for revaluing foreign currency denominated assets and liabilities.

• Announcement of ‘spot date’ at the start of each trading day to ensure uniformity in settlement between different market participants.

• Circulate guidelines for quotation of rates, charging of commissions etc. by ADs to their customers and by brokers for interbank transactions.

Due to continuing integration of the global financial markets and increased pace of de-regulation, the role of self-regulatory organizations like FEDAI has also transformed. In such an environment, FEDAI plays a catalytic role for smooth functioning of the markets through closer co-ordination with the RBI, other organizations like FIMMDA (fixed income money market and derivatives association), 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.

The Role of Reserve Bank of India In The Control And Growth Of The Foreign Exchange Market In India

In terms of Reserve Bank of India Act, 1934 the RBI is the custodian of the foreign currency assets of the country. In terms of foreign exchange management act,1999 the RBI is responsible for controlling and supervising the foreign exchange business in the country. The primary role of the RBI in the context of these two acts therefore is to maintain stability to the external value of the rupee. This objective is approached through a balance between its domestic policy and the regulation of the foreign exchange market. The role of the RBI in the Indian Foreign Exchange Market is as follow:

1. To identify and implement an appropriate exchange rate mechanism.

2. To manage the external value of the Indian Rupee. (i.e. the exchange rate. Currently through the Managed Float Mechanism)

3. To achieve the convergence between domestic monetory policy and exchange control regulations.

4. To manage the Foreign Exchange Management Act, 1999.

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FOREIGN EXCHANGE MARKET IN INDIA5. Too progressively build higher reserves and manage the same in a cost effective manner.

6. To progressively liberalize Capital Account transactions to meet the demands of the growing economy.

7. To achieve a viable balance between the external and internal economy of the country. (This is achieved through mechanisms such as the market stabilisation scheme)

8. To interact and negotiate with other monetary authorities and with international banks and financial institutions such as the IMF, World Bank, etc.

9. To manage the investment of reserves in gold, shares and securities issued by foreign governments and deposits with international banks and financial institutions.

10. To periodically disclose foreign exchange related data to achieve transparency regarding market operations and the extent of RBI participation.

11. To specify policy guidelines for risk management relating to foreign exchange operations in banks. (at a universal level standard guidelines are developed by the Bank of International Settlements-BIS)

12. The RBI is also responsible for licensing of banks and money changers to deal in foreign exchange and reviewing the same. The role of the RBI as a proactive participant in the domestic foreign exchange Market, for stabilizing that market and the INR exchange rate has become more critical with the floating of the INR and introduction of convertibility on capital account.

Statistical and Graphical Data

USD v/s INR

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Indian Rupee per 1 US Dollar

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Indian Rupee per 1 Euro

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Indian Rupee per 1 British Pound

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Indian Rupee per 100 Japanese Yen

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1 Indian Rupee Rates table

Conclusion:

Foreign exchange market is one of the influential areas in the economy of the country.

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