The Exchange Rate Mechanism and the Ruble Devaluation

8/9/2019 The Exchange Rate Mechanism and the Ruble Devaluation

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The Exchange Rate Mechanism and the RubleDevaluationof 1998By: Philip Porter,

Florida State UniversityI'm writing on this subject because of my interest in the foreign exchangerate mechanism. I want to settle, in my own mind, the questions: Whatdetermines the value of a currency? And, why does this value change inrelationto other currencies?I was hoping to examine the recent Russian currency crisis as anexemplar case of devaluation in emerging markets, but as I researched theproject, I discovered that the Russian case was not so typical. I was expectingtofind a currency that was in fundamental disequilibrium due to a prolonged

tradedeficit. I was expecting to find a currency that was overvalued and maintainedsoby an artificially high peg to the dollar. Instead, I was surprised to find a tradesurplus, which begged the question: Why wasn't the Russian currencyappreciating?With this in mind I will first examine what I see as the common sensefundamentals of the exchange rate mechanism, noting as I go, therelationshipwith the current Russian crisis. In my examination, I will take the simplestapproach, assuming free trade, unrestricted capital movements and negligible

transaction costs. Concluding, I will delve into the quagmire of the Russiansituation.2

Determining value:The value of anything is determined by what you can get in exchange forit. Or, on the other hand, what you have to give up in order to obtain and keepit.So in effect, the value of anything is its opportunity cost. This holds true formoney itself. It is worth what you can get for it... and, what you're willing togiveup, in order to get it.Thus, money itself is a commodity and can be used as barter in exchangefor other commodities.But why do different currencies have different value? And, why do thesevalues change in relation to other currencies?Purchasing Power Parity (PPP): Is the relationship between the currenciesof two or more countries and the commodities that can be purchased. Paritysuggests that, products that are substitutes for each other in internationaltradeshould have similar prices in all countries when measured against the samecurrency. But most often, it is the comparison of what a foreign currency can

buyas opposed to, what the U.S. dollar can buy.


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Traders buy and sell the currency based on perceptions of parity plusdeviations in the country's balance of payments. If a country's current andcapitalaccounts are in balance, then the country's currency should be at its parityvalue.

4Any deviations from this parity value should be due to changes in the ratio ofimports/exports and/or capital inflows/outflows. These ratios representchangesin demand for the country's currency and will cause the exchange rate tofluctuate above or below parity value.

Balance of trade:If a country has a greater demand for its exports, than it has for imports,then demand for the country's currency will increase. The exchange rate willincrease. It will take more foreign currency to buy one unit of the country'scurrency.

After the appreciation shown in (figure 2), $1 dollar would only cost aRussian 8 rubles, instead of the 10 rubles it cost him before the appreciation.This scenario will make imports relatively less expensive to the country'sconsumers, and will make the country's exports relatively more expensive tothe rest of the world.(Figure 2)Supply of rubles$$1.50$1.00Demand for rubles with trade surplusDemand for rubles at parity10 12 rubles

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So, with free trade and a floating exchange rate, the country wouldstart importing more and exporting less until the country's trade ratio equaled1and the exchange rate was at parity.The opposite is also true: If a country has a greater demand for imports,as opposed to its exports, then demand for the country's currency willdecrease.The exchange rate will decrease. It will take more local currency to buy oneunitof foreign currency. Similarly, as with the above scenario, the country'sexportswill now become relatively cheaper to the rest of the world and there will be atendency toward equilibrium.If a country's trade deficit is increasing (exports down- imports up) relativeto GDP and its money supply remains proportional relative to GDP and thereisno change in the exchange rate, then the country's currency is overvalued.Instead of the currency's value decreasing, as it should when imports rise, theexchange rate has remained the same. Thus, it has had a relativeappreciation.

This overvaluation/appreciation could be caused by several factors. One islack of response time. Another, short-term capital inflow due to high interest


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rates. Another, government selling of foreign currency reserves. (Long termcapital inflows would have the same effect of appreciating the currency, but asdiscussed later, in the case of Direct Foreign Investment (DFI), the effects oflong- term investment should act to stabilize the currency at a higher value.)Government deficits... Capital inflows... And the exchange rate:

Governments finance their deficits by borrowing. (They can also monetarize thedebt by printing money, see note(1) page 13) When they do this, they crowd outprivate6

investment by driving up the cost of funds. If a government's demand forfundsexceed the supply of funds at a given interest rate, then the interest rate mustrise until supply equals demand.It is thus beneficial for a government to desire foreign capital to supply theadditional funds necessary to finance its deficit, as this allows the country tomaintain a viable interest rate while it continues to deficit spend.

(Figure3)InterestRater Supply (Domestic)Supply (Domestic + International)R2R1Demand (Private + Government)Demand (Private)Q Q1 Q2 Q3Loanable Funds

Figure 3 shows that when the government borrows it crowds out privateborrowing. When the government enters the loanable funds market, theinterest

rate rises from R1 to R2 and thus crowds out the privately borrowed quantityof Qminus Q1.When foreign capital inflows enter the market the supply of loanable fundsshifts to the right. Now, both private and government borrowing can befinancedat the lower interest rate of R1.So, there is incentive for a government to pay for its deficit partially withforeign debt. Essentially they use this capital to purchase their own currencyin7

order to pay domestic debt, such as wages for government workers and topayfor other government projects including infrastructure construction andmaintenance... For all the things that governments do....The effect of this is to create excessive demand for the domestic currency.A demand that is in excess of the currency's value when it is viewed againstthecountry's merchandise trade equilibrium. From this perspective, capital inflowsinexcess of capital outflows, overvalue a country's currency. It will make importsrelatively cheaper than domestically produced equivalent goods. And, it will

havethe opposite effect on the county's exports.


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A further consequence of government deficits is the need for hardcurrency (Generally dollars) to pay off foreign debt. As foreign debt grows,morecapital is needed to service the debt, as well as providing for debt retirement.So,

as long as a country maintains a budget deficit, there will be an increasingdemand for loanable funds. This increasing demand will exert upwardpressureon interest rates.Cheaper imports have a positive effect for consumers, showing up aslower consumer prices and creating higher real incomes. But negatively, agovernment supports its fiscal deficit at the expense of the country's exportindustries, as well as at the expense of its domestic import competingindustriesand, additionally, at the expense of the entrepreneurial enterprises thatdepend

on loanable funds. Also, it should be noted that, increased consumerspendingencouraged by cheaper imports, discourages domestic savings and increasesthe country's dependence on foreign capital.Further, as the deficit grows, the interest rate must rise to accommodatethe increasing demand for funds. If the rate rises to some unbelievable level(like150% in the recent Russian crisis), then private investment will virtually halt.Veryfew legitimate investment opportunities can match that return. Further, privatelenders, if they were willing to lend, would be opening themselves to a severeadverse selection problem. At such a cost of funds, only the most riskyborrowers, involved in the most risky ventures, would be seeking loans.8

This is not to say that all capital inflows are bad. Direct foreign investment(DFI) represents a long-term commitment to a productive endeavor, one thatcannot be easily liquidated, thus inhibiting capital outflow. This type of increase inthedemand for a country's currency could be viewed to be a real increase invalue,rather than an excessive increase... or over-valuation.Frankel and Rose have suggested that DFI is linked directly to productiveactivity. It represents a real investment in plant, equipment and infrastructure.Foreign borrowing, on the other hand, particularly short term, does not add totheproductive capacity that is necessary to generate export earnings. It is theseexport earnings that generate the hard currency needed to service the foreigndebt in the future. But, "the stronger argument in favor of DFI is that ofstability. Inthe event of a crash, investors can suddenly dump securities and banks canrefuse to roll over loans, but multi-national corporations cannot quickly pack

uptheir factories and go home."


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(Currency Crashes in Emerging Markets: Empirical Indicators, Jeffery A. Frankel,Andrew K. Rose, Working Paper #5437 NBER. 1996, p.7-8.)

Contagion of a currency crisis:Did the Asian currency crisis spread to Russia?One Theory by Gerlach and Smets (1995) proposed that contagion could

spread between "two countries linked together by trade in merchandise andfinancial assets." "A successful attack on one exchange rate leads to its realdepreciation, which enhances the competitiveness of the country'smerchandiseexports. This produces a trade deficit in the second country, a gradual declineinthe international reserves of its central bank, and ultimately an attack on itscurrency." "Further, lower import prices in the second country causesconsumersto demand less of their own currency, preferring to swap domestic currencyfor

foreign exchange. This drain on the foreign reserves of the central bank mayshiftthe second economy from a no attack equilibrium; one where sufficientreservesexist to ward off a speculative currency attacks, to a new equilibrium in whichaspeculative currency attack may succeed. "9(Contagious Currency Crises, NBER Working Paper Series, #5681, July 1996Barry Eichengreen, Andrew K. Rose, Charles Wyplosz)

So, did the Asian crisis cause the Russian crisis? Certainly not for the

above mentioned causes of contagion. The Asian crisis certainly contributedtothe growing risk aversion of international investors and to the timing of theRussian devaluation, but it served only as a trigger in setting off a devaluationthat was basically of Russia's own making. It wasn't a matter of 'if' the rublewould devalue, but ... when it would devalue.In the short run, authorities can counter speculative pressure by runningdown their international reserves or by adjusting interest rates."The interest rate on Russia's short- term debt preceding its August 17thdevaluation soared past 150%. As money flowed out of the country the centralbank's reserves diminished by around $1 billion a week." (The Economist,

August 15, 1998. p.60.)"Last month the central bank vowed not to intervene heavily in the foreignexchange markets after having admitted to burning through some $9 billion inJuly and August in a futile attempt to support the flagging ruble. That efforthelped deplete the central bank's gold and hard currency reserves to anestimated $11 billion. " (Ruble Stronger in Trade, Scarce in the Street,Reuters,Sept. 9, 1998 NYT.)If we consider that Russia was running a trade surplus, then this shouldhave put upward pressure on the exchange rate, making the rubleundervaluedat the pegged rate rather than overvalued. Now, considering the high interestrate and substantial foreign capital inflows, it can only be inferred that the


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Russians themselves were moving out of rubles, creating a huge capitaloutflow,large enough to offset the trade surplus and foreign investment.This contention is supported by this quote from the CIA World Fact-book:"...capital flight continues to exceed in volume the inflow of foreign capital. The

10central bank estimates that $30 billion in US currency circulates in theRussianeconomy. "" Russia's trade surplus, after adjustment for unreported "shuttle"trade, grew to a record $28.5 billion in 1996, according to official Russianstatistics. Export growth, which slowed from 18% to 9%, was due mostly toincreased raw material prices. "(CIA World Fact-book,http://www.odci.gov/cia/publications/factbook/index.html)Also, from the (Economist, July 11, 1998 p. 19): It was indicated thatRussia's notorious tycoons, the so called "oligarchs" who control vast swathes

ofthe economy, send much of their asset stripping profits abroad rather thanreinvesting at home."A huge amount of money has fled Russia -- according to Credit Suisse-First Boston, at least $66 billion from 1994 to 1997 alone. Cyprus, thebestknownoffshore tax haven, is home to at least 2,000 subsidiaries of Russiancompanies, according to Steven Shevoley, a Thomson Bankwatch vicepresidentwho watches Russian banks from the island."(Hooked on High-Yield Loans Creditors Reap the Whirlwind, New York Times, 8-28-

98)Having a trade surplus should have been ideal for Russia. A trade surplus,along with a constant demand for its exports and an appreciating currencyshouldhave set the stage for a dynamic economy. But a corrupt and inept bankingsystem made it impossible to have any faith in the ruble and led to the capitaloutflows that devalued and virtually destroyed the currency.Exemplifying this, the Wall Street Journal said, regarding a release ofreserves from the central bank: "Russian banks don't really understand theconcept of liability - and thus regard all credits as free money - the new fundswillmost likely show up in Switzerland. Most Russians will understand that theirbanks are on borrowed time and avoid doing business with them whereverpossible." In the same article, " Prosecutor General Yuri Skuratov claims thatlarge amounts of the first tranche of the IMF bailout to Russia ended upoutside11

Russia and that foreign credits are routinely either embezzled or grosslymisallocated."(Russia Slides Backwards, WSJ Editorial, Sept. 23, 1998)"A key factor in Russia's collapse was a failure to collect taxes, whichwere supposed to replace the revenues previously generated by state-ownedenterprises. And with oil prices collapsing, Russia could no longer count on


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enough money from what had been its most valuable resource. Withoutenoughrevenues to pay its bills, and to support ailing local banks that owned thebonds,Russia issued more GKO's with ever-higher interest rates attractive to foreign

and domestic investors -- a short-term fix that eventually buried thegovernmentunder a pyramid of debt that collapsed last month. "" "Unfortunately, I think the GKO market didn't bring any real investment to theRussian economy," said Dmitri Vasiliev, chairman of Russia's FederalCommission for the Securities Market. "It just covered very high governmentdeficits." " (New York Times, Sept. 11,1998 Moscow Madness From theInside:Investment Bank Goes Bust)The New York Times reported this example of Russian bankingindiscretion: "The heavy trading on currency markets Tuesday suggested that

many Russians banks were using their ruble reserves to buy dollars, now thecurrency of choice in Russia. "Of course, we are worried that many banks areusing their credits to speculate on the currency market, not to pay theircreditors,"said Central Bank spokesman Irina Yasina. "But we cannot interfere with themarket." " (NYT 8-26-98 Russia Intervenes as Ruble Tumbles to a 4-YearLow)From the same article Charles Blitzer, the London-based director ofemerging markets research for Donaldson, Lufkin & Jenrette said:"It seems Russia's oligarchs are engaging in big-time capital flight,underminingthe ruble and fleeing the country. For the Central Bank to say they can'tcontrol itis a total abdication of what a central bank's responsibilities are."12

Russia's currency crisis stated simplistically, can be attributed to financinga large deficit through the issue of short-term debt rather than tax receipts, aninept and inadequately regulated banking system (including a lack oftransparency), and a lack of confidence in the currency as a store of value. Toalesser extent, it could be said that, the lack of clearly defined and enforceableproperty rights (as well as the banking problems) has discouraged DirectForeignInvestment that would have greatly benefited the developing Russianeconomy.DFI would serve to encourage the development of institutions andinfrastructureneeded in a modern industrial economy.Many developing countries fear foreign ownership. This fear is misplacedhowever, because the benefits gained far outweigh the costs. They could gainjobs, wages, infrastructure, vendor industries, taxes, as well as a myriad ofancillary benefits. The owner only takes away his profit (which wouldn't exist

except through his efforts and capital) and this, only if he chooses to notreinvest


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(which he would if he liked his profit margin). Further, it is the country'scitizens,with the power of the vote, who are ultimately in control. They are more likelytoget screwed by their own oligarchs (i.e. manipulators, the power elite, the

rulingclass) than by foreigners. Foreign investors cannot engage in an enterprisethatwould be detrimental to a country unless there is collusion with localauthorities.The problem of detrimental exploitation cannot be blamed on foreigners. Theblame lies with corrupt local officials.Also, fearing competition, local special interest groups may exploit andfuel the fear of foreign ownership to block DFI, thus protecting local monopolyprofits.It's easy to give advice in hindsight, but right from the beginning of its

market experiment, Russia should have promoted DFI as well as institutingandmaintaining some type of currency control. DFI adds stability and currencycontrols counter distrust in the monetary authorities. To establish trust amonetary authority must be consistent, transparent and ethical. All of whichmustbe established over time. No one wants to hold a currency they can't trust.

Unfortunately for Russia, the ruble was such a currency.

6.1 Globally, operations in the foreign exchangemarket started in a major way after the breakdown ofthe Bretton Woods system in 1971, which also markedthe beginning of floating exchange rate regimes inseveral countries. Over the years, the foreignexchange market has emerged as the largest marketin the world. The decade of the 1990s witnessed aperceptible policy shift in many emerging marketstowards reorientation of their financial markets interms of new products and instruments, developmentof institutional and market infrastructure and

realignment of regulatory structure consistent with theliberalised operational framework. The changingcontours were mirrored in a rapid expansion of foreignexchange market in terms of participants, transactionvolumes, decline in transaction costs and moreefficient mechanisms of risk transfer.6.2 The origin of the foreign exchange market inIndia could be traced to the year 1978 when banksin India were permitted to undertake intra-day tradein foreign exchange. However, it was in the 1990sthat the Indian foreign exchange market witnessedfar reaching changes along with the shifts in thecurrency regime in India. The exchange rate of the

rupee, that was pegged earlier was floated partiallyin March 1992 and fully in March 1993 following therecommendations of the Report of the High Level


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Committee on Balance of Payments (Chairman: Dr.C.Rangarajan). The unification of the exchange ratewas instrumental in developing a market-determinedexchange rate of the rupee and an important step inthe progress towards current account convertibility,which was achieved in August 1994.

6.3 A further impetus to the development of theforeign exchange market in India was provided withthe setting up of an Expert Group on ForeignExchange Markets in India (Chairman: Shri O.P.Sodhani), which submitted its report in June 1995.The Group made several recommendations fordeepening and widening of the Indian foreignexchange market. Consequently, beginning fromJanuary 1996, wide-ranging reforms have beenundertaken in the Indian foreign exchange market.After almost a decade, an Internal Technical Groupon the Foreign Exchange Market (2005) wasconstituted to undertake a comprehensive review of

the measures initiated by the Reserve Bank andidentify areas for further liberalisation or relaxationof restrictions in a medium-term framework.6.4 The momentous developments over the pastfew years are reflected in the enhanced risk-bearingcapacity of banks along with rising foreign exchangetrading volumes and finer margins. The foreignexchange market has acquired depth (Reddy, 2005).The conditions in the foreign exchange market havealso generally remained orderly (Reddy, 2006c).While it is not possible for any country to remaincompletely unaffected by developments ininternational markets, India was able to keep the

spillover effect of the Asian crisis to a minimumthrough constant monitoring and timely action,including recourse to strong monetary measures,when necessary, to prevent emergence of selffulfillingspeculative activities (Mohan, 2006a).6.5 Against the above background, this chapterattempts to analyse the role of the central bank indeveloping the foreign exchange market. Section Iprovides a brief review of different exchange rateregimes being followed in emerging marketeconomies (EMEs). Section II traces the evolution ofIndias foreign exchange market in line with the shiftsin Indias exchange rate policies in the postindependence

period from the pegged to the marketdetermined regime. Various regulatory and policyinitiatives taken by the Reserve Bank and theGovernment of India for developing the foreignexchange market in the market determined set uphave also been highlighted. Section III presents adetailed overview of the current foreign exchangemarket structure in India. It also analyses the availablemarket infrastructure in terms of market players,trading platform, instruments and settlementmechanisms. Section IV assesses the performanceof the Indian foreign exchange market in terms ofliquidity and efficiency. The increase in turnover in

both onshore and offshore markets is highlighted inthis section. Empirical exercises have also been


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attempted to assess the behaviour of forward premia,bid-ask spreads and market turnover. Havingdelineated the market profile, Section V thendiscusses the journey of the Indian foreign exchangemarket since the early 1990s, especially through

VI FOREIGN EXCHANGE MARKET212

REPORT ON CURRENCY AND FINANCE

periods of volatility and its management by theauthorities. As central bank intervention has been animportant element of managing volatility in the foreignexchange market, its need and effectiveness in amarket determined exchange rate and open capitalregime has been examined in Section VI. Section VIImakes certain suggestions with a view to furtherdeepening the foreign exchange market so that it canmeet the challenges of an integrated world. Section

VIII sums up the discussions.I. EXCHANGE RATE REGIMES IN EMERGINGMARKETS6.6 The regulatory framework governing theforeign exchange market and the operational freedomavailable to market participants is, to a large extent,influenced by the exchange rate regime followed byan economy. In this section, therefore, we take a lookat the exchange rate regimes that the EMEs haveadopted during the 1990s.6.7 The experience with capital flows in the1990s has had an important bearing on the choiceof the exchange rate regime by EMEs in recentyears. The emphasis on corner solutions - a fixedpeg a la the currency board without monetary policyindependence or a freely floating exchange rateretaining discretionary conduct of monetary policy -is distinctly on the decline. The trend seems to beclearly in favour of intermediate regimes withcountry-specific features and with no fixed targetsfor the level of the exchange rate.6.8 An important feature of the conduct ofmonetary policy in recent years has been the foreignexchange market interventions either by the centralbank on its own behalf or on behalf of public sectorentities to ensure orderly conditions in markets andto fight extreme market turbulence (Box VI.1).Besides, EMEs, in general, have also beenaccumulating foreign exchange reserves as aninsurance against shocks. It is a combination ofthese strategies which will guide monetaryauthorities through the impossible trinity of a fixedexchange rate, open capital account and anindependent monetary policy (Mohan, 2003). Thedebate on appropriate policies relating to foreignexchange markets has now converged around somegenerally accepted views: (i) exchange rates shouldbe flexible and not fixed or pegged; (ii) there iscontinuing need for many emerging marketeconomies to be able to intervene or manageexchange rates- to some degree - if movements are


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believed to be destablising in the short run; and(iii) reserves should at least be sufficient to take careof fluctuations in capital flows and liquidity at risk(Jalan, 2003).6.9 Broadly, the overall distribution of exchangerate regimes across the globe among main categories

remained more or less stable during 2001-06, thoughthere was a tendency for some countries to shiftacross and within exchange regimes (Table 6.1). Asat end-April 2006, there were more floating regimes(79 countries including 53 managed floats and 26independent floats) than soft pegs (60 countries) orhard pegs (48 countries) (Exhibit VI.1). Managedfloats are found in all parts of the globe, whileconventional fixed pegs are mostly observed in theMiddle East, the North Africa and parts of Asia. Onthe other hand, hard pegs are found primarily inEurope, Sub-Saharan Africa (the CFA zones) andsmall island economies (for instance, in the Eastern

Caribbean). While 20 countries moved from a softpeg to a floating regime during the past four years,this was offset by a similar number of other countriesabandoning the floating arrangements in favour ofsoft pegs.6.10 The substantial movement between soft pegsand floating regimes suggests that floating is notnecessarily a durable state, particularly for lower andmiddle-income countries, whereas there appears tobe a greater state of flux between managed floatingand pegged arrangements in high-income economies.The frequency with which countries fall back to pegsafter a relatively short spell in floating suggests that

many countries face institutional and operationalconstraints to floating. The preference for tightermanagement seems to have intensified recently as anumber of countries have enjoyed strong externaldemand and capital inflows. Other notable trendsincluded a shift away from currency baskets, with theUS dollar remaining the currency of choice forcountries with hard pegs as well as soft pegs. Onethird of the dollar pegs are hard pegs and theremaining are soft pegs. The choice of the US dollarfor countries with soft pegs reflects its continuedimportance as an invoicing currency and a high shareof trade with the US or other countries that peg to

the US dollar. The euro is the second most importantcurrency and serves as an exchange rate anchor forcountries in Europe and the CFA franc zone in Africa.6.11 During the last 15 years, there was ageneral tendency among the emerging marketeconomies to adopt a more flexible exchange rateregime (Table 6.2). In emerging Asia, there is a broadconsensus that the soft US dollar peg operated by a213

FOREIGN EXCHANGE MARKET

Economic literature suggests that, at an aggregated level,the adoption of more flexible exchange rate regimes inEmerging Market (EM) countries has been associated

with greater monetary policy independence. EM countrieswith exchange rate anchors are generally associated withpegged regimes. Here, the exchange rate serves as the


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nominal anchor or intermediate target of monetary policy.Around 27 per cent of the EM countries followedexchange rate anchors at the end of April 2006 (Table).When the exchange rate is directly targeted in order toachieve price stability, intervention operations areunsterilised with inter-bank interest rates adjusting fully.In Singapore, while pursuing a target band for the

exchange rate is the major monetary policy instrument,the central banks decision on whether to steriliseintervention is made with reference to conditions in thedomestic markets1 .In other regimes, where the exchange rate is not themonetary policy anchor, any liquidity impact ofintervention that would cause a change in monetaryconditions is generally avoided. Most foreign exchangeoperations are sterilised. Interventions may also be usedin coordination with changes in monetary policy, givingthe latter a greater room for manoeuvre. For example,where a change in monetary policy is unexpected,surprising the market can erode confidence or destabilisethe market. Intervention may help minimise the costs of

surprising financial markets, allowing monetary policygreater capacity to move ahead of market expectations.Around 17 per cent of the EM countries have adoptedmonetary aggregate target, most of which are associatedwith managed floating exchange rate regimes. In the caseof a monetary aggregate target, the monetary authorityuses its instruments to achieve a target growth rate for amonetary aggregate (reserve money, M1, M2, etc.), andthe targeted aggregate becomes the nominal anchor orintermediate target of monetary policy.Around 43 per cent of the EM countries have adoptedinflation targeting as their monetary policy regime, wherechanges in interest rates are the principal instrumentsof monetary policy. Inflation targeting involves the publicannouncement of medium-term numerical targets forinflation with an institutional commitment by the monetaryauthority to achieve these targets. Here, intervention

Box VI.1Exchange Rate Regimes and Monetary Policy in EMEsbecomes important when movements in the exchangerate inconsistent with economic fundamentals threatento push inflation outside the target band. However, wherethe exchange rate is responding appropriately to a realshock, it may be necessary either to acknowledge theexpected departure from the inflation target for someperiod of time or to offset the shock by altering monetarypolicy. Most of the countries with inflation targeting asthe monetary policy regime have adopted independentfloating as the exchange rate policy. Empirical evidence

suggests that most emerging economies that moved toa free float, introduced full-fledged inflation targeting onlyafter a transition. There are other EM countries, viz.,Algeria, India, Romania, and Russia, which have noexplicitly stated nominal anchor, but rather monitorvarious indicators in the conduct of monetary policy. Insome of the EM countries, coordinating these policiesmay be more difficult because foreign exchangeoperations are not the responsibility of the monetaryauthority. In such instances, the maintenance of a closedialogue between the respective authorities is importantin avoiding any conflict arising between monetary andexchange rate policies.1 EMEAP Study on Exchange Rate Regimes, June 2001.

Table: Monetary Policy Framework - April 2006Exchange Rate Monetary InflationAnchor Aggregate Target


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TargetBulgaria Argentina BrazilEcuador China ChileEgypt Indonesia ColombiaHong Kong Tunisia Czech RepublicMalaysia Uruguay HungaryVenezuela KoreaMorocco Mexico

Hungary PeruPhilippinesPolandSouth AfricaThailandTurkeySource : Annual Report on Exchange Arrangements andExchange Restrictions, 2006, IMF.

number of Asian countries contributed to the regionalfinancial crisis in 1997-98. Since the Asian financialcrisis, several Asian economies have adopted moreflexible exchange rate regimes except for Hong Kong,which continued with its currency boardarrangement, and China, which despite some

adjustments, virtually maintained its exchange ratepeg to the US dollar. After experiencing some214


Table 6.1: Evolution of Exchange Rate Regimes, 1996 - April 2006(Number of countries; end-December data)Regime 1996 2001 2002 2003 2004 2005 2006 April1 2 3 4 5 6 7 8I. Hard Pegs 30 47 48 48 48 48 48No separate legal tender 24 40 41 41 41 41 41Currency board arrangements 6 7 7 7 7 7 7II. Soft Pegs 94 58 59 59 59 61 60a. Conventional Pegged arrangements 50 42 46 46 48 49 49Pegs to Single Currency 36 32 36 38 40 44 44Pegs to Composite 14 10 10 8 8 5 5

b. Intermediate Pegs 44 16 13 13 11 12 11Pegged within horizontal bands 18 5 5 4 5 6 6Crawling Pegs 14 6 5 6 6 6 5Crawling Bands 12 5 3 3 0 0 0III. Floating Regimes 60 81 80 80 80 78 79Managed Floating 37 43 45 46 49 52 53Independently Floating 23 38 35 34 31 26 26Note : To ensure comparability, all data are based on the current de facto methodology applied retroactively, unlessotherwise specified.Source : Annual Report on Exchange Arrangements and Exchange Restrictions, 2006, IMF and other sources.

transitional regime, Malaysia started pegging to theUS dollar on September 1, 1998, but shifted overrecently (July 2005) to a managed float regime. Incontrast, Thailand, Indonesia, Korea, the Philippinesand Taiwan have floated their currencies since the

crisis, while adopting a monetary policy strategybased on inflation targeting. The Monetary Authorityof Singapore (MAS) continues to monitor theSingapore dollar against an undisclosed basket ofcurrencies of Singapores major trading partners andcompetitors. The Taiwanese government replaced itsearlier managed foreign exchange rate by a floatingrate in 1989, consequent to an increase in its tradesurplus and the resulting rise in the foreign exchangereserves.215


6.12 Most of the Latin American economies have

a history of very high inflation rates. As such, inflationcontrol has been a major objective of exchange ratepolicies of these countries in recent years. Starting


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from the end of 1994, a floating rate policy wasmaintained in Mexico, with the Bank of Mexicointervening in the foreign exchange market underexceptional circumstances to minimise volatility andensure an orderly market. Chile adopted exchangerate flexibility in 1999, after experiencing an exchange

rate band for the previous 17 years starting from 1982.After pursuing various forms of exchange rate pegsfor more than four decades, which included occasionaldevaluation as also a change of the currency,Argentina had to finally move away from its currencyboard linked to the US dollar in January 2002. Brazil,after having a floating exchange rate regime withminor interventions in 1990s, adopted anindependently floating exchange rate regime in theaftermath of its currency crisis in 19992.6.13 An analysis of the complexities, challengesand vulnerabilities faced by EMEs in the conduct ofexchange rate policy and managing volatilities in

foreign exchange market reveal that the choice of aparticular exchange rate regime alone cannot meetall the requirements. The emerging consensus is thatfor successful conduct of exchange rate policy, it isessential for countries to pursue sound and crediblemacroeconomic policies so as to avoid the build-upof major macro imbalances in the economy. Second,it is essential for EMEs to improve the flexibility oftheir product and factor markets in order to cope andadjust to shocks arising from the volatility of currencymarkets and swings in the terms of trade in worldproduct markets. Third, it is crucial for EMEs todevelop and strengthen their financial systems in

order to enhance their resilience to shocks. In addition,a sound and efficient banking system together withdeep and liquid capital market contributes to theefficient intermediation of financial flows. This couldhelp prevent the emergence of vulnerabilities in thefinancial system by minimising unsound lendingpractices that lead to the build-up of excessiveleveraging in the corporate sector and exposure toforeign currency borrowings. Fourth, countries wouldneed to build regulatory and supervisory capabilitiesto keep pace with financial innovations and theemergence of new financial institutions activities, andnew products and services, which have complicated

the conduct of exchange rate policy. Fifth, policymakers need to promote greater disclosures andtransparency.6.14 Fur thermore, the perception about thevolatility and flexibility in exchange rate is contextual.What may be perceived as flexible for someeconomies may turn out to be volatile for othereconomies. The level of development andpreparedness of financial markets and their risktakingability is crucial in this context (Reddy, 2007).If the level of development and preparedness offinancial markets is low, a small movement inexchange rate could be interpreted as volatile, while

even large movement in exchange rate in developedforeign exchange markets may not be seen as


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volatile. Thus, as financial markets develop in anemerging economy, the tolerance to volatilityimproves and hence what was once volatility wouldlater become flexibility. A key issue, therefore, forthe authorities is where and when to make policyadjustments, including the use of official intervention

2 Brazil had an adjustable band during 1995 to 1999 in a programme to control money creation.Table 6.2: Emerging Market Countries:Transition to More Flexible Exchange RateRegimes: 1990 - April 2006Transition Type Country1 2Move towards a more flexible Algeria Koreaexchange rate regime Argentina MexicoBrazil PeruChile PolandColombia RomaniaCzech Republic RussiaEgypt SlovakiaIndia ThailandIndonesia TurkeyMove towards a less flexible China Uruguayexchange rate regime MalaysiaHong KongEcuadorVenezuelaBulgariaNote : The Classification of the countries exchange rateregimes is based on the IMFs de facto classificationand does not necessarily represent the views of theauthorities.Source: Annual Report on Exchange Arrangements andExchange Restrictions, IMF, various issues.

216


to help avoid substantial volatility and seriousmisalignments.

6.15 With gradual liberalisation and opening upof the capital account, capital flows to EMEs,particularly to Asian economies increasedsignificantly during the 1990s, posing newchallenges for central banks. Surges in capital flowsand their associated volatility have implications forthe conduct of monetary policy by central banks. Thechallenges facing central banks pertain to liquiditymanagement, exchange rate and foreign exchangereserve management. Central banks in theseeconomies, thus, need to be equipped to deal withlarge capital flows. Since capital flows in somecountries in recent years have been associated with

various crises, there is also a rethinking aboutunfettered capital account liberalisation.6.16 Intervention by most Asian central banks inforeign exchange markets has become necessaryfrom time to time primarily because of the growingimportance of capital flows in determining exchangerate movements in these economies as against tradedeficits and economic growth, which were importantin the earlier days. The latter does matter, but onlyover a period (Jalan, 2003). On a day-to-day basis, itis capital flows, which influence the exchange rateand interest rate arithmetic of financial markets.Capital movements have also rendered exchange

rates significantly more volatile than before (Mohan,2003). For the relatively open economies, this raises


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the issue of appropriate monetary policy response tosharp exchange rate movements since exchange ratevolatility has had significant real effects in terms offluctuations in employment and output and thedistribution of activity between tradable and nontradable,especially in the developing countries, which

depend on export performance as a key to the healthof their balance of payments. In the fiercelycompetitive trading environment, countries seek toexpand market shares aggressively by paring downmargins. In such cases even a small change inexchange rates can develop into significant andpersistent real effects. Thus, in order to benefit frominternational capital inflows, host countries need topursue sound macroeconomic policies, developstrong institutions, and adopt appropriate regulatoryframeworks for the stability of financial systems andsustained economic progress.6.17 To sum up, while some flexibility in foreign

exchange markets and exchange rate determinationis desirable, excessive volatility can have adverseimpact on price discovery, export performance,sustainability of current account balance, andbalance sheets in view of dollarisation. The EMEsexperience has highlighted the need for developingcountries to allow greater flexibility in exchangerates. However, the authorities also need to havethe capacity to intervene in foreign exchangemarkets in view of herd behaviour. With progressiveopening of the emerging markets to financial flows,capital flows are playing an increasingly importantrole in exchange rate determination and are often

reflected in higher exchange rate volatility. Againstthis backdrop, it would be appropriate to have a peepinto the exchange rate regime followed in India andthe evolution of foreign exchange market in the postindependence period.II. INDIAN FOREIGN EXCHANGE MARKET:A HISTORICAL PERSPECTIVEEarly Stages: 1947-19776.18 The evolution of Indias foreign exchangemarket may be viewed in line with the shifts in Indiasexchange rate policies over the last few decades froma par value system to a basket-peg and further to amanaged float exchange rate system. During the

period from 1947 to 1971, India followed the par valuesystem of exchange rate. Initially the rupees externalpar value was fixed at 4.15 grains of fine gold. TheReserve Bank maintained the par value of the rupeewithin the permitted margin of 1 per cent usingpound sterling as the intervention currency. Since thesterling-dollar exchange rate was kept stable by theUS monetary authority, the exchange rates of rupeein terms of gold as well as the dollar and othercurrencies were indirectly kept stable. Thedevaluation of rupee in September 1949 and June1966 in terms of gold resulted in the reduction of thepar value of rupee in terms of gold to 2.88 and 1.83

grains of fine gold, respectively. The exchange rateof the rupee remained unchanged between 1966


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and 1971 (Chart VI.1).6.19 Given the fixed exchange regime during thisperiod, the foreign exchange market for all practicalpurposes was defunct. Banks were required toundertake only cover operations and maintain asquare or near square position at all times. The

objective of exchange controls was primarily toregulate the demand for foreign exchange for variouspurposes, within the limit set by the available supply.The Foreign Exchange Regulation Act initiallyenacted in 1947 was placed on a permanent basis217


in 1957. In terms of the provisions of the Act, theReserve Bank, and in certain cases, the CentralGovernment controlled and regulated the dealingsin foreign exchange payments outside India, exportand import of currency notes and bullion, transfersof securities between residents and non-residents,

acquisition of foreign securities, etc3 .6.20 With the breakdown of the Bretton WoodsSystem in 1971 and the floatation of majorcurrencies, the conduct of exchange rate policyposed a serious challenge to all central banks worldwide as currency fluctuations opened up tremendousopportunities for market players to trade in currenciesin a borderless market. In December 1971, the rupeewas linked with pound sterling. Since sterling wasfixed in terms of US dollar under the SmithsonianAgreement of 1971, the rupee also remained stableagainst dollar. In order to overcome the weaknessesassociated with a single currency peg and to ensure

stability of the exchange rate, the rupee, with effectfrom September 1975, was pegged to a basket ofcurrencies. The currency selection and weightsassigned were left to the discretion of the ReserveBank. The currencies included in the basket as wellas their relative weights were kept confidential inorder to discourage speculation. It was around thistime that banks in India became interested in tradingin foreign exchange.Formative Period: 1978-19926.21 The impetus to trading in the foreignexchange market in India came in 1978 when banksin India were allowed by the Reserve Bank to

undertake intra-day trading in foreign exchange andwere required to comply with the stipulation ofmaintaining square or near square position only atthe close of business hours each day. The extent ofposition which could be left uncovered overnight (theopen position) as well as the limits up to which dealerscould trade during the day were to be decided by themanagement of banks. The exchange rate of therupee during this period was officially determined bythe Reserve Bank in terms of a weighted basket ofcurrencies of Indias major trading partners and theexchange rate regime was characterised by dailyannouncement by the Reserve Bank of its buying and

selling rates to the Authorised Dealers (ADs) forundertaking merchant transactions. The spread


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between the buying and the selling rates was 0.5 percent and the market began to trade actively withinthis range. ADs were also permitted to trade in crosscurrencies (one convertible foreign currency versusanother). However, no position in this regard couldoriginate in overseas markets.

6.22 As opportunities to make profits began toemerge, major banks in India started quoting twowayprices against the rupee as well as in crosscurrencies and, gradually, trading volumes began toincrease. This led to the adoption of widely differentpractices (some of them being irregular) and theneed was felt for a comprehensive set of guidelinesfor operation of banks engaged in foreign exchangebusiness. Accordingly, the Guidelines for InternalControl over Foreign Exchange Business, wereframed for adoption by the banks in 1981. The foreignexchange market in India till the early 1990s,however, remained highly regulated with restrictions

on external transactions, barriers to entry, lowliquidity and high transaction costs. The exchangerate during this period was managed mainly forfacilitating Indias imports. The strict control onforeign exchange transactions through the ForeignExchange Regulations Act (FERA) had resulted inone of the largest and most efficient parallel marketsfor foreign exchange in the world, i.e., the hawala(unofficial) market.6.23 By the late 1980s and the early 1990s, it wasrecognised that both macroeconomic policy and3 The Act was later replaced by a more comprehensive legislation, i.e., the Foreign Exchange Regulation Act, 1973.

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REPORT ON CURRENCY AND FINANCEstructural factors had contributed to balance ofpayments difficulties. Devaluations by Indiascompetitors had aggravated the situation. Althoughexports had recorded a higher growth during thesecond half of the 1980s (from about 4.3 per centof GDP in 1987-88 to about 5.8 per cent of GDP in1990-91), trade imbalances persisted at around 3 percent of GDP. This combined with a precipitous fall ininvisible receipts in the form of private remittances,travel and tourism earnings in the year 1990-91 ledto further widening of current account deficit. Theweaknesses in the external sector were accentuated

by the Gulf crisis of 1990-91. As a result, the currentaccount deficit widened to 3.2 per cent of GDP in1990-91 and the capital flows also dried upnecessitating the adoption of exceptional correctivesteps. It was against this backdrop that Indiaembarked on stabilisation and structural reforms inthe early 1990s.Post-Reform Period: 1992 onwards6.24 This phase was marked by wide rangingreform measures aimed at widening and deepeningthe foreign exchange market and liberalisation ofexchange control regimes. A crediblemacroeconomic, structural and stabilisation

programme encompassing trade, industry, foreigninvestment, exchange rate, public finance and thefinancial sector was put in place creating an


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environment conducive for the expansion of tradeand investment. It was recognised that trade policies,exchange rate policies and industrial policies shouldform part of an integrated policy framework toimprove the overall productivity, competitiveness andefficiency of the economic system, in general, and

the external sector, in particular.6.25 As a stabilsation measure, a two stepdownward exchange rate adjustment by 9 per centand 11 per cent between July 1 and 3, 1991 wasresorted to counter the massive drawdown in theforeign exchange reserves, to instill confidenceamong investors and to improve domesticcompetitiveness. A two-step adjustment of exchangerate in July 1991 effectively brought to close theregime of a pegged exchange rate. After the Gulfcrisis in 1990-91, the broad framework for reforms inthe external sector was laid out in the Report of theHigh Level Committee on Balance of Payments

(Chairman: Dr. C. Rangarajan). Following therecommendations of the Committee to move towardsthe market-determined exchange rate, the LiberalisedExchange Rate Management System (LERMS) wasput in place in March 1992 initially involving a dualexchange rate system. Under the LERMS, all foreignexchange receipts on current account transactions(exports, remittances, etc.) were required to besurrendered to the Authorised Dealers (ADs) in full.The rate of exchange for conversion of 60 per cent ofthe proceeds of these transactions was the marketrate quoted by the ADs, while the remaining 40 percent of the proceeds were converted at the Reserve

Banks official rate. The ADs, in turn, were requiredto surrender these 40 per cent of their purchase offoreign currencies to the Reserve Bank. They werefree to retain the balance 60 per cent of foreignexchange for selling in the free market for permissibletransactions. The LERMS was essentially atransitional mechanism and a downward adjustmentin the official exchange rate took place in earlyDecember 1992 and ultimate convergence of the dualrates was made effective from March 1, 1993, leadingto the introduction of a market-determined exchangerate regime.6.26 The dual exchange rate system was replaced

by a unified exchange rate system in March 1993,whereby all foreign exchange receipts could beconverted at market determined exchange rates. Onunification of the exchange rates, the nominalexchange rate of the rupee against both the US dollaras also against a basket of currencies got adjustedlower, which almost nullified the impact of the previousinflation differential. The restrictions on a number ofother current account transactions were relaxed. Theunification of the exchange rate of the Indian rupeewas an important step towards current accountconvertibility, which was finally achieved in August1994, when India accepted obligations under Article

VIII of the Articles of Agreement of the IMF.6.27 With the rupee becoming fully convertible on


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all current account transactions, the risk-bearingcapacity of banks increased and foreign exchangetrading volumes started rising. This wassupplemented by wide-ranging reforms undertakenby the Reserve Bank in conjunction with theGovernment to remove market distortions and

deepen the foreign exchange market. The processhas been marked by gradualism with measuresbeing undertaken after extensive consultations withexperts and market participants. The reform phasebegan with the Sodhani Committee (1994) which inits report submitted in 1995 made severalrecommendations to relax the regulations with a viewto vitalising the foreign exchange market (Box VI.2).219


The Expert Group on Foreign Exchange Markets in India(Chairman: Shri O.P.Sodhani), which submitted its Reportin 1995, identified various regulations inhibiting thegrowth of the market. The Group recommended that thecorporates may be permitted to take a hedge upondeclaring the existence of an exposure. The Grouprecommended that banks should be permitted to fix theirown exchange position limits such as intra-day andovernight limits, subject to ensuring that the capital isprovided/earmarked to the extent of 5 per cent of thislimit based on internationally accepted guidelines. TheGroup also favoured fixation of Aggregate Gap Limit(AGL), which would also include rupee transactions, bythe managements of the banks based on capital, risktaking capacity, etc. It recommended that banks beallowed to initiate cross currency positions abroad andto lend or borrow short-term funds up to six months,subject to a specified ceiling. Another important

suggestion related to allowing exporters to retain 100per cent of their export earnings in any foreign currencywith an Authorised Dealer (AD) in India, subject toliquidation of outstanding advances against export bills.The Group was also in favour of permitting ADs todetermine the interest rates and maturity period inrespect of FCNR (B) deposits. It recommended selectiveintervention by the Reserve Bank in the market so as toensure greater orderliness in the market.In addition, the Group recommended various other shorttermand long-term measures to activate and facilitatefunctioning of markets and promote the developmentof a vibrant derivative market. Short-term measures

Box VI.2

Recommendations of the Expert Group on Foreign Exchange Markets in Indiarecommended included exemption of domestic interbankborrowings from SLR/CRR requirements tofacilitate development of the term money market,cancellation and re-booking of currency options,permission to offer lower cost option strategies such asthe range forward and ratio range forward and permittingADs to offer any derivative products on a fully coveredbasis which can be freely used for their own asset liabilitymanagement.As part of long-term measures, the Group suggestedthat the Reserve Bank should invite detailed proposalsfrom banks for offering rupee-based derivatives, shouldrefocus exchange control regulation and guidelines onrisks rather than on products and frame a fresh set ofguidelines for foreign exchange and derivatives riskmanagement.


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As regards accounting and disclosure standards, themain recommendations included reviewing of policyprocedures and transactions on an on-going basis by arisk control team independent of dealing and settlementfunctions, ensuring of uniform documentation and marketpractices by the Foreign Exchange Dealers Associationof India (FEDAI) or any other body and development of

accounting disclosure standards.Reference:Reserve Bank of India. 1995. Report on ForeignExchange Markets in India (Chairman : Shri O.PSodhani), June.

Most of the recommendations of the SodhaniCommittee relating to the development of the foreignexchange market were implemented during the latterhalf of the 1990s.6.28 In addition, several initiatives aimed atdismantling controls and providing an enablingenvironment to all entities engaged in foreignexchange transactions have been undertaken since

the mid-1990s. The focus has been on developing theinstitutional framework and increasing the instrumentsfor effective functioning, enhancing transparency andliberalising the conduct of foreign exchange businessso as to move away from micro management offoreign exchange transactions to macro managementof foreign exchange flows (Box VI.3).6.29 An Internal Technical Group on the ForeignExchange Markets (2005) set up by the ReserveBank made various recommendations for furtherliberalisation of the extant regulations. Some of therecommendations such as freedom to cancel andrebook forward contracts of any tenor, delegation of

powers to ADs for grant of permission to corporatesto hedge their exposure to commodity price risk inthe international commodity exchanges/markets andextension of the trading hours of the inter-bankforeign exchange market have since beenimplemented.6.30 Along with these specific measures aimed atdeveloping the foreign exchange market, measurestowards liberalising the capital account were alsoimplemented during the last decade, guided to a largeextent since 1997 by the Report of the Committee onCapital Account Convertibility (Chairman: Shri S.S.Tarapore). Various reform measures since the early

1990s have had a profound effect on the marketstructure, depth, liquidity and efficiency of the Indianforeign exchange market as detailed in the followingsection.220


III. FOREIGN EXCHANGE MARKET STRUCTUREMarket Segments6.31 Foreign exchange market activity in mostEMEs takes place onshore with many countriesprohibiting onshore entities from undertaking theoperations in offshore markets for their currencies.Spot market is the predominant form of foreign

exchange market segment in developing andemerging market countries. A common feature is thetendency of importers/exporters and other end-users


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to look at exchange rate movements as a source ofreturn without adopting appropriate risk managementpractices. This, at times, creates uneven supplydemandconditions, often based on news and views.Though most of the emerging market countries allowoperations in the forward segment of the market, it is

still underdeveloped in most of these economies. Thelack of forward market development reflects manyfactors, including limited exchange rate flexibility, thede facto exchange rate insurance provided by thecentral bank through interventions, absence of a yieldInstitutional Framework The Foreign Exchange Regulation Act (FERA), 1973was replaced by the market friendly Foreign ExchangeManagement Act (FEMA), 1999. The Reserve Bankdelegated powers to authorised dealers (ADs) torelease foreign exchange for a variety of purposes. In pursuance of the Sodhani Committeesrecommendations, the Clearing Corporation of IndiaLimited (CCIL) was set up in 2001.

To further the participatory process in a more holisticmanner by taking into account all segments of thefinancial markets, the ambit of the Technical AdvisoryCommittee (TAC) on Money and Securities Marketsset up by the Reserve Bank in 1999 was expanded in2004 to include foreign exchange markets and theCommittee was rechristened as TAC on Money,Government Securities and Foreign ExchangeMarkets.Increase in Instruments in the Foreign ExchangeMarket The rupee-foreign currency swap market was allowed. Additional hedging instruments such as foreigncurrency-rupee options, cross-currency options,

interest rate swaps (IRS) and currency swaps, caps/collars and forward rate agreements (FRAs) wereintroduced.Liberalisation Measures Authorised dealers were permitted to initiate tradingpositions, borrow and invest in overseas market,subject to certain specifications and ratification byrespective banks Boards. Banks were also permittedto (i) fix net overnight position limits and gap limits(with the Reserve Bank formally approving the limits);(ii) determine the interest rates (subject to a ceiling)and maturity period of FCNR(B) deposits with

Box VI.3Measures Initiated to Develop the Foreign Exchange Market in Indiaexemption of inter-bank borrowings from statutory preemptions;and (iii) use derivative products for assetliabilitymanagement. Participants in the foreign exchange market, includingexporters, Indians investing abroad, and FIIs werepermitted to avail forward cover and enter into swaptransactions without any limit, subject to genuineunderlying exposure. FIIs and NRIs were permitted to trade in exchangetradedderivative contracts, subject to certainconditions. Foreign exchange earners were permitted to maintainforeign currency accounts. Residents were permittedto open such accounts within the general limit of US $25,000 per year, which was raised to US $ 50,000 per

year in 2006, has further increased to US $ 1,00,000since April 2007.


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Disclosure and Transparency Initiatives The Reserve Bank has been taking initiatives in puttingin public domain all data relating to foreign exchangemarket transactions and operations. The Reserve Bankdisseminates: (a) daily reference rate which is anindicative rate for market observers through its website,(b) data on exchange rates of rupee against some

major currencies and foreign exchange reserves on aweekly basis in the Weekly Statistical Supplement(WSS), and (c) data on purchases and sales of foreigncurrency by the Reserve Bank in its Monthly Bulletin.The Reserve Bank has already achieved full disclosureof information pertaining to international reserves andforeign currency liquidity position under the SpecialData Dissemination Standards (SDDS) of the IMF.Reference:Mohan, Rakesh. 2006. Financial Sector Reforms andMonetary Policy: The Indian Experience. RBI Bulletin,July.

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curve on which to base the forward prices and shallowmoney markets, in which market-making banks canhedge the maturity risks implicit in forward positions(Canales-Kriljenko, 2004).6.32 Most foreign exchange markets in developingcountries are either pure dealer markets or acombination of dealer and auction markets. In thedealer markets, some dealers become market makersand play a central role in the determination ofexchange rates in flexible exchange rate regimes.Market makers set two-way exchange rates at whichthey are willing to deal with other dealers. The bidofferspread reflects many factors, including the level

of competition

The Exchange Rate Mechanism and the Ruble Devaluation

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