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6.1Globally, 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 andrealignment 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.6.2The 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 therupee, that was pegged earlier was floated partiallyin March 1992 and fully in March 1993 following therecommendations of the Report of the High LevelCommittee 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 1994.6.3A 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 ofthe measures initiated by the Reserve Bank andidentify areas for further liberalisation or relaxationof restrictions in a medium-term framework.6.4The 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 thespillover 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 self-fulfilling speculative activities (Mohan, 2006a).6.5Against 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 ofIndia’s foreign exchange market in line with the shiftsin India’s exchange rate policies in the post-independence 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 inboth onshore and offshore markets is highlighted inthis section. Empirical exercises have also beenattempted 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
FOREIGN EXCHANGE MARKET
VI
 
212
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. SectionVIII sums up the discussions.
I.EXCHANGE RATE REGIMES IN EMERGINGMARKETS
6.6The 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.6.7The 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.6.8An 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 arebelieved 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).6.9Broadly, the overall distribution of exchangerate regimes across the globe among main categoriesremained 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 EasternCaribbean). 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.6.10The 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 thatmany 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 tothe 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.6.11During 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 a
 
213
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 associatedwith greater monetary policy independence. EM countrieswith exchange rate anchors are generally associated withpegged regimes. Here, the exchange rate serves as thenominal 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 theexchange rate is the major monetary policy instrument,the central bank’s decision on whether to steriliseintervention is made with reference to conditions in thedomestic markets
1
.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 ofsurprising 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 EMEs
becomes 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 “real”shock, 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 evidencesuggests 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 2006
Exchange RateMonetaryInflationAnchorAggregateTargetTarget
BulgariaArgentinaBrazilEcuadorChinaChileEgyptIndonesiaColombiaHong KongTunisiaCzech RepublicMalaysiaUruguayHungaryVenezuelaKoreaMoroccoMexicoHungaryPeruPhilippinesPolandSouth AfricaThailandTurkey
Source :
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 someadjustments, virtually maintained its exchange ratepeg to the US dollar. After experiencing some

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