CHAPTER 19.

RBIs INTERVENTION AND EXCHANGE RATE MANAGEMENT

Q. 1: Explain the various exchange rate systems.

Ans. A) INTRODUCTION
The earliest exchange rate system was popularly known as Gold standard,
this system existed during 1879-1934. In this exchange rate system the value of
currencies of different countries was fixed in terms of gold. Hence under gold standard
exchange rate system there could be only fixed exchange rates.
After the end of World War II to 1971, another Fixed Exchange Rate
System known as Bretton Woods System prevailed.
After 1971, the exchange rate system was not purely flexible, hence it was
called Managed Float System.
B) EXCHANGE RATE SYSTEMS
Fixed Exchange Rates
IMF was established with the object of stabilising the rates of exchange
between the member countries. Under its charter, every member country was required to
fix and declare the par value of its currency in terms of gold or dollar and maintain it. The
system of fixed exchange is known as pegged exchange rates. The Government
determines the exchange rate by pegging operations (i.e. buying and selling foreign
exchange at particular exchange rate).
In pegging operation, Government fixes an official exchange rate and
enforce it through Central Bank. A exchange stabilisation fund may be set up in order to
maintain the exchange rate by buying its currency when market exchange rate falls
below specified exchange rate and vice versa. The major defect in this system was that
if the market exchange rate falls consistently pegging operations will be very expensive
as it will lead to heavy reduction in reserves.
Under gold standard, rate of exchange varied within a small range of gold
export point and gold import point. But gold standard was given up by all countries in
19'30s. Since the fixed exchange rates do not reflect true value of currencies, flexible
exchange rates were adopted by countries.
Flexible Exchange Rate
Flexible exchange rates are determined by forces of demand and
supply in the foreign exchange market without the interference of Government. The

relative positions of demand and supply depends on the deficit or surplus in the balance
of payments of the country. The exchange rates are not rigidly fixed up but allowed to
float with changing conditions. The relative value of currencies alter far more rapidly with
automatic devaluation or revaluation.
The free floating rate is allowed to seek its own level as no par of
exchange is fixed. Since 1980s as many countries were in favour of the flexible
exchange rates IMF was forced to adopt flexible exchange rates.
Managed Exchange Rate System I Managed Flexibility :A system of managed flexibility came up to take the merits of fixed and
flexible exchange rate and to overcome their demerits. This system is based on the par
value concept under IMF guidelines.
In managed flexibility of exchange rate system, the range of flexibility
around fixed par values is determined by the country as per its economic need and the
prevailing trend in international monetary system. This system of exchange rate requires
the country to interfere in foreign exchange market from time to time in view of the
emerging disequilibrium.
The Central Bank of the country holds large amount of foreign
exchange. Hence the Central Bank can control the exchange rate by manipulating the
magnitude of demand or supply in the forex market. For instance, the Central Bank
resorts to large scale buying of foreign currency when there is an excess supply of
foreign currency and vice versa.
Q. 2 : Explain RBIs intervention in exchange rate management in India. (M.2011)
OR
RBI is the apex body that intervenes and control foreign exchange in India. Discuss.
OR
How does RBI intervene in the foreign exchange market.
Ans. A) RBIs INTERVENTION AND EXCHANGE RATE MANAGEMENT :In 1939, the Exchange Control Department of RBI was set up. In order
to conserve the scarce foreign exchange reserves, the Foreign Exchange Regulation Act
(FERA) was passed in 1947.
India adopted fixed exchange rate of IMF upto 1971, whereby the
Indian Rupee external par value was fixed. In 1973, FERA was amended and it came in
force on January 1st, 1974. It gave wide powers to RBI to administer exchange control
mechanism properly.
In 1992, RBI introduced LERMS (Liberalised Exchange Rate
Management System) Under LERMS a dual exchange rate was fixed. The 1993-94

Budget made Indian Rupee fully convertible on trade account. LERMS was withdrawn.
Developing countries allowed market forces to determine the exchange rate. Under
flexible exchange rate system, if demand for foreign currency is more than that of its
supply, foreign currency appreciates and domestic currency depreciates and vice versa.
To minimise the disadvantages of flexible exchange rate, most of the developing
countries including India have adopted the concept of managed Flexible Exchange Rate
(MFER).
Under MFER, the Central bank intervenes to bring stability in
exchange rate. RBIs intervention involves purchase of foreign currency from market or
release (sale) of foreign currency in the market, to bring stability in exchange rates.
ROLE OF RBI IN FOREIGN EXCHANGE MARKET
The role of RBI in the foreign exchange market is revealed by the provisions of FERA
(1973).
Administrative Authority
The RBI is the administrative authority for exchange control in India.
The RBI has been given powers to issue licences to those who are involved in foreign
exchange transactions.
Authorised Dealers
The RBI has appointed a number of authorised dealers. They are permitted to carry out
ail transactions involving foreign exchange. The above provision is laid down in Section
3 of FERA.
Issue Of Directions
The 'Exchange Control Manual' contains all directions and procedures given by RBI to
authorised dealers from time to time.
Fixation Of Exchange Rates :The RBI has the responsibility of fixing the exchange value of home currency in terms of
other currencies. This rate is known as official rate of exchange. All authorised dealers
and money lenders are required to follow this rate strictly in all their foreign exchange
transactions.
Foreign Investments :Non-residents can make investments in India only after obtaining the necessary
permission from Central Government or RBI. Great investment opportunities are
provided to non-resident Indians.
Foreign Travel :-

Indian residents can get foreign exchange released from RBI upto a
specified amount for travelling abroad through proper application.

Import Trade
The RBI regulates import trade. Imports are permitted only against
proper licenses. The items of imports that can be imported freely are specified under
Open General Licence.
Export Trade
The RBI controls export trade. Export of gold and jewellery are allowed
only with special permission from RBI.
Gold. Silver. Currency Notes Etc.
In recent years, the limits fixed for bringing gold, silver, currency notes etc.
has been relaxed considerably.
Submission Of Returns
All foreign exchange transactions made by authorised dealers must be
reported to RBI. This enables the RBI to have a close watch on foreign exchange
dealings in India.
Thus, from above points we can say that RBI is the apex bank that
intervens, supervises, controls the foreign exchange markets in order to create an stable
and active exchange market.
Q. 3 : Explain the exchange controls administered by RBI under FERA.
OR
FERA act was administered by RBI to conserve exchange reserves. Explain. OR
Write note on FERA I FEMA.
Ans. A) FERA AND EXCHANGE CONTROLS :In 1939, under the Defence of India Rules (DIR), the Exchange Control was
imposed. In 1973, FERA was amended. India has accepted a system of multilateral
payments, i.e., the rupee should be freely convertible to currencies of all member
countries of IMF. But the RBI adopted exchange controls under FERA, in order to
conserve India's Foreign exchange reserves.
Foreign exchange was rationed out strictly according to availability.
Purchase and Sale of foreign securities by Indians were strictly controlled.

All external payments had to be made through authorised dealers controlled by RBI.
Exporters who acquired foreign exchange had to surrender their earnings to
authorised deale rs and get rupees in exchange.
Imports were rigidly controlled and imports of unnecessary items were prohibited.
The RBI as the apex bank supervised and controlled the foreign
exchange market. The RBI decided the exchange rate of rupee in terms of pound
sterling on a day to day basis. It would sell pound sterling against specific demand and
would also buy US dollar, pound sterling, German mark and Japanese yen. In 1992, the
Pound sterling was replaced by dollar as intervention currency. Hence, RBI would sell
only dollar and continue to buy Dollar, Pound, Mark and Yen.
In New Industrial Policy of 1991, the government announced major
concessions to FERA companies.
FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)
The relaxation of FERA encouraged the inflow of foreign capital and
the growth of Multi National Corporations (MNC's) in India. FERA was replaced by FEMA
in 1999.
Under FERA RBI's permission was necessary. Under FEMA, except for Section 3
(relates to foreign exchange) no other permission is required from RBI. The purpose of
FEMA is to facilitate external trade and payments and promote orderly development and
maintenance of foreign exchange market in India.
FEMA has simplified the provisions of FERA. The two key aspects of
FEMA are the relaxation of foreign exchange controls and move towards capital account
convertibility. To facilitate foreign trade restrictions drawals of foreign exchange for
current and capital account transactions have been removed. FEMA regulates both
import and export trade methods of payment.
If any person contravens any provisions of FEMA, he shall be liable to
a penalty upto twice the sum involved in such contravention. There would be no
punishment by way of imprisonment.