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1 Foreign Exchange Markets Introduction During 2003-04 the average monthly turnover in the Indian foreign exchange market

touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash, derivatives and debt instruments put together in the country, and the sheer size of the foreign exchange market becomes evident. Since then, the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,foreign exchange constitutes the largest financial market by far. Liberalization has radically changed India‟s foreign exchange secto r. Indeed the liberalization process itself was sparked by a severe Balance of Payments and foreign exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe import and foreign exchange controls and a thriving black market is being replaced with a less regulated, “market driven” arrangement. While the rupee is still far from being “fully floating” (many studies indicate that the effective pegging is no less marked after the reforms than before), the nature of intervention and range of independence tolerated have both undergone significant changes. With an overabundance of foreign exchange reserves, imports are no longer viewed with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in the foreign exchange markets not always to support the rupee but often to avoid an appreciation in its value. Full convertibility of the rupee is clearly visible in the horizon. The effects of these development s are palpable in the explosive growth in the foreign exchange market in India. Definition and characteristics ofthe foreign exchange market The foreign exchange market is the market in which national currencies are bought and sold against one another. This market is called the „foreign exchange‟ market and not the „foreign currency‟ market because the „commodity‟ that is traded on the market is more appropriately called „foreign exchange‟ than „foreign currency‟: the latter is only a small part of what is traded. Foreign exchange consists mainly of bank deposits denominated in various

There is no building called the „Sydney Foreign Exchange Market‟. The products traded on the foreign exchange market are currencies: no matter where you buy your yens. Unlike the stock market and the futures market. but there are buildings called the „Sydney Stock Exchange‟ and the „Sydney Futures Exchange‟.The buyers and sellers of currencies operate from approximately 12 major centres (the most important being London. Unfortunately. its function of exchange rate determination is not very well understood in the sense that economists are yet to come up with a theory of exchange rate determination that appears empirically valid. The 24 hours of a . as participants rarely meet and actual currencies are rarely seen. where buyers and sellers contact each other via means of telecommunication. It is the largest in terms of trading volume (turnover). which are organised exchanges. Still.currencies. the term „foreign currency‟ will be used interchangeably with the term „foreign exchange‟. The foreign exchange market is made up of a vast number of participants (buyers and sellers). free flow of information. dollars or pounds they are always the same. however. Finally. euros. for example. Rather. The foreign exchange market is the largest and most perfect of all markets. the foreign exchange market is an over-the-counter (OTC) market. New York and Tokyo) and many minor ones. any point in time around the clock must fall within the business hours of at least one centre. Because major foreign exchange centres fall in different time zones. It is an OTC market in the sense that it is not limited to a particular locality or a physical location where buyers and sellers meet. the exchange rate. which affects to a considerable extent the performance of economies and businesses.This market is needed because every international economic transaction requires a foreign exchange transaction. It is the most perfect market because it possesses the requirements for market perfection: a large number of buyers and sellers. which currently stands at over one trillion US dollars per day. homogenous products. The importance of the foreign exchange market stems from its function of determining a crucial macroeconomic variable. and the absence of barriers to entry.There is no restriction on access to information. and insider trading is much less important than. anyone can participate in the market to trade currencies. in the stock market. it is an international market that is open around the clock.

Tokyo and Hong Kong).) in their dealers‟ homes. The growth of the foreign exchange market in the last few years has been nothing less than momentous. allowing them to fix their own trading limits. forwards and forward cancellations) has more than tripled. and then passing through the US centres. from 2000-01 to 2005-06. about 80% of the total transactions. a self regulatory association of dealers. In the last 5 years. clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3. Since 2001. The liberalization process has significantly boosted the foreign exchange market in the country by allowing both banks and corporations greater flexibility in holding and trading foreign currencies. The Sodhani Committee set up in 1994 recommended greater freedom to participating banks. starting with the Far Eastern centres (Sydney. Foreign Exchange Markets in India – a brief background The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade foreign exchange with one another.5 billion US dollars a day. Figure 1 shows the growth of foreign exchange trading in India between . Some banks and financial institutions may for this reason operate a 24-hour dealing room or install the necessary hardware (Reuters‟ screen. interest rates on FCNR deposits and the use of derivative products. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI). Others may delegate the task to foreign affiliates or subsidiaries in active time zones. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. passing through the Middle East (Bahrain). across Europe (Frankfurt and London). This is why the first task of a foreign exchange dealer on arrival at work in the morning is to find out what happened while he or she was asleep overnight. ending up with San Francisco.day are almost covered by these centres. growing at a compounded annual rate exceeding 25%. trading volume in the foreign exchange market (including swaps. etc. The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day.

5% for 3-months and 3. result s from doublecounting since purchase and sales are added separately. In March 2006. About two-thirds of all transactions had the rupee on one side. for instance) reflects the market‟s beliefs about future changes in its value. The inter-bank forex trading volume has continued to account for the dominant share (over 77%) of total trading over this period.3% of the world turnover. The forward premium or discount on the rupee (vis-à-vis the US dollar.1999 and 2006. according to the triennial central bank survey of foreign exchange and derivative markets conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee featured in the 20th position among all currencies in terms of being on one side of all foreign transactions around the globe and its share had tripled since 1998. As a host of foreign exchange trading activity. With these two figures in the same . and a single inter-bank transaction leads to a purchase as well as a sales entry.5% for the 6-months period. The CIP is a no-arbitrage relationship that ensures that one cannot borrow in a country. insure the returns in the original currency by selling his anticipated proceeds in the forward market and make profits without risk through this process.horizon forward transaction in the reverse direction) accounted for 34% and forwards and forward cancellations made up 11% and 7% respectively. In 2004. Features of the Forward premium on the Indian rupee The Indian rupee has had an active forward market for some time now. while swap transactions (essentially repurchase agreements with a one-way transaction – spot or forward – combined with a longer. India ranked 23rd among all countries covered by the BIS survey in 2004 accounting for 0. about half (48%) of the transactions were spot trades.) This is in keeping with global patterns. Trading is relatively moderately concentrated in India with 11 banks accounting for over 75% of the trades covered by the BIS 2004 survey. though there is an unmistakable downward trend in that proportion. During the period the average difference between 90-180 day bank deposit rates in India and the inter-bank USD offer rate was about 4. though. The strength of the relationship of this forward premium with the interest rate differential between India and the US – the Covered Interest Parity (CIP) condition – gives us a measure of India‟s integration with global markets. convert to and lend in another currency. (Part of this dominance. Chakrabarti (2006) reports that between late 1997 and mid-2004 the average discount on the rupee was about 4% per annum.

annual averages of interest rate differences and the forward exchange premium also indicate a moderate degree of co-movement between the two variables. This would indicate arbitrage opportunities and market imperfections provided we could be sure of the comparability of the interest rates considered. exhibits long-lived swings on both sides of the zero line. . Therefore. since the value of a country‟s currency has significant bearing on its economy. India has allowed restricted capital mobility and followed a “managed float” type exchange rate policy. However. As in any market essentially the demand and supply for a particular currency at any specific point in time determines its price (exchange rate) at that point. Interventions can range from quantitative restrictions on trade and crossborder transfer of capital to periodic trades by the central bank of the country or its allies and agents so as to move the exchange rate in the desired direction. In recent years India has witnessed both kinds of intervention though liberalization has implied a long-term policy push to reduce and ultimately remove the former kind. to maintain the value of a currency at or near its “desired” level. more careful empirical analysis involving directly comparable interest rates is necessary to measure the strength of the covered interest parity condition and the efficiency of the foreign exchange market. the forward exchange rate is considered to be an unbiased predictor of the future spot rate. any conclusion in this matter too must await more rigorous analysis. While the prediction errors of forward rates on the rupee appear to show some degree of persistence. The interest rate differential explains about 20% of the total variation in the forward discount. Intervention in Foreign Exchange Markets The two main functions of the foreign exchange market are to determine the price of the different currencies in terms of one another and to transfer currency risk from more riskaverse participants to those more willing to bear it.ballpark (particularly given that bank deposit rates and inter-bank rates are not strictly comparable). The deviation of the Indian rupee-US dollar from the covered interest parity. however. It is safe to say that over the years since liberalization. with random prediction errors. Under market efficiency. while the behavior of the forward premium on the Indian rupee is broadly in lines with the CIP. foreign exchange markets frequently witness government intervention in one form or another.

has been to manage “volatility” in exchange rates without targeting any specific levels. Meanwhile the dollar appreciated against major currencies in the late 90‟s and then went into an extended decline particularly during 2003 and 2004. More importantly. indicates that India had a dollar beta of 1.94. the devaluation in the Indian Rupee. This has been hard to do in practice. The overt objective of India‟s exchange rate policy. Several studies have established the pegged nature of the rupee in recent years (see Chakrabarti (2006) for a more detailed discussion). Over a reasonably long period of time. It is instructive to consider the Rupee-Dollar exchange rate in the light of the purchasing power parity (PPP) holding that the exchange rate between two currencies should equal the ratio of price levels in two countries. the rupee reverted to a crawling peg arrangement in practice. The lock-step pattern of the US dollar and the Rupee is best reflected in the movements in the two currencies against a third currency like the Euro. Between 1991 and 2003. An analysis of the ratio of the variance of the exchange rate to the sum of the variances of the interest rate and the foreign exchange reserves reveals a move even closer to the fixed exchange rate system. Clearly the Indian rupee has been an excellent “tracker” of the US dollar. The correlation of the exchange rates of the two currencies against the Euro during 1999-2004 was 0. India moved from a fixed exchange rate regime to “market determined” exchange rate system in 1993. Officially speaking.01 – tenth highest among the 53 countries considered. vis-àvis the US dollar does seem to have an association with the difference in the inflation rates in the two countries. A comparison of the sensitivity (beta) of the Dollar-rupee rate with the Euro-rupee rate for a three year period (1999 through 2001). the US dollar-Euro exchange rate explained about 97% of all movements in the Indian rupee-Euro exchange rate – highest among all the 53 countries considered.During the early years of liberalization. according to various policy pronouncements. the Rangarajan committee recommended that India‟s exchange rate be flexible. From mid-1995 to end-2001. The Indian rupee has had a remarkably stable relationship with the US dollar. India had a de facto crawling peg to the US dollar between 1979 and 1991 which changed to a de facto peg from mid-1991 to mid-1995. with a major devaluation in March 1993. Based on volatility. In its dynamic form PPP holds that that the rate of depreciation of a currency should equal the excess of its inflation rate to that in the other country. the two variables have had visible co- .

forward and swap transactions (see Ghosh (2002)). the measures were mostly in the nature of crisis management of saving-the-rupee kind and sometimes the direct deals would be repeated over several days till the desired outcome was accomplished. which essentially states that a country may have any two but not all of the following three things – a fixed exchange rate. in more extreme situations. This relationship comes from the so-called “impossible trinity” or “trilemma” of international finance. the Bank for International Settlements (BIS (2005b)) found that out of 11 emerging market countries considered. The Tarapore Committee report had urged more transparency in the intervention process and recommended. monetary measures to affect the value of the rupee as well as direct purchase and sale in the foreign exchange market using spot. Regulation of cross-border currency flows A feature of the economy that is intricately related with the exchange rate regime followed is the freedom of cross-border capital flows. Other public sector banks. Since . no information on actual interventions (five others did the same) and did not cover foreign exchange intervention in annual reports (like two other countries). free flow of capital across its borders and autonomy in its monetary policy. In a recent survey on foreign exchange market intervention in emerging markets.movements with a correlation of about 0. particularly the SBI often aided or veiled the intervention process. India gave out most complete information on intervention strategy (along with three others). The exact details of the interventions are shrouded in mystery.57 (Chakabarti (2006)). that a „Monitoring Exchange Rate Band‟ of ± 5% be used around an announced neutral real effective exchange rate (REER). in 1997. This may be a result of Indo-US trade flows dominating the exchange rate markets but it is perhaps more likely that it reflects the exchange rate management principles of the monetary authorities The Reserve Bank of India has used a varied mix of techniques in intervening in the foreign exchange market – indirect measures such as press statements (sometimes called “open mouth operations” in central bank speak) and. something yet to be implemented. On the whole it ranked fourth most opaque in matters of foreign exchange intervention among the eleven countries compared. with weekly publication of relevant figures. Till around 2002. not unusual for central banks ever wary of disclosing too much of their hand to the currency speculators.

the lack of . the wisdom of the move has been hotly debated . a mandated inflation target and strengthening of the financial system as its three main preconditions. Convertibility can spur domestic investment and growth because of easier and cheaper financing. on the inflow side. the Tarapore committee. and on the outflow side. It can also contribute to greater efficiency in the banking and financial systems.liberalization. the argument goes. allowing. fiscal discipline. viz. though it is not expected to be accomplished before 2009. In 2000. skeptics like Williamson (2006). foreign direct and portfolio investments. Expectedly. defined the concept as “the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange” and laid down fiscal consolidation. In any case. for instance. with a public sector deficit of 7. The ultimate goal of capital account convertibility now seems to be within the government‟s sights and efforts are on to chalk out the roadmap for the last leg. Close on the heels of the adoption of market determined exchange rate (within limits) in 1993 came current account convertibility in 1994. It is generally held that it was. On the other hand. and tapping foreign capital markets by Indian companies as well as considerably better remittance privileges for individuals.6% of the GDP and the ratio of public debt to GDP of over 83% in 2005-06. in fact. India has been having close to a de facto peg to the dollar and simultaneously has been liberalizing its foreign currency flow regime. on Capital Account Convertibility. Meanwhile capital flows have been gradually liberalized. Advocates of convertibility cite the “consumption smoothing” benefits of global funds flow and point out that it actually improves macroeconomic discipline because of external monitoring by the global financial markets. the benefits of convertibility do not necessarily outweigh the risks and cross-border short-term bank loans – usually the last item to be liberalized – are the most volatile. international expansion of domestic companies. In 1997. the infamous Foreign Exchange Regulation Act (FERA) was replaced with the much milder Foreign Exchange Management Act (FEMA) that gave participants in the foreign exchange market a much greater leeway. points out that India is yet to fulfill at least one of the three major preconditions to Capital Account Convertibility set out by the Tarapore committee.

the latter figure is likely to have been larger and the reserves accumulation less spectacular. The Dynamics of Swelling Reserves An important corollary of India‟s foreign exchange policy has been the quick and significant accumulation of foreign currency reserves in the past few years. India‟s foreign exchange position rocketed to one of the largest in the world with over $155 billion in mid-2006. beyond a point. During these two years the US dollar fell against the Euro by 19% and against the rupee by 9%.convertibility that protected India from contamination during the Asian contagion in 199798. Starting from a situation in 1990-91 with foreign exchange reserves level barely enough to cover two weeks of imports. this implies a compounded annual growth rate of about 28% with the years 2003 and 2004 having the most stunning rises at 48% and 45% respectively. A sizable foreign exchange reserve acts as liquidity cover and protects against a run on the country‟s currency. However. there has been discussion about the unique proposal to use part of the reserves to fund infrastructure projects. Given this low rate of return. . and reduces the rate of interest on Indian debt in the world market by lowering the country risk perception by international rating agencies. and about $32 billion at the beginning of 2000. There are significant “sterilization costs” to avoid this and the RBI loses money by earning low returns on the safe assets used to park the reserves. it begins to affect the money supply in the country. Without RBI intervention. Since 2000. and interest rates.