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A foreign exchange market refers to buying foreign currencies with domestic currencies
and selling foreign currencies for domestic currencies. Thus it is a market in which the
claims to foreign moneys are bought and sold for domestic currency. Exporters sell
foreign currencies for domestic currencies and importers buy foreign currencies with
domestic currencies.

According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions
and individuals who buy and sell foreign exchange which may be defined as foreign
money or any liquid claim on foreign money". Foreign Exchange transactions result in
inflow and outflow of foreign exchange.


The foreign exchange market is a crucial international market and is the worlds most
respected financial institution. On a daily basis, the Forex exchange trades with
approximately two trillion U.S Dollars.
Forex trade has facilitated international trade among countries. When your business is
dealing with investors from another country, you need to acquire their currency to trade.
Transfer of purchasing is facilitated through foreign exchange among countries. You are
able to acquire capital that will enhance you purchasing power when dealing with
another country, Importance of Foreign Exchange Markets.
Forex markets have a credit provision and this goes a long way in enhancing the growth
of foreign trade. Most investors dealing with international trade depend on the credit
facilities that are advanced to them by Forex markets. The advanced credit is used to
purchase imports from other countries. It is easier to get credit from Forex markets
because they have enormous capital reserves that are in liquid form.

Governments as a way of protecting their currencies trade in the foreign exchange to

accumulate reserves. Money reserves affect the value of currencies, and at the same
time they can be used to payments. Governments through their central banks must
ensure they have sufficient reserves to be able to stabilize their currencies in the event of
changes in the economy.
Foreign exchange markets also provide the market with hedging facilities. Hedging here
means that you can protect your business against risk. It provides business owners with
mechanisms that guard them against incurring losses in the event that values of the
currencies they trade in fluctuate. As the economy changes the value of currencies is
affected. Therefore, as a business person you need to have hedging facilities to prevent
suffering losses, Importance of Foreign Exchange Markets.
The foreign exchange market provides liquidity for currencies. Liquidity is the ease with
which you can convert a foreign currency into a domestic currency. The ease with
which currencies are changed translates to ease with which business transactions are
carried out. If you are a business and have foreign exchange reserves, it becomes easy to
change the currency to your domestic carry and transact effectively.
Another importance of foreign exchange is the provision of job opportunities. With the
increased use of the internet, online Forex exchange has become an prominent feature in
the foreign exchange market. Many people earn a living by trading currencies online on
a daily basis. There are enormous returns to the investment made in starting up a foreign
exchange market.


Unlike a stock market, the foreign exchange market is divided into levels of access. At
the top is the interbank market, which is made up of the largest commercial banks and
securities dealers. Within the interbank market, spreads, which are the difference
between the bid and ask prices, are razor sharp and not known to players outside the
inner circle. The difference between the bid and ask prices widens to 1 pip to 12 pips
as you go down the levels of access. This is due to volume. If a trader can guarantee
large numbers of transactions for large amounts, they can demand a smaller difference
between the bid and ask price, which is referred to as a better spread. The levels of

access that make up the foreign exchange market are determined by the size of the "line"
(the amount of money with which they are trading). The top-tier interbank market
accounts for 39% of all transactions. From there, smaller banks, followed by large
multi-national corporations (which need to hedge risk and pay employees in different
countries), large hedge funds, and even some of the retail market makers. According to
Galati and Melvin, Pension funds, insurance companies, mutual funds, and other
institutional investors have played an increasingly important role in financial markets in
general, and in FX markets in particular, since the early 2000s. (2004) In addition, he
notes, Hedge funds have grown markedly over the 20012004 period in terms of both
number and overall size. Central banks also participate in the foreign exchange market
to align currencies to their economic needs.
The interbank market caters for both the majority of commercial turnover and large
amounts of speculative trading every day. A large bank may trade billions of dollars
daily. Some of this trading is undertaken on behalf of customers, but much is conducted
by proprietary desks, trading for the bank's own account.
Until recently, foreign exchange brokers did large amounts of business, facilitating
interbank trading and matching anonymous counterparts for small fees. Today,
however, much of this business has moved on to more efficient electronic systems, such
as EBS, Reuters Dealing 3000 Matching, the Chicago Mercantile Exchange, Bloomberg
and Trade Book. The broker squawk box lets traders listen in on ongoing interbank
trading and is heard in most trading rooms, but turnover is noticeably smaller than just a
few years ago.


An important part of this market comes from the financial activities of companies
seeking foreign exchange to pay for goods or services. Commercial companies often
trade fairly small amounts compared to those of banks or speculators, and their trades
often have little short term impact on market rates. Nevertheless, trade flows are an
important factor in the long-term direction of a currency's exchange rate. Some

multinational companies can have an unpredictable impact when very large positions
are covered due to exposures that are not widely known by other market participants.


National central banks play an important role in the foreign exchange markets. They try
to control the money supply, inflation, and/or interest rates and often have official or
unofficial target rates for their currencies. They can use their often substantial foreign
exchange reserves, to stabilize the market.
Milton Friedman argued that the best stabilization strategy would be for central banks to
buy when the exchange rate is too low, and to sell when the rate is too high - that is, to
trade for a profit.
Nevertheless, central banks do not go bankrupt if they make large losses, like other
traders would, and there is no convincing evidence that they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize
a currency, but aggressive intervention might be used several times each year in
countries with a dirty float currency regime. Central banks do not always achieve their
objectives, however. The combined resources of the market can easily overwhelm any
central bank. Several scenarios of this nature were seen in the 1992-93 ERM collapse,
and in more recent times in South East Asia.


Investment Management firms (who typically manage large accounts on behalf of
customers such as pension funds, endowments etc.) use the Foreign exchange market to
facilitate transactions in foreign securities. For example, an investment manager with an
international equity portfolio will need to buy and sell foreign currencies in the spot
market in order to pay for purchases of foreign equities. Since the forex transactions are
secondary to the actual investment decision, they are not seen as speculative or aimed at
Some investment management firms also have more speculative specialist currency
overlay units, which manage clients' currency exposures with the aim of generating

profits as well as limiting risk. The number of this type of specialist is quite small, their
large assets under management (AUM) can lead to large trades.


Hedge funds, such as George Soros's Quantum fund have gained a reputation for
aggressive currency speculation since 1990. They control billions of dollars of equity
and may borrow billions more, and thus may overwhelm intervention by central banks
to support almost any currency, if the economic fundamentals are in the hedge funds'


Non-bank foreign exchange companies offer currency exchange and international
payments to private individuals and companies. These are also known as foreign
exchange brokers but are distinct in that they do not offer speculative trading but rather
currency exchange with payments (i.e., there is usually a physical delivery of currency
to a bank account).
It is estimated that in the UK, 14% of currency transfers payments are made via Foreign
Exchange Companies. These companies' selling point is usually that they will offer
better exchange rates or cheaper payments than the customer's bank. These companies
differ from Money Transfer/Remittance Companies in that they generally offer highervalue services.
Money transfer companies/remittance companies perform high-volume low-value
transfers generally by economic migrants back to their home country. In 2007, the Aite
Group estimated that there were $369 billion of remittances (an increase of 8% on the
previous year). The four largest markets (India, China, Mexico and the Philippines)
receive $95 billion. The largest and best known provider is Western Union with 345,000
agents globally followed by UAE Exchange.

Bureaux de change or currency transfer companies provide low value foreign exchange
services for travelers. These are typically located at airports and stations or at tourist
locations and allow physical notes to be exchanged from one currency to another. They
access the foreign exchange markets via banks or non-bank foreign exchange


Retail forex brokers or market makers handle a minute fraction of the total volume of
the foreign exchange market. According to CNN, one retail broker estimates retail
volume at $25-50 billion daily, which is about 2% of the whole market. CNN also
quotes an official of the National Futures Association "Retail forex trading has
increased dramatically over the past few years. Unfortunately, the amount of forex fraud
has also increased dramatically."
All firms offering foreign exchange trading online are either market makers or facilitate
the placing of trades with market makers.In the retail forex industry market makers
often have two separate trading desks- one that actually trades foreign exchange (which
determines the firm's own net position in the market, serving as both a proprietary
trading desk and a means of offsetting client trades on the interbank market) and one
used for off-exchange trading with retail customers (called the "dealing desk" or
"trading desk").Many retail FX market makers claim to "offset" clients' trades on the
interbank market (that is, with other larger market makers), e.g. after buying from the
client, they sell to a bank. Nevertheless, the large majority of retail currency speculators
are novices and who lose money, so that the market makers would be giving up large
profits by offsetting.
Offsetting does occur, but only when the market maker judges its clients' net position as
being very risky. The dealing desk operates much like the currency exchange counter at
a bank. Interbank exchange rates, which are displayed at the dealing desk, are adjusted
to incorporate spreads (so that the market maker will make a profit) before they are
displayed to retail customers. Prices shown by the market maker do not neccesarily
reflect interbank market rates. Arbitrage opportunities may exist, but retail market
makers are efficient at removing arbitrageurs from their systems or limiting their trades.

A limited number of retail forex brokers offer consumers direct access to the interbank
forex market. But most do not because of the limited number of clearing banks willing
to process small orders. More importantly, the dealing desk model can be far more
profitable, as a large portion of retail traders' losses are directly turned into market
maker profits.
While the income of a market maker that offsets trades or a broker that facilitates
transactions is limited to transaction fees (commissions), dealing desk brokers can
generate income in a variety of ways because they not only control the trading process,
they also control pricing which they can skew at any time to maximize profits.
The rules of the game in trading FX are highly disadvantageous for retail speculators.
Most retail speculators in FX lack trading experience and and capital (account
minimums at some firms are as low as 250-500 USD). Large minimum position sizes,
which on most retail platforms ranges from $10,000 to $100,000, force small traders to
take imprudently large positions using extremely high leverage.
In the US, "it is unlawful to offer foreign currency futures and option contracts to retail
customers unless the offeror is a regulated financial entity" according to the Commodity
Futures Trading Commission.Legitimate retail brokers serving traders in the U.S. are
most often registered with the CFTC as "futures commission merchants" (FCMs) and
are members of the National Futures Association (NFA).Potential clients can check the
broker's FCM status at the NFA. Retail forex brokers are much less regulated than stock
brokers and there is no protection similar to that from the Securities Investor Protection
Corporation. The CFTC has noted an increase in forex scams.



Currency changes affect you, whether you are actively trading in the foreign exchange
market, planning your next vacation, shopping online for goods from another country
or just buying food and staples imported from abroad.
Like any commodity, the value of a currency rises and falls in response to the forces of
supply and demand. Everyone needs to spend, and consumer spending directly affects
the money supply (and vice versa). The supply and demand of a countrys money is
reflected in its foreign exchange rate.
When a countrys economy falters, consumer spending declines and trading sentiment
for its currency turns sour, leading to a decline in that countrys currency against other
currencies with stronger economies. On the other hand, a booming economy will lift the
value of its currency, if there is no government intervention to restrain it.
Consumer spending is influenced by a number of factors: the price of goods and
services (inflation), employment, interest rates, government initiatives, and so on. Here
are some economic factors you can follow to identify economic trends and their effect
on currencies.
The state of a countrys economy determines its currency value. A growing economy is
generally the foundation for a stable currency that is valued highly in comparison with
others. Any factors which impact the growth of the economy, either positively or
negatively also affect currency prices. For example, during inflation, currency values
typically fall. Inflation reduces the purchasing power of money so that less can be
bought for each unit of money.
There are many economic indicators that need to be considered before making a forex
trade decision. These indictors represent various aspects of the economy. As the general
economic condition influences the currency value, these indicators are very useful in
determining how the currency prices will fare given the current economic conditions.

GDP The Gross Domestic product of a country measures the industrial growth and
production. This figure is a good indicator of how active the economy is. A steady GDP
is the indication of a healthy, growing economy. Currency values are likely to rise when
such circumstances prevail.
Purchasing Power Parity PPP measures the comparative power of a currency to
purchase goods and services in a country. Consider two countries, A and B. 100 units of
currency of A are equal to 1 unit of currency of B as per prevailing exchange rates in the
market. PPP aims to measure the purchasing power of As currency with respect to Bs

What can be bought for 100 units of local currency in country A should be available for
1 unit of local currency in country B. Then the countries are at par as far as purchasing
power is concerned. If the countries are not evenly matched with respect to PPP and one
currency has greater purchasing power than the other then it has a higher value in the
forex market.
Interest Rate Parity "Benchmark" interest rates from central banks influence the
retail rates financial institutions charge customers to borrow money. For instance, if the
economy is under-performing, central banks may lower interest rates to make it cheaper
to borrow; this often boosts consumer spending, which may help expand the economy.
To slow the rate of inflation in an overheated economy, central banks raise the
benchmark so borrowing is more expensive.

Interest rates are of particular concern to investors seeking a balance between yield
returns and safety of funds. When interest rates go up, so do yields for assets
denominated in that currency; this leads to increased demand by investors and causes an
increase in the value of the currency in question. If interest rates go down, this may lead
to a flight from that currency to another. The interest rates prevalent in both countries
must also be comparable so that investments yield similar returns. The ability of a
countrys currency to multiply in this way ultimately determines its own value. This is
why interest rate parity is also an important factor in determining currency prices.

Employment Levels Employment levels determine the productivity of a nation. This

is an indicator of future growth in the economy. A high level of employment means that
most of the countrys population is engaged in contributing to economic growth. A good
employment rate is a sign of a healthy economy and forms the basis for more
This, in turn, increases the currency value. A low employment rate shows that fewer
people are contributing to the economy. Production of goods and services is being
carried out by a smaller proportion of the population, although consumption is at the
same level. Currency value will be subdued when employment levels are low.
Consumer Spending The amount of money which the people of a country are
spending gives an idea of what they think about the economy. If spending is low and
saving is high, then it shows that people fear an economic downturn. This indicates that
the currency value may fall in future.
Increased consumer spending shows that people are confident of their future earnings
and investment yields. Consumer spending is also an indicator of the purchasing power
of the average citizen and the standard of living. A prosperous economy is one where
consumer spending is at a sustainable level. Such an economy is likely to have a stable
currency with a high value


The government constantly assesses the economy and takes actions. Government
policies are created and implemented to encourage prevailing economic conditions
during a positive trend and to correct the imbalance if the economy is not doing well.
Most economic policies fall under two categories fiscal policies and monetary
policies. Fiscal policies are those which outline the spending of the government. The
annual budget is a part of the fiscal policy. It determines the areas where the government
will be spending money. Government spending boosts the prospects of industries and
segments of the economy.
Monetary policies are those which influence the various components of the countrys
financial fabric to improve or sustain the economy. The central bank of a country
implements the governments policies by using various investment strategies in the

Given the huge amount of funds the central bank can control, any action by the bank has
a huge impact on the market. An inflationary trend can be curbed, falling prices can be
shored and many other economic imbalances can be set right by central banks though
their market activities.
Both monetary and fiscal policies affect currency prices, though the impact of monetary
policies is almost immediate.

A natural disaster like floods, famine or drought in a country will have a negative
impact on its currency value. The flow of money within the countys boundaries is
restricted severely under adverse circumstances like these.
The general public is more cautious in spending and there is likely to be a dramatic
reduction in the overall amount of funds which are being used for investments. High
risk investments like forex do not find many takers during these times. Government
spending is also reduced because of huge expenditure in relief measures. Any excess
funds are diverted toward rehabilitation programs because the governments focus is on
getting the country back on its feet.

Countries trade with each other to buy and sell products and services. As with any
transaction, this too requires an exchange of money. In fact, the level of international
trade is a good indicator of demand for a countrys currency. When countries with
different currencies trade, the deal influences the value of currencies for both of them.
Such international trade is a permanent feature of any economy with goods and services
being bought and sold from many different countries at any given point in time. When
imports are higher than exports, the economy is said to have a trade deficit and when
exports are higher than imports, there is a trade surplus. Governments publish the
balance of trade figures showing this status every month.
A government has to pay for its purchases or imports and it receives money for its
exports. In a trade deficit situation, it will be spending more of the domestic currency to
buy foreign currency to fund the purchases. In this case, the domestic currency will fall
in value in comparison with the foreign one. When exports exceed imports, there is a
trade surplus which also translates into a higher domestic currency value. The status of
this equation is given by the capital flow of a country.

Both capital flow and balance of trade are combined into the balance of payments
statistics, which are released by the government. Three components make up the balance
of payments of a country:

Current account Measures the goods bought and sold in international trade.

Capital account Measures the acquisition of disposal of assets that are nonfinancial in nature.

Financial account Measures the cross-border flow of money.

The balance of payments statistics play an important role in determining currency value
of any country. This is one of the most important factors that a forex trader must
consider when he makes investment decisions, especially long term ones.


With interest rates in several major economies already very low (and set to stay that way
for the time being), central bank and government officials are now resorting to other,
less commonly used measures to directly intervene in the market and influence
economic growth.
For example, quantitative easing is being used to increase the money supply within an
economy. It involves the purchase of government bonds and other assets from financial
institutions to provide the banking system with additional liquidity. Quantitative easing
is considered a last resort when the more typical responselowering interest rates
fails to boost the economy. It comes with some risk: increasing the supply of a currency
could result in a devaluation of the currency.

The global capital markets are perhaps the most visible indicators of an economy's
health. Stock and bond markets are the most noticeable markets in the world. With
constant media coverage and up-to-the-second information on the dealings of
corporations, institutions and government entities, there is not much public information
that the capital markets miss. A wide rally or sell-off of securities originating from one
country or another should be a clear signal that the future outlook (short term or long
term) for that economy has changed in investors' eyes.
A rally in oil prices would likely lead to the appreciation of the loonie relative to other
currencies. Commodity traders, like forex traders, rely heavily on economic data for

their trades, so in many cases, the same economic data will have a direct affect on both
markets. (For more on this correlation, see How to Trade Currency and Commodity
Moreover, the bond markets are critical to what is happening in the forex market, since
both fixed income securities and currencies are rely heavily on interest rates.
Movements in Treasuries are a first level factor in movements in currencies, meaning
that a change in yields will directly affect currency values. Because of how closely tied
the two markets are, it is important to understand how bonds - and government bonds
especially - are valued in order to excel as a forex trader.

Market sentiments play an important role in determining currency values. These directly
influence demand and supply within the market. During times of global economic
unrest, values will increase for stronger currencies which are linked to countries viewed
as stable.
A country whose inflation levels are high will be viewed as a poor prospect for forex
trading because future economic growth is likely to be hampered by high prices.
Investors perception of an economy and interpretation of various economic indicators
determine the overall market sentiment for a currency.

Politics often determines the direction which an economy will take. Political unrest
brings a lot of uncertainty about the future and subdues both economic growth and
currency value. An upcoming election or war may give rise to a cautious investment
approach, reducing the capital flow into a country.
A change in leadership also often subdues the price movement of a currency in the forex
market. Until the new leaderships political views, monetary and fiscal policies and
views on international trade become clear, the markets do not show a clear trend in the
currencys value.
A country that is considered politically unstable will not be a favored trading partner.
This will affect its forex trade and the value of its currency in this market. On the other
hand, a progressive political leader and a stable leadership pave the way for increased
investments as investor confidence becomes strong.


FEMA permits only authorised person to deal in foreign exchange or foreign security.
Such an authorised person, under the Act, means authorised dealer,money changer, offshore banking unit or any other person for the time being authorised by Reserve Bank.
The Act thus prohibits any person who:

Deal in or transfer any foreign exchange or foreign security to any person not
being an authorized person.

Make any payment to or for the credit of any person resident outside India in any

Receive otherwise through an authorized person, any payment by order or on

behalf of any person resident outside India in any manner;

Enter into any financial transaction in India as consideration for or in association

with acquisition or creation or transfer of a right to acquire, any asset outside
India by any person is resident in India which acquire, hold, own, possess or
transfer any foreign exchange, foreign security or any immovable property
situated outside India.


Save otherwise provided in this Act, no person resident in India shall acquire, hold,
own, possess or transfer any foreign exchange, foreign security or any immovable
property situated outside India.

Any person may sell or draw foreign exchange to or from an authorized person if such
sale or drawl is a current account transaction: Provided that the Central Government

may, in public interest and in consultation with the Reserve Bank, impose such
reasonable restrictions for current account transactions as may be prescribed.


(1) Subject to the provisions of sub-section (2), any person may sell or draw foreign
exchange to or from an authorized person for a capital account transaction.
(2)The Reserve Bank may, in consultation with the Central Government, specify(a) any class or classes of capital account transactions which are permissible,
(b) the limit up to which foreign exchange shall be admissible for such transactions:
Provided that the Reserve Bank shall not impose any restriction on the drawl of foreign
exchange for payments due on account of amortization of loans or for depreciation of
direct investments in the ordinary courts of business.

(3) Without prejudice to the generality of the provisions of sub-section (2), the Reserve
Bank may, by regulations, prohibit, restrict or regulate the following(a) transfer or issue of any foreign security by a person resident in India;
(b) transfer or issue of any security by a person resident outside India;
(c) transfer or issue of any security or foreign security by any branch, office or agency
in India of a person resident outside India;
(d) any borrowing or lending in rupees in whatever form or by whatever name called;
(e) any borrowing or lending in rupees in whatever form or by whatever name called
between a person resident in India and a person resident outside India;
(f) deposits between persons resident in India and persons resident outside India;
(g) export, import or holding of currency or currency notes;
(h) transfer of immovable property outside India, other than a lease not exceeding five
years, by a person resident in India;
(i) acquisition or transfer of immovable property in India, other than a lease not
exceeding five years, by a person resident outside India;
(j) giving of a guarantee or surety in respect of any debt, obligation or other liability
incurred(i) by a person resident in India and owed to a person resident outside India; or
(ii)by a person resident outside India.

(4) A person resident in India may hold, own, transfer or invest in foreign currency,
foreign security or any immovable property situated outside India if such currency,
security or property was acquired, held or owned by such person when he was resident
outside India or inherited from a person who was resident outside India.

(5) A person resident outside India may hold, own, transfer or invest in Indian currency,
security or any immovable property situated in India if such currency, security or
property was acquired, held or owned by such person when he was resident in India or
inherited from a person who was resident in India.

(6) Without prejudice to the provisions of this section, the Reserve Bank may, by
regulation, prohibit, restrict, or regulate establishment in India of a branch, office or
other place of business by a person resident outside India, for carrying on any activity
relating to such branch, office or other place of business.


(1) Every exporter of goods shall(a) furnish to the Reserve Bank or to such other authority a declaration in such form and
in such manner as may be specified, containing true and correct material particulars,
including the amount representing the full export value or, if the full export value of the
goods is not ascertainable at the time of export, the value which the exporter, having
regard to the prevailing market conditions, expects to receive on the sale of the goods in
a market outside India
(b) furnish to the Reserve Bank such other information as may be required by the
Reserve Bank for the purpose of ensuring the realization of the export proceeds by such

(2) The Reserve Bank may, for the purpose of ensuring that the full export value of the
goods or such reduced value of the goods as the Reserve Bank determines, having
regard to the prevailing market conditions, is received without any delay, direct any
exporter to comply with such requirements as it deems fit.


(3) Every exporter of services shall furnish to the Reserve Bank or to such other
authorities a declaration in such form and in such manner as may be specified,
containing the true and correct material particulars in relation to payment for such


Save as otherwise provided in this Act, where any amount of foreign exchange is due or
has accrued to any person resident in India, such person shall take all reasonable steps to
realize and repatriate to India such foreign exchange within such period and in such
manner as may be specified by the Reserve Bank.



The provisions of sections 4 and 8 shall not apply to the following, namely:(a) possession of foreign currency or foreign coins by any person up to such limit as the
Reserve Bank may specify;
(b) foreign currency account held or operated by such person or class of persons and the
limit up to which the Reserve Bank may specify;
(c) foreign exchange acquired or received before the 8th day of July, 1947 or any
income arising or accruing thereon which is held outside India by any person in
pursuance of a general or special permission granted by the Reserve Bank;
(d) foreign exchange held by a person resident in India up to such limit as the Reserve
Bank may specify, if such foreign exchange was acquired by way of gift or inheritance
from a person referred to in clause (c), including any income arising there from;
(e) foreign exchange acquired from employment, business, trade, vocation, services,
honorarium, gifts, inheritance or any other legitimate means up to such limit as the
Reserve Bank may specify,
(f) such other receipts in foreign exchange as the Reserve Bank may specify.



A feature of the economy that is intricately related with the exchange rate regime
followed is the freedom of cross-border capital flows. This relationship comes from the
so-called impossible trinity or trilemma of international finance, which essentially
states that a country may have any two but not all of the following three things a fixed
exchange rate, free flow of capital across its borders and autonomy in its monetary
policy. Since liberalization, India has been having close to a de facto peg to the dollar
and simultaneously has been liberalizing its foreign currency flow regime.

Close on the heels of the adoption of market determined exchange rate (within limits) in
1993 came current account convertibility in 1994. In 1997, the Tarapore committee, on
Capital Account Convertibility, 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, a mandated inflation target and
strengthening of the financial system as its three main preconditions.

Meanwhile capital flows have been gradually liberalized, allowing, on the inflow side,
foreign direct and portfolio investments, and tapping foreign capital markets by Indian
companies as well as considerably better remittance privileges for individuals; and on
the outflow side, international expansion of domestic companies. In 2000, 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.

The ultimate goal of capital account convertibility now seems to be within the
governments sights and efforts are on to chalk out the roadmap for the last leg, though
it is not expected to be accomplished before 2009. Expectedly, the wisdom of the move
has been hotly debated. 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. Convertibility
can spur domestic investment and growth because of easier and cheaper financing. It
can also contribute to greater efficiency in the banking and financial systems. On the

other hand, skeptics like Williamson (2006), for instance, 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, viz. fiscal discipline, with a public sector deficit of 7.6%
of the GDP and the ratio of public debt to GDP of over 83% in 2005-06. In any case, the
argument goes, 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. It is generally held that it was, in fact, the lack of convertibility that
protected India from contamination during the Asian contagion in 1997-98.




The theoretical as well as empirical relationship between the interest rate and exchange
rate has been a debatable issue among the economists. According to Mundell-Fleming
model, an increase in interest rate is necessary to stabilize the exchange rate
depreciation and to curb the inflationary pressure and thereby helps to avoid many
adverse economic consequences. The high interest rate policy is considered important
for several reasons. Firstly, it provides the information to the market about the
authorities resolve not to allow the sharp exchange rate movement that the market
expects given the state of the economy and thereby reduce the inflationary expectations
and prevent the vicious cycle of inflation and exchange rate depreciation. Secondly, it
raises the attractiveness of domestic financial assets as a result of which capital inflow
takes place and thereby limiting the exchange rate depreciation. Thirdly, it not only
reduces the level of domestic aggregate demand but also improves the balance of
payment position by reducing the level of imports. But the East Asian currency crisis
and the failure of high interest rates policy to stabilize the exchange rate at its desirable
level during 1997-1998 have challenged the credibility of raising interest rates to defend
the exchange rate. Critics argue that the high interest rates imperil the ability of the
domestic firms and banks to pay back the external debt and thereby reduce the
probability of repayment. As a result, high interest rates lead to capital outflows and
thereby depreciation of the currency.







The evolution of Indias foreign exchange market may be viewed in line with the shifts
in Indias exchange rate policies over the last few decades. With the breakdown of the
Bretton Woods System in 1971 and the floatation of major currencies, the conduct of
exchange rate policy posed a serious challenge to all central banks world-wide as
currency fluctuations opened up tremendous opportunities for market players to trade in
currencies in a borderless market. In order to overcome the weaknesses associated with
a single currency peg and to ensure stability of the exchange rate, the rupee, with effect
from September 1975, was pegged to a basket of currencies. The impetus to trading in
the foreign exchange market in India since 1978 when banks in India were allowed to
undertake intra-day trading in foreign exchange. The exchange rate of the rupee was
officially determined by the Reserve Bank in terms of a weighted basket of currencies of
Indias major trading partners and the exchange rate regime was characterized by daily
announcement by the Reserve Bank of its buying and selling rates to the Authorized
Dealers (ADs) for undertaking merchant transactions. The spread between the buying
and the selling rates was 0.5 percent and the market began to trade actively within this
range and the foreign exchange market in India till the early 1990s, remained highly
regulated with restrictions on external transactions, barriers to entry, low liquidity and
high transaction costs. The exchange rate during this period was managed mainly for
facilitating Indias imports and the strict control on foreign exchange transactions
through the Foreign Exchange Regulations Act (FERA) had resulted in one of the
largest and most efficient parallel markets for foreign exchange in the world, i.e., the
hawala (unofficial) market.


The Post-Reform Period (1992 onwards) phase was marked by wide ranging reform
measures aimed at widening and deepening the foreign exchange market and
liberalization of exchange control regimes. It was recognized that trade policies,
exchange rate policies and industrial policies should form part of an integrated policy
framework to improve the overall productivity, competitiveness and efficiency of the
economic system, in general, and the external sector, in particular. As a stabilization
measure, a two step downward exchange rate adjustment in July 1991 effectively
brought to close the regime of a pegged exchange rate.
Following the recommendations of Rangarajans High Level Committee on Balance of
Payments, to move towards the market-determined exchange rate, the Liberalized
Exchange Rate Management System (LERMS) was introduced in March 1992, was
essentially a transitional mechanism and a downward adjustment in the official
exchange rate and ultimate convergence of the dual rates was made effective and a
market-determined exchange rate regime was replaced by a unified exchange rate
system in March 1993, whereby all foreign exchange receipts could be converted at
market determined exchange rates. On unification of the exchange rates, the nominal
exchange rate of the rupee against both the US dollars also against a basket of
currencies got adjusted lower. Thus, the unification of the exchange rate of the Indian
rupee was an important step towards current account convertibility, which was finally
achieved in August 1994, when India accepted obligations under Article VIII of the
Articles of Agreement of the IMF.

With the rupee becoming fully convertible on all current account transaction, risk
bearing capacity of banks increased and foreign exchange trading volumes started
raising. This was supplemented by wide ranging reforms undertaken by the reserve bank
in conjunction with the government to remove market distortion and deepen the foreign
exchange market. Several initiatives aimed at dismantling control and providing an
enabling environment to all entities engaging in foreign exchange transaction have been
undertaken since the mid1990s. The focus has been on developing the institutional
framework and increasing the instruments for effective functioning, enhancing
transparency and liberalizing the conduct of foreign exchange business so as to move
away from micro management of foreign exchange transaction to macro management of

foreign exchange flows. Along with the specific measures aimed at developing the
foreign exchange market, Measures towards liberalization the capital account were also
implemented during the last decade. Thus the various measures since the early1990
have had a profound effect on the market structure, depth, liquidity and efficiency of the
Indian foreign exchange market.



Foreign Exchange Market in India works under the central government in India and
executes wide powers to control transactions in foreign exchange. The Foreign
Exchange Management Act, 1999 or FEMA regulates the whole foreign exchange
market in India. Before this act was introduced, the foreign exchange market in India
was regulated by the reserve bank of India through the Exchange Control Department,
by the FERA or Foreign Exchange Regulation Act, 1947. After independence, FERA
was introduced as a temporary measure to regulate the inflow of the foreign capital. But
with the economic and industrial development, the need for conservation of foreign
currency was urgently felt and on the recommendation of the Public Accounts
Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973
and gradually, this act became famous as FEMA.

Until 1992 all foreign investments in India and the repatriation of foreign capital
required previous approval of the government. The Foreign-Exchange Regulation Act
rarely allowed foreign majority holdings for foreign exchange in India. However, a new
foreign investment policy announced in July 1991, declared automatic approval for
foreign exchange in India for thirty-four industries. These industries were designated
with high priority, up to an equivalent limit of 51 percent. The foreign exchange market
in India is regulated by the reserve bank of India through the Exchange Control

Initially the government required that a company`s routine approval must rely on
identical exports and dividend repatriation, but in May 1992 this requirement of foreign
exchange in India was lifted, with an exception to low-priority sectors. In 1994 foreign

and nonresident Indian investors were permitted to repatriate not only their profits but
also their capital for foreign exchange in India. Indian exporters are enjoying the
freedom to use their export earnings as they find it suitable. However, transfer of capital
abroad by Indian nationals is only allowed in particular circumstances, such as
emigration. Foreign exchange in India is automatically made accessible for imports for
which import licenses are widely issued.

Indian authorities are able to manage the exchange rate easily, only because foreign
exchange transactions in India are so securely controlled. From 1975 to 1992 the rupee
was coupled to a trade-weighted basket of currencies. In February 1992, the Indian
government started to make the rupee convertible, and in March 1993 a single floating
exchange rate in the market of foreign exchange in India was implemented. In July
1995, Rs 31.81 was worth US$1, as compared to Rs 7.86 in 1980, Rs 12.37 in 1985, and
Rs17.50 in 1990.

Since the onset of liberalization, foreign exchange markets in India have witnessed
explosive growth in trading capacity. The importance of the exchange rate of foreign
exchange in India for the Indian economy has also been far greater than ever before.
While the Indian government has clearly adopted a flexible exchange rate regime, in
practice the rupee is one of most resourceful trackers of the US dollar.
Predictions of capital flow-driven currency crisis have held India back from capital
account convertibility, as stated by experts. The rupee`s deviations from Covered
Interest Parity as compared to the dollar) display relatively long-lived swings. An
inevitable side effect of the foreign exchange rate policy in India has been the
ballooning of foreign exchange reserves to over a hundred billion dollars. In an
unparalleled move, the government is considering to use part of these reserves to
sponsor infrastructure investments in the country.

The foreign exchange market India is growing very rapidly, since the annual turnover of
the market is more than $400 billion. This foreign exchange transaction in India does
not include the inter-bank transactions. According to the record of foreign exchange in
India, RBI released these transactions. The average monthly turnover in the merchant
segment was $40.5 billion in 2003-04 and the inter-bank transaction was $134.2 for the
same period. The average total monthly turnover in the sector of foreign exchange in

India was about $174.7 billion for the same period. The transactions are made on spot
and also on forward basis, which include currency swaps and interest rate swaps.
The Indian foreign exchange market is made up of the buyers, sellers, market mediators
and the monetary authority of India. The main center of foreign exchange in India is
Mumbai, the commercial capital of the country. There are several other centers for
foreign exchange transactions in India including the major cities of Kolkata, New Delhi,
Chennai, Bangalore, Pondicherry and Cochin. With the development of technologies, all
the foreign exchange markets of India work collectively and in much easier process.
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Foreign Exchange Dealers Association is a voluntary association that also provides
some help in regulating the market. The Authorized Dealers and the attributed brokers
are qualified to participate in the foreign Exchange markets of India. When the foreign
exchange trade is going on between Authorized Dealers and RBI or between the
Authorized Dealers and the overseas banks, the brokers usually do not have any role to
play. Besides the Authorized Dealers and brokers, there are some others who are
provided with the limited rights to accept the foreign currency or travelers` cheque, they
are the authorized moneychangers, travel agents, certain hotels and government shops.
The IDBI and Exim bank are also permitted at specific times to hold foreign currency.
The Foreign Exchange Market in India is a flourishing ground of profit and higher
initiatives are taken by the central government in order to strengthen the foundation.


When a business enterprise imports goods from other countries, exports its products to
them or makes investments abroad, it deals in foreign exchange. Foreign exchange
means 'foreign currency' and includes:- (i) deposits, credits and balances payable in any
foreign currency; (ii) drafts, travellers cheques, letters of credit or bills of exchange,
expressed or drawn in Indian currency but payable in any foreign currency; and (iii)
drafts, travellers cheques, letters of credit or bills of exchange drawn by banks,
institutions or persons outside India, but payable in Indian currency.
In India, all transactions that include foreign exchange were regulated by Foreign
Exchange Regulations Act (FERA),1973. The main objective of FERA was

conservation and proper utilization of the foreign exchange resources of the country. It
also sought to control certain aspects of the conduct of business outside the country by
Indian companies and in India by foreign companies. It was a criminal legislation which
meant that its violation would lead to imprisonment and payment of heavy fine. It had
many restrictive clauses which deterred foreign investments.
In the light of economic reforms and the liberalized scenario, FERA was replaced by a
new Act called the Foreign Exchange Management Act (FEMA), 1999.The Act
applies to all branches, offices and agencies outside India, owned or controlled by a
person resident in India. FEMA emerged as an investor friendly legislation which is
purely a civil legislation in the sense that its violation implies only payment of monetary
penalties and fines. However, under it, a person will be liable to civil imprisonment only
if he does not pay the prescribed fine within 90 days from the date of notice but that too
happens after formalities of show cause notice and personal hearing. FEMA also
provides for a two year sunset clause for offences committed under FERA which may
be taken as the transition period granted for moving from one 'harsh' law to the other
'industry friendly' legislation.


In November 1993 the Third Plenum of the Fourteenth CPC Central Committee
approved a comprehensive reform strategy in which foreign exchange management
reforms were highlighted as a key element for a market -oriented economy. A marketbased unified floating exchange regime and RMB convertibility were seen as the
ultimate goals of the exchange reform. A Foreign Exchange Surrender and Purchase
system (FESPS) was put in place. Firms were to surrender their foreign exchange
earnings from current account transactions and purchase foreign exchange from a
Foreign Exchange Designated Bank (FEDB) when a payment in foreign currency was
needed. The RMB thereby achieved so-called conditional convertibility under the
current account. In 1996 foreign-funded enterprises were included in the system and
China officially announced its acceptance of Article VIII of the IMF Articles of

In recent years, quotas for enterprises holding their foreign exchange earnings under the
current account have been raised several times; enterprises with authentic trade
activities have been allowed to purchase foreign exchange in advance to pay foreign
counterparties; enterprises' foreign exchange accounts under the current account have
been managed on a recording basis; and foreign exchange purchase and payment
procedures for trade in services have been simplified. Since 2007, annual foreign
exchange purchases and sales quotas for individuals have been set at US$ 50,000 to
meet their needs for holding and using foreign exchange.
In sequencing the liberalization of the capital account, China has followed an FDI first
policy. After 1994, significant progress was made in opening up to FDI. More regions
were opened to foreign investment, and ownership requirements for FDI in most
industries were relaxed. The authority to approve FDI projects was assigned to local
governments. From 1995, Foreign-Funded Enterprises (FFEs) could engage in StateOwned Enterprise (SOE) reform by purchasing equity or injecting capital.


Except for FDI, all capital account transactions were to be approved by the Peoples
Bank of China (PBC). The receipts from capital account transactions, including external
borrowing, IPO and bond issuance, had to be deposited in a specified account and used
for specified expenditures. Conversion of receipts into RMB was generally not allowed.

In December 2001 China joined the World Trade Organization (WTO). This event
marked a new era for Chinas external sector liberalization. In addition to tariff cuts,
China promised to eliminate over the next few years most restrictions on foreign entry
and ownership, as well as most forms of discrimination against foreign firms. A large
number of key services were to be opened up to foreign competition, including
important business services, courier services, wholesale trade, franchising, tourism
services, rail and road transport, and freight forwarding services. In many other services,
substantial foreign entry was to be allowed, including in telecommunications,
audiovisual services, construction, retail trade, insurance, banking, securities, and
maritime transport.
Since Chinas accession to the WTO, significant progress has been made. In the banking
sector, more cities have been opened to foreign banks to conduct business in RMB;
China has also made a breakthrough in capital market liberalization. Since 2001,
domestic investors, including individual residents, have been allowed to invest their
own foreign exchange in B-shares. Starting from 2002, Qualified Foreign Institutional
Investors (QFII) have been allowed to invest in the domestic capital market. Since 2004,
insurance companies have been allowed to use their own foreign exchange to invest in
the international capital market. In 2005, the first foreign company was listed on the
Shanghai Stock Exchange, and in the same year, domestic firms were allowed to set up
special purpose corporations abroad to facilitate overseas listing, mergers and

Since China joined the WTO, the country has experienced a sharp increase in both
current account surplus and capital inflows. By end-2007, the foreign exchange reserves
had increased to USD 1,528.2 billion. The rapid build -up of foreign exchange reserves
has complicated monetary policy and increased pressure for RMB appreciation.

In response to these developments, the authorities have taken measures to promote


balanced capital inflows and outflows. The measures include: (i) enhancing the
verification of export receipts to stop disguised capital inflows; (ii) expanding the right
of firms to hold foreign exchange earnings abroad or in bank accounts; the
qualifications for domestic firms retaining foreign exchange in a bank account were
lowered and the ceiling on the account was raised several times during the period; and
(iii) imposing limits on FFEs and foreign banks external borrowing, etc.

In 2003, the provisional regulation on external debt further limited capital inflows. The
long-term external debt quota was extended to foreign banks in China. In 2005, import
payments overdue six months or amounting to over USD 200,000 had to be registered
as external debt. Ceilings were imposed on the scale of the external debt of foreign
invested companies. Measures introduced to facilitate capital outflows included: (i) in
October 2002, a pilot programme was launched in six coastal provinces to allow
provincial authorities to approve firms purchase of foreign exchange for overseas
investment; this policy was eventually extended nationwide in 2005; (ii) the ceilings on
residents carrying of foreign exchange in cash across the border and on residents
purchase of foreign exchange for purposes of tourism and overseas study were raised
several times and, in 2004, the restriction on transferring assets overseas was further
relaxed; (iii) the ceiling on firms settlement account balance was abandoned; and (iv) in
2007, overseas financial investments were expanded by broadening the commercial
banks overseas investment instruments and including trust and investment companies
to develop Qualified Domestic Institutional Investors (QDII) businesses.
For a long time China has been implementing relatively strict foreign exchange
administration system due to shortage of foreign exchange resources, insufficiency of
macro control capability, imperfection of market system. Since China took on the
innovative opening-up policy in 1978, China forms a foreign exchange administration
profile--RMB (Chinese Yuan) is convertible for current account items, while partially
convertible for capital account step by step.


Chinas foreign exchange reform can be divided into three periods:

Exchange regime during the planned economy (1949-1978). A highly centered,

planning system was implemented in the planned economy environment. Bank of China
was the only specialized bank involving in foreign exchange business. All foreign
exchange receipts were obliged to surrender to the state, any purchase of foreign
exchange should be included in the state plan. The nation never incurred foreign
borrowings or allowed foreign direct investment.

Exchange regime during the transitional period (1979-1993). (1) The State
Administration of Foreign Exchange, which is authorized for charging foreign exchange
control matters under the leadership of the Peoples Bank of China, was established. (2)
The enterprises were permitted to retain a portion of their foreign exchange earnings. (3)
Foreign exchange swap center was set up and developed. (4) The RMB exchange rate
regime was reformed. (5) Various financial institutions were allowed to involve in
foreign exchange business. (6) Restrictions on domestic individuals foreign exchange
receipts were relaxed. (7) The foreign exchange certificate was introduced in order to
encourage foreign exchange inflows and sales for RMB from oversea Chinese residents.

Exchange regime after 1994. (1) In 1994, China realized RMB conditionally
convertible under current account transactions. (2) The dual exchange rate regime of the
RMB was unified into a single managed floating exchange rate on the basis of market
demand and supply. (3) A system of purchasing and surrendering foreign exchange
through designated foreign exchange banks was formed. (4) A nationwide, unified and
standard inter - bank foreign exchange market, i.e. China Foreign Exchange Trade
System (CFETS) was established. (5) Domestic enterprises that meeting some
conditions was allowed to open settlement foreign exchange account to keep export
receipts within the upper limit set by SAFE.

On December 1st, 1996, China officially accepted the obligations of Article VIII of the
IMF Articles of Agreement and made the RMB fully convertible for current account



When people talk about convertibility, they normally think that China is one of the few
countries still with strict capital control. But if we go into this issue in more detail, we
will find that at present Chinas capital account is partially convertible. Corresponding
to the 43 items of the seven categories under capital account transactions set up by the
IMF, some of the items have always be treated as fully or basically convertible ; some
of them are still strictly or totally prohibited. When evaluating the extension of Chinas
capital account opening-up, some international organizations, including the BIS,
conclude that the RMB has become convertible to a substantial extent for capital
account transactions. In conclusion, China is already on its way to capital account

First of all, FDI flows are encouraged. The only measure applied is authenticity test.
The priority area for FDI has enlarged from manufacturing sector to high technology
and infrastructures. At present, China fulfills its commitment to access to WTO, foreign
investments are also allowed in financial services, insurance, securities and other
specialist service areas. In the future, China support the foreign investors to take part in
the restructuring and reform of state-owned enterprises and commercial banks by way of
merger and acquisition.

Secondly, portfolio investment liberalization has been conducted in a cautious manner

in order to stay away from associated shocks. Foreign investors are allowed to invest in
B-shares and foreign currency-denominated bonds issued domestically and H-shares
and N-shares issued on overseas markets except for RMB-denominated equities and
bonds on the domestic markets. According to the WTO commitments, there is
possibility to set up Chinese and foreign joint venture securities companies. However,
their trading activities are limited to primary market underwriting and fiduciary trading
on the secondary market. In addition, priority trading is not allowed.

Thirdly, external debts are strictly controlled and China are working towards centralized
administration on foreign debts. Short-term foreign debts are monitored by their
outstanding amounts whereas medium and long-tem foreign debts are controlled by the

pre-determined quota. The borrowers are also subject to qualification examination. In

principal, international borrowings of domestic enterprises are subject to permission
from the administrative agencies and have to be carried out through qualified financial
institutions. The exceptions are that foreign-invested enterprises have the discretion to
borrow internationally to make up the difference between their registered capital and
paid-in capital. The international borrowings of foreign banks and short-term trade
finance within three months have been included in the foreign debt statistics.