Foreign exchange

Determinations Systems
If a Kashmiri shawlmaker sells his goods to a buyer in Kanyakumari, he will receive in terms
of Indian rupee. This suggests that the domestic trade is conducted in terms of domestic
currency.

Within the country, transactions are, then, simple and straight-forward. But if the Indian
shawlmaker decides to go abroad, he must exchange Indian rupee into Jap yen or dollar or
pound or euro. To facilitate this exchange form, banking institutions appear. Indian
shawlmaker will then go to a bank for foreign currencies.

The bank will then quote the day’s exchange rate—the rate at which Indian rupee will be
exchanged for foreign currencies. Thus, foreign currencies are needed for the conduct of
international trade. In a foreign exchange market comprising commercial banks, foreign
exchange brokers and authorised dealers and the monetary authority (i.e., the RBI), one
currency is converted into another currency.

A (foreign) exchange rate is the rate at which one currency is exchanged for another. Thus,
an exchange rate can be regarded as the price of one currency in terms of another. An
exchange rate is a ratio between two monies. If 5 UK pounds or 5 US dollars buy Indian
goods worth Rs. 400 and Rs. 250 then pound-rupee or dollar-rupee exchange rate becomes
Rs. 80 = £1 or Rs. 50 = $1, respectively. Exchange rate is usually quoted in terms of rupees
per unit of foreign currencies. Thus, an exchange rate indicates external purchasing power of
money.

A fall in the external purchasing power or external value of rupee (i.e., a fall in the exchange
rate, say for Rs. 80 = £1 to Rs. 90 = £1) amounts to depreciation of the Indian rupee.
Consequently, an appreciation of the Indian rupee occurs when there occurs an increase in
the exchange rate from the existing level to Rs. 78 = £1. In other words, the external value of
rupee rises. This indicates strengthening of the Indian rupee. Conversely, the weakening of
the Indian rupee occurs if external value of rupee in terms of pound falls.

Remember that each currency has a rate of exchange with every other currency. Not ail
exchange rates between about 150 currencies are quoted since no significant foreign
exchange market exists for all currencies. That is why exchange rate of these national
currencies are quoted usually in terms of the US dollars and euros.

Determination of Exchange Rate:

Now two pertinent questions that usually arise in the foreign exchange market are to be
answered now. First, how is the equilibrium exchange rate determined, and secondly, why
does exchange rate move up and down?

There are two methods of foreign exchange rate determination. One method falls under the
classical gold standard mechanism and another method falls under the classical paper
currency system. Today, gold standard mechanism does not operate since no standard
monetary unit is now exchanged for gold. All countries now have paper currencies not
convertible to gold.

Under inconvertible paper currency system, there are two methods of exchange rate
determination. The first is known as the purchasing power parity theory and the second is
known as the demand-supply theory or the balance of payments theory. Since today there is
no believer of purchasing power parity theory, we consider only demand-supply approach to
foreign exchange rate determination.

Demand-Supply Approach of Foreign Exchange:

Or, BOP Theory of Foreign Exchange Rate Determination:

Since the foreign exchange rate is a price, economists apply supply-demand conditions of
price theory in the foreign exchange market. A simple explanation is that the rate of foreign
exchange equals its supply. For simplicity, we assume that there are two countries: India and
the USA. Let the domestic currency be rupee.

The US dollar stands for foreign exchange and the value of rupee in terms of dollars (or
conversely, the value of dollars in terms of rupee) stands for foreign exchange rate. Now the
value of one currency in terms of another currency depends upon the demand for and the
supply of foreign exchange.

Demand for Foreign Exchange:

When Indian people and business firms want to make payments to the US nationals for using
US goods and services or to make gifts to the US citizens or to buy assets there, the demand
for foreign exchange (here dollar) is generated. In other words, Indians demand or buy
dollars by paying rupee in the foreign exchange market. A country releases its foreign
currency for buying imports. Thus what appears in the debit side of the BOP account are the
sources of demand for foreign exchange. Larger the volume of imports, greater is the demand
for foreign exchange.

The demand curve for foreign exchange is negative sloping. A fall in the price of foreign
exchange or a fall in the price of dollar in terms of rupee (i.e., dollar depreciates) means that
foreign goods are now more cheaper. Thus, an Indian could buy more American goods at a
low price. Consequently, imports from the USA would increase—resulting in an increase in
the demand for foreign exchange, i.e., dollar.

Conversely, if the price of foreign exchange or the price of dollar rises (i.e., dollar
appreciates) foreign goods will now be expensive leading to a fall in import demand and,
hence, fall in the demand for foreign exchange. Since price of foreign exchange and demand
for foreign exchange move in opposite directions, the importing country’s demand curve for
foreign exchange is downward sloping from left to right.

In Fig. 6.6, DD1 is the demand curve for foreign exchange. In this figure, we measure
exchange rate expressed in terms of domestic currency that costs 1 unit of foreign currency
(i.e., dollar per rupee) on the vertical axis. This makes the demand curve for foreign
exchange negative sloping. If the exchange rate is expressed in terms of foreign currency that
could be purchased with a 1 unit of domestic currency (i.e., dollar per rupee), the demand
curve would exhibit positive slope. Here we have chosen the former one.

Supply of Foreign Exchange:

In a similar fashion, we can determine the supply of foreign exchange. Supply of foreign
currency comes from receipts for its exports. If the foreign nationals and firms intend to
purchase Indian goods or buy Indian assets or give grants to the Government of India, the
supply of foreign exchange is generated. In other words, what the Indian exports (both goods
and invisibles) to the rest of the world is the source of foreign exchange. To be more specific,
all the transactions that appear on the credit side of the BOP account are the sources of
supply of foreign exchange.

A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to
foreigners in terms of dollars. This will induce India to export more. Foreigners will also find
that investment is now more profitable. Thus, a high price or exchange rate ensures larger
supply of foreign exchange. Conversely, a low exchange rate causes exchange rate to fall.
Thus, the supply curve of foreign exchange, SS1, is positive sloping.

Now we can bring both the demand and supply curves together to determine foreign
exchange rate. The equilibrium exchange rate is determined at that point where the demand
for foreign exchange equals the supply of foreign exchange. In Fig. 6.6, DD 1 and SS, curves
intersect at point E. The foreign exchange rate thus determined is OP.
At this rate, quantities of foreign exchange demanded (OM) equals quantity supplied (OM).
The market is cleared and there is no incentive on the part of the players to change the rate
determined. Note that at the rate OP, (say, Rs. 50 = $1) demand for foreign exchange is
matched by the supply of foreign exchange.

If the current exchange rate OP, (suppose, pc 55 = $ 1) exceeds the equilibrium rate of
exchange (OP), there occurs an excess supply of dollar by the amount ‘ab’. Now the bank
and other institutions dealing with foreign exchange, wishing to make money by exchanging
currency, would lower the exchange rate to reduce excess supply.

Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand for
foreign exchange by the amount ‘cd’ arises if the exchange rate falls below OP, i.e., OP.
Banks would then experience a shortage of dollars to meet the demand. The rate of foreign
exchange will rise till demand equals supply.

The exchange rate that we have determined is called a floating or ‘flexible exchange’ rate.
(Under this exchange rate system, the government does not intervene in the foreign exchange
market.) A floating exchange rate, by definition, results in an equilibrium rate of exchange
that will move up and down according to a change in demand and supply forces. The process
by which currencies float up and down following a change in demand or a change in supply
forces is thus illustrated in Fig. 6.7.
Let us assume that national income rises. This results in an increase in demand for imports of
goods and services and, hence, demand for dollar rises. This results in a shift in the demand
curve from DD1 to DD2. Consequently, exchange rate rises as determined by the intersection
of the new demand curve and supply curve. Note that dollar appreciates while rupee
depreciates.

Similarly, if the supply curve shifts from SS1 to SS2 as shown in Fig. 6.8, the new exchange
rate thus determined would be OP 2. If Indian goods are exported more following an increase
in national income of the USA, the supply curve would then shift rightward. Consequently,
dollar depreciates and rupee appreciates. New exchange rate is settled at that point where the
new supply curve SS2 intersects the demand curve at E2.
This is the balance of payments theory of exchange rate determination. Wherever govern-
ment does not intervene in the market, a floating or a flexible exchange rate prevails. Such a
system may not necessarily be ideal since frequent changes in demand and supply forces
cause frequent as well as violent changes in the exchange rate. Consequently, an air of
uncertainty in trade and business would prevail.

Such uncertainty may be damaging for the smooth flow of trade. To prevent this awkward
situation, government intervenes in the foreign exchange rate. It may keep the exchange rate
fixed. This exchange rate is called a ‘fixed exchange’ rate system where both the demand and
supply forces are manipulated or calibrated by the central bank in such a way that the
exchange rate is kept pegged at the old level.

Often ‘managed exchange rate’ is suggested. Under this system, exchange rate as usual is
determined by the demand for and the supply of foreign exchange. But the central bank
intervenes in the foreign exchange market when the situation demands to stabilise or
influence the rate of foreign exchange. If rupee depreciates in terms of dollar, the RBI would
then sell dollars and buy rupee in order to reduce the downward pressure in the exchange
rate.

Basic Concepts Relating to

Foreign exchange
AKTUTHEINTACTONE2 OCT 20191 COMMENT
Foreign exchange market is one of the important components of any economy today. It
involves currency exchange, remittances, import & export, investments etc. This article gives
an idea about what is foreign exchange & foreign exchange market. It also throws light on
basic terminology involved in foreign exchange transactions.

In this era of globalization and highly interconnected economies, foreign exchange market
has become very prominent. In fact, it has a huge role to play in a developing economy like
India. Financial institutions like banks are constantly looking for professionals well-versed in
foreign exchange market as the volume of transactions & the participation is increasing at a
rapid rate. In this article we will try to get the basics of foreign exchange.

Meaning of foreign exchange

In simple terms, foreign exchange means exchange of currency of one nation into that of
another nation. You can relate it directly with the export & import of the commodities
between two nations. So an import-export relationship between two people in USA and India
would involve exchange of Dollar & Rupee. In broader terms, however, the definition of
foreign exchange encompasses a lot of other things. The Foreign Exchange Management Act
(FEMA), 1999, has given a broad definition of foreign exchange. To keep the things simple
for the beginners, foreign exchange in this article refers to foreign currency & exchange of
one currency into another. Foreign exchange is also called Forex.

Foreign exchange market

So what is a foreign exchange market? Is it a market based out of some place? No, we can’t
define the foreign exchange market in the same way as we define a normal market, say a
commodity market. This is because forex market is not bounded by any boundary. It is not
confined to 4 walls in a particular place. Moreover, it is a 24*7 market and works round the
clock.

A forex market refers to a market where different participants can buy, sell and exchange
currencies. It’s a decentralized market i.e. the foreign exchange activities take place across
the globe in different time zones. So, even when the Indian market is calling it a day, the US
market is initiating its daily operations. In this way it keeps on going across the world. As the
world economies are highly interconnected today, forex market is always open at some
place.

Forex participants

We mentioned the word participants in the definition of forex market. Who are the
participants actually? The participants are the entities who seek foreign exchange for their
needs. They can be banks, investors, or any individual etc. Let’s go through the different
types of participants in the forex market.
Central & commercial banks: A central Bank, like RBI, make use of forex market to
manage their reserves and take corrective steps whenever home currency (say Rupee) faces
abrupt devaluation. Commercial banks, on the other hand, need forex market for the
exchange of currencies for their clients. They also use it for the purpose of investments.

Investment Banks: As their name implies, investment banks primarily use forex market for
the purpose of investment.

Broker: A broker, like the one in the stock market, works as a middleman between two
participants of forex market.

Individuals: Normal people who seek forex market for different purposes like investment,
business, travel etc.
Basic terminology related to foreign exchange

Exchange Rate

An exchange rate refers to the rate at which one currency can be exchanged with another. So
if someone says that exchange rate between USD and Rupee is 64 that means one USD can
be exchanged for INR 64. We understand the exchange rate by looking at the quotes.

Direct & Indirect Quotes

A quote is a way of expressing one currency in certain units of the other currency. So 1 USD
= Rs. 64 would mean 1 unit of USD is equivalent to 64 units of Indian Rupee. The quotes
can be given in two ways – direct and indirect. Under direct method, local currency or the
home currency is variable. For instance, the quote we mentioned above is a direct quote as
we can get the value of home currency against USD directly. Direct quote is also known as
Home currency.

In indirect quote, the foreign currency is variable while home currency is fixed. For instance,
Rs. 128 = 2 USD is an indirect quote. Generally direct quotes are used across the globe with
few notable exceptions

Cross Rate Mechanism

Sometimes, in a particular market, we might not get a quote between two currencies and we
need to exchange them. In such a case we make use of cross rate mechanism. Under this, we
make use of a currency having quotes with both of the above currencies. The most common
example is that of USD. So we will obtain direct quotes involving USD for both the
currencies and by simply crossing them out using plain mathematics, we can get the desired
quote.

Spot Rate

Most of the forex transactions are not necessarily settled on the same day. They may be
settled in future also. So, depending on the settlement time, the exchange also varies.
Generally, the settlement of forex transactions takes place on the second working day. The
rate then applied is called Spot rate. Even though the word ‘spot’ indicates a quick
settlement, the actual transaction is completed only on the second working day.

Forward Rate
If settlement of funds takes place after second working day i.e. spot date, then the rate
applied is called forward rate. This rate is derived from the spot rate.

Ready/Cash

When the settlement takes place on the same day of the deal, it is called Ready or Cash.

Tom

If settlement takes place on next working day of the deal, it is referred to as Tom.

Premium & Discount

If the forward rate is more than spot rate of a currency, then that currency is said to be at
premium. On the other hand, if the forward rate is less than spot rate, the currency is said to
be at discount. This relationship can be expressed as
Forward Rate = Spot rate +Premium ( or – discount)

Bid & Offered rate

They are nothing but buying & selling rates of currencies. So a bid rate refers to the rate at
which a financial institution is ready to buy currency while offer rate is the rate at which it is
ready to sell currency.

Authorized Dealers

The authorized dealers are the entities who are authorized to deal in foreign exchange. They
are basically financial institutions who have been allowed to undertake transactions
pertaining to forex by RBI. There was a change in the definition of the authorized dealers in
the year 2005. As per new definition, these entities are called Authorized Persons. Moreover,
they have been divided into three different categories.

Authorised Person: Category I refer to financial institutions that are authorized to handle
all types of forex transactions.

Authorised Person: Category II refers to entities who can deal with buying/selling of
foreign currency, remittances, travelers cheques etc.

Authorised Person: Category III refers to entities who are authorized for purchasing of
foreign currency and traveler’s cheques only.
 Various types of Exchange
Rate Regimes
AKTUTHEINTACTONE2 OCT 20191 COMMENT
There are three broad exchange rate systems—currency board, fixed exchange rate and
floating rate exchange rate. A fourth can be added when a country does not have its own
currency and merely adopts another country’s currency. The fixed exchange rate has three
variants and the floating exchange rate has two variants.

1. Fixed (or Pegged) Exchange Rate:

This consists of – (i) rigid peg with a horizontal band, (ii) crawling peg and (iii) crawling
band.

Variants of a Fixed Exchange Rate System:

1. Rigid Peg with a Horizontal Band:

It is an exchange rate system under which the exchange rate fluctuation is maintained by the
central bank within a range that may be specified (Iceland) or not specified (Croatia). The
specified band may be one-sided (+7% in Vietnam), a narrow range (+ 2.25% in Denmark)
or a broad range (+ 77.5% in Libya).

2. Crawling Peg:

The par value of the domestic currency is set with reference to a selected foreign currency (or
precious metal or currency basket) and is reset at intervals, according to pre-set criteria such
as change in inflation rate. The central bank decides the new par value based on the average
exchange rate over the previous few weeks or months in the foreign exchange market. The
biggest advantage of the crawling peg is its responsiveness to the market value of the
domestic currency.

3. Crawling Band:

The domestic currency is on a crawling peg which is maintained within a range (band).

2. Floating Exchange Rate:

 This consists of – (i) managed float and (ii) free float.

When a country has its own currency as legal tender, it can choose between the three broad
types of exchange rate systems. Within the fixed exchange rate, a country can choose a rigid
peg or a crawling peg. Again within each peg, it can choose to have a horizontal band within
which its exchange rate would be permitted to fluctuate. Within the floating exchange rate
system, a country can choose a free float or a managed float. The main source of the
exchange rate system followed by any country is the IMF’s Annual Report on exchange rate
arrangements.

Many countries declare that they follow a particular exchange rate system, but may
follow another system in practice:

1. Exchange Arrangements with No Separate Legal Tender:

A few countries (such as Micronesia and San Marino) select another country’s currency as
legal tender. This is called Dollarization, since the selected foreign currency is usually the
US dollar.

1. Currency Board:

The central bank of the country promises to convert domestic currency (on demand and at
any point in time) for a predetermined number of units of a specific foreign currency. In
order to fulfill this promise, the central bank has to hold foreign exchange reserves in the
selected foreign currency. Usually a government decides to adopt a currency board when the
holders of domestic currency lose confidence in it is as a medium of exchange, triggered by
rampant inflation, unbridled government debt (resulting in fiscal deficits) and recession. A
currency board is expected to restore faith in the domestic currency.

The first currency board was set up in Mauritius in 1849. Hong Kong has had a currency
board since 1983 when its currency was linked to the US dollar. Argentina chose the
currency board in 1991 and Bosnia in 1997. Argentina’s currency board promised to convert
each peso into one US dollar. The Central Bank held only 66% of the peso as dollar reserves,
when it should have held 100% (given the 1:1 peso/dollar currency board arrangement). In
2001, Argentina defaulted in repayment of its external debt and confidence in the Argentine
peso plunged. There was a run on the banking system, and the government abandoned the
currency board.

iii. Fixed Exchange Rate:

It is also called the pegged exchange rate. The par value of the domestic currency is set with
reference to a selected foreign currency (or precious metal or currency basket). The exchange
rate fluctuates with a range (usually +1% of the par value).
 The domestic currency’s par value is fixed by the monetary authorities against any of
the following:

1. A precious metal (gold in the gold standard)

2. A single currency, which can be an artificial currency (such as the SDR), or an existing
currency (such as the US dollar or the pound sterling). When a single currency is chosen, in
some cases colonial legacy determines the choice—most former French colonies chose the
French franc, while former British colonies tended to choose the pound sterling. Sometimes, a
fixed exchange rate is adapted to arrest the steep fall in value of the domestic currency. In
September 1998, the Malaysian monetary authorities announced a rigid peg of 3.8 ringgit/USD
after the Ringgit plunged by 60% against the US dollar.
3. A currency basket as in the case of the Indian rupee in 1975; the Indian rupee was de-
linked from the pound and linked to a basket of currencies. The central bank may keep the
currencies in the basket a secret, or make the currency In 2005, China pegged its yuan to a
currency basket whose composition and weights are undisclosed.

Variants of a Floating Exchange Rate System:

1. Managed Float:

A floating exchange rate (or flexible exchange rate) is the opposite of the fixed exchange
rate. Market forces determine the value of the domestic currency against a selected foreign
currency. A managed float (or dirty float) is a floating exchange rate in which the monetary
authorities influence the exchange rate (through direct or indirect intervention without
specifying the target exchange rate. India is on a managed float.

2. Free Float or Clean Float:

Here, the exchange rate is purely determined by market forces (demand and supply of the
currency).

De Facto and De Jure Exchange Rate Systems:

A de facto exchange rate is the one that a country actually follows. A de jure exchange rate
system is the one that the country claims to follow. Both systems need not always be the
same. China’s de facto system was the fixed rate but it insisted that its de jure system was a
managed float. The IMF conducts surveys of exchange rate systems around the world. The
surveys take into account both the de facto and de jure systems for each country.

Fixed versus Floating Exchange Rate:

Which exchange rate system is the best? The answer depends upon the objectives of the
monetary authorities in a country.
 There are three possible objectives:

1. Maintain stable exchange rates

2. Allow mobility of capital

iii. Have control over monetary policy.

With a floating exchange rate, the last two objectives can be attained but there will be
exchange rate volatility. With a fixed exchange rate, the first two objectives can be attained
but there will be no control over the monetary policy. In other words, irrespective of whether
the fixed rate or the floating exchange rate is selected, only two of the three objectives can be
attained. Thus, the three objectives are called the impossible trinity. In practice, countries can
and do fine-tune their exchange rate systems, and need not choose either extreme.

Some countries (Canada, USA) consistently follow a particular exchange rate while others
(Argentina, Russia) shift from one exchange rate to another. Canada has followed a flexible
exchange rate since 1971, Hong Kong has had a currency board since 1983 and Argentina
moved from a flexible exchange rate to a currency board in 1991. India moved from a fixed
exchange rate to a partially floating rate in 1993 and a full float in 1994.

There has been a gradual shift from fixed exchange rate (and its variants) to flexible
exchange rate. While a majority of developing countries had a fixed exchange rate in 1975,
less than half had a fixed exchange rate 20 years later. Economists advocate a fixed exchange
rate when an economy is affected by shifts in the demand for money that can affect price
levels.

They advocate a flexible exchange rate when an economy is affected by changes in demand
for products. A country that makes a successful transition from a fixed to a floating rate has a
deep foreign exchange market, a well thought out policy of intervention by the central bank,
and effective mechanisms to manage exchange rate risks.

The pegged exchange rate was popular in the early 1990s among countries that were making
the transition to becoming market economies. Countries moved away from the hard peg
towards the crawling peg. The efficacy of a particular exchange rate system is a function of
each country’s unique economic circumstances, stage of development, strength of the
financial system, and the degree of autonomy enjoyed by its monetary authority. No single
exchange rate system has been an unqualified success across countries in terms of
improvement in growth rates or financial stability.

The fixed exchange rate did not accelerate growth rates in countries that adopted it, nor did it
protect them from currency crises. The same is true of the floating exchange rate. On the
other hand, the central banks of many developing countries fear the impact a floating
 exchange rate would have through a sharp appreciation or depreciation of their currency on
their exports and imports, as well as their capacity to repay overseas debt.

Exchange Rate Systems in Selected Emerging Markets (1980-2010):

The Brazilian real – The crawling peg was replaced by a floating exchange rate in 1990. 

The Hong Kong dollar – It is on a currency board.

The Indonesian rupiah – The managed float was replaced by a floating exchange rate in
1997.

The Malaysian ringitt – The currency peg to a currency basket was replaced by a fixed
exchange rate in 1998.

The Phillipine peso – It is on a floating exchange rate.

The Singapore dollar – The currency peg to a currency basket was replaced by a fixed
exchange rate in 1985.

The South Korean won – The currency peg to the US dollar was replaced by a managed float
in 1980.

The Thai baht – It is on a managed float.

Differences between Flexible and Fixed Exchange Rate System:

Flexible Exchange Rate System:

Advantages:

1. It permits quicker adjustments in the exchange rate to changes in macro-economic factors

such as changes in inflation rate, growth rate, and interest rates.
2. There is less likelihood of currency overvaluation. So the country’s growth prospects are
brighter.

Disadvantages:

1. Exchange rate risk is high due to greater volatility in the short- and long-term. This
makes exchange rate forecasting extremely important as well as extremely difficult.
2. There is a tendency for capital inflows through foreign portfolio investment, or ‘hot
money’.
3. Imports and overseas debt repayment are adversely affected by depreciation of domestic
currency.

Fixed Exchange Rate System:

Advantages:

1. There is stability in exchange rate and exchange rate risk is nil.

2. Capital inflows through foreign direct investment are higher because there is no exchange
rate volatility. FDI is a ‘desirable’ capital inflow due to its stable and long- term nature.
3. Inflation rates tend to be lower and therefore real interest rates (nominal interest rates
adjusted for inflation) are higher.

Disadvantages:

1. The exchange rate does not reflect macro-economic changes. The entire foreign exchange
entering and leaving the country has to be converted at the fixed exchange rate.
2. Punitive action for contravening rules.

In a fixed exchange rate regime, the entire institutional infrastructure is geared towards
identifying evasion of foreign exchange controls and imposing penal punishments. A fixed
exchange rate creates a flourishing parallel market for foreign exchange in which the ‘true’
value of the domestic currency is determined by market forces. This is because the par value
of the domestic currency is very often at variance with what the exchange rate would be if
left to the vagaries of supply and demand.

Very often countries fix a separate par value for exports and a separate one for imports. This
is done to boost its exports and deter imports. This merely increase the draconian system
needed to monitor foreign currency inflows and outflows.

The problems with a fixed exchange rate are described below:

1. The possibility of overvaluation of the domestic currency is quite high. Suppose the rupee
is on a fixed exchange rate of Rs. 40/$ instead of Rs. 43/$ when left to market forces. So, instead
of 1$ being able to buy Rs. 43 worth of goods, it can buy only Rs. 40 worth of goods). This
would hurt the competitiveness of India’s exports and therefore hamper its growth prospects.
2. When the country on a fixed exchange rate is seen consistently to have trade surpluses, it
generates a lot of ill will, and a perception that the trade surpluses are the result of currency
manipulation of keeping the exchange rate artificially high (or low as the case may be). Consider
the hypothetical example below. If the Chinese yuan should have an exchange rate of yuan
5.60/$ but is instead kept at yuan 7.00/$, Chinese exports have extremely competitive prices in
world markets, and China has a trade surplus.
 Sustained trade surpluses should make the yuan appreciate, and this should be reflected by
moving the fixed exchange rate to yuan 5.60/$. The trade surpluses would decrease, and
perhaps result in a trade deficit. This was USA’s argument for several years preceding the
2010 G20 Summit in Seoul. In Table 11.5, you can see the change in balance of trade (BOT)
when the yuan-dollar exchange rate moves from fixed to flexible rate mechanism.

3. There is a loss of control over monetary policy. When a country is on a fixed exchange
rate, inflows of capital lead to an increase in money supply and lending by domestic banks,
whereas outflows of capital lead to contraction of commercial bank credit and money supply.
When there are huge inflows, money supply in the country increases, and inflation rises. The
central bank cannot contract money supply and rein in inflation because the country’s money
supply is dependent on inflows and outflows unless the central bank undertakes sterilization of
foreign exchange.
4. Regular intervention by the central bank in the foreign exchange markets to maintain the
rigid peg could either lead to accumulation of enormous foreign exchange reserve by the central
bank (as in China between 2001 and 2010) or a drain of the country’s foreign exchange reserves.
When there are sustained foreign exchange inflows, sterilization causes the central bank to
accumulate foreign exchange reserves. 

China pegged its currency at 8.28 yuan/USD in 1998. Due to inflows of capital and a balance
of trade surplus with the United States, the Chinese central bank (People’s Bank of China or
PBOC) used government bonds and central bank bills to conduct sterilization, and had to
purchase billions of US dollars to maintain the yuan/dollar peg. Sustained intervention can
cause a depletion of foreign exchange reserves. The Thai baht was pegged to the US dollar.
In 1997, speculative attacks on the baht forced the Bank of Thailand to sell $40 billion until
all its reserves were depleted, and it was forced to abandon the peg.

5. Any instability in the anchor currency is immediately transmitted to the domestic

currency. If a country’s currency is pegged to the US dollar, then all the ups and downs of the
dollar become the ups and downs of the country’s currency. If the anchor currency’s value drops,
so does the value of the country’s currency.
6. Market participants are unable to anticipate and manage exchange rate risk.
7. It is difficult for the country to make changes in fiscal policy and still retain overseas
investor confidence in the economy. To make the country recover from recession, the standard
fiscal response is to increase government spending. This is what USA did in the aftermath of the
subprime crisis of 2007. But the US was on a floating exchange rate.

However, when a country on a fixed exchange rate increases government spending, overseas
investors may view it as a signal that the country may not recover from the recession. It
prompts capital to flow out of the country. So the fiscal policy response has an unintended
consequence of increasing capital outflows.

8. The official exchange rate does not adjust quick enough to reflect the new purchasing
power of the country’s currency.
9. A huge country on a fixed exchange rate, with massive surpluses, can destabilize the
entire global financial system. China is a case in point—it faces a problem of plenty— its rising
forex reserves have to be continuously invested. It chose to buy US Treasury Bills, and is now
one of the largest overseas holders of US government bonds.

When US bond prices fell in 2009, China issued a veiled warning to the US asking it to
ensure that its portfolio of US bonds does not lose more of its value. When China chooses to
sell its US bond portfolio, it will result in a steep fall in US bond market prices quickly
transmitting to stock markets in the US and around the world due to integration of financial
markets, thus causing a meltdown in global stock markets, and severely destabilizing the
financial markets.

Determination of Floating Exchange Rates:

There are four theories that explain how floating exchange rates are set. The first theory (the
demand and supply theory) is called a flow theory because it studies how the demand for and
supply of a domestic currency over a period of time results in a particular level for the
exchange rate. The other three theories (the monetary theory, the asset price theory, and the
portfolio balance theory) are called stock theories, since they study the amount of currency
available at a certain time—the stock of currency—and peoples’ willingness to hold the
currency. They are also called modern theories of exchange rate determination.

Supply and Demand Theory:

This theory states that the exchange rate is the intersection of the supply of domestic
currency (shown as the supply curve) and its demand (shown as the demand curve). The
supply of domestic currency is determined by imports and the demand is determined by
exports.

Monetary Theory:

This theory links money supply and prices to the exchange rate. An increase in money
supply leads to an increase in prices (inflation). According to the monetary theory, the
exchange rate is the ratio of prices in two countries, so an increase in price causes the
exchange rate to be reset. Consider two countries A and B. When the money supply in each
country rises, the prices in each country rise. If the growth of money supply in A is greater
than the growth of money supply in B, then A experiences a higher inflation rate than B.

According to the Purchasing Power Parity theory, the exchange rate is nothing but the ratio
of prices between two countries. Since A has had a relatively greater rise in prices, A’s
currency depreciates, will fall, and a new exchange rate will get established.
 The monetary theory states that there is a direct connection between relative changes in
money supply in two countries and the exchange rate between both countries, provided there
are no transportation costs in moving goods between both countries.

Asset Price Theory:

The theory states that currency is an asset just as real estate or securities or gold. The desire
to hold a particular type of asset is driven by the perception of the asset’s future value. If the
value is likely to rise, people will want to buy the asset now and sell it at a higher price so as
to make a profit. Conversely, if they think the asset’s value will drop, all those holding the
asset now will start selling the asset fearing a greater decline in price in the near future.
Therefore, the asset’s current attractiveness is a function of what the market believes its
value is going to be in future. In other words, future expectations decide current buy/sell
decisions.

This is true even for currency. If the market believes that the domestic currency is going to
rise in value, everyone will start buying it. If the current exchange rate is Rs. 43/$, and the
expectation is that the rupee will appreciate over the next six months. Participants will start
purchasing the rupee and this will drive up demand. Because demand rises, the rupee will
appreciate against the dollar, and the exchange rate will settle at Rs. 42/$.

If on the other hand, the market expects the rupee to depreciate, there will be selling pressure
and the rupee will depreciate, probably settling at Rs. 44/$. At any point in time, the current
exchange rate contains market expectations of the future value of the domestic currency.

Portfolio Balance Theory:

The portfolio balance theory connects money supply, supply and demand for domestic
securities, demand for foreign securities, and the exchange rate.

Its assumptions are:

1. Investors can hold only two types of assets—currency and bonds (domestic bonds issued
in domestic currency and foreign bonds issued in foreign currency).
2. Investors in two countries have identical asset preferences.
3. When the wealth of investors in either country increases, they would prefer to hold more
of the asset that they already hold in excess.
 Factors affecting
Exchange Rates
AKTUTHEINTACTONE2 OCT 20191 COMMENT
1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a
lower inflation rate than another’s will see an appreciation in the value of its currency. The
prices of goods and services increase at a slower rate where the inflation is low. A country
with a consistently lower inflation rate exhibits a rising currency value while a country with
higher inflation typically sees depreciation in its currency and is usually accompanied by
higher interest rates. 

2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest
rates, and inflation are all correlated. Increases in interest rates cause a country’s currency to
appreciate because higher interest rates provide higher rates to lenders, thereby attracting
more foreign capital, which causes a rise in exchange rates

3. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of
its domestic currency.

4. Government Debt
Government debt is public debt or national debt owned by the central government. A country
with government debt is less likely to acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market if the market predicts government debt
within a certain country. As a result, a decrease in the value of its exchange rate will follow.

5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export
prices to import prices. A country’s terms of trade improves if its exports prices rise at a
greater rate than its imports prices. This results in higher revenue, which causes a higher
 demand for the country’s currency and an increase in its currency’s value. This results in an
appreciation of exchange rate.

6. Political Stability & Performance

A country’s political state and economic performance can affect its currency strength. A
country with less risk for political turmoil is more attractive to foreign investors, as a result,
drawing investment away from other countries with more political and economic stability.
Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic
currency. A country with sound financial and trade policy does not give any room for
uncertainty in value of its currency. But, a country prone to political confusions may see a
depreciation in exchange rates.

7. Recession

When a country experiences a recession, its interest rates are likely to fall, decreasing its
chances to acquire foreign capital. As a result, its currency weakens in comparison to that of
other countries, therefore lowering the exchange rate.

8. Speculation

If a country’s currency value is expected to rise, investors will demand more of that currency
in order to make a profit in the near future. As a result, the value of the currency will rise due
to the increase in demand. With this increase in currency value comes a rise in the exchange
rate as well.

Brief History of Indian Rupee

Year What Happened

1540- Sher Shah Suri issued a Silver coin which was in use during the Mughal period,
45 Maratha era and British India.
1770- The earliest paper rupees were issued by Bank of Hindostan (1770– 1832),
1832 General Bank of Bengal and Bihar (1773–75), and Bengal Bank (1784–91).

1 Apr
Reserve Bank of India is set up.
1935

Jan
Reserve Bank issues first note of Rs 5
1938

Feb-
Jun RBI issues Rs 10, Rs 100, Rs 1,000 and Rs 10,000 notes.
1938

Aug Rs 1 note reintroduced. Rs 1 was first introduced on 30 Nov 1917, followed by Rs

1940 2 and 8 annas, and was discontinued on 1 Jan 1926.

Mar
Rs 2 note introduced
1943

RBI issues first post-Independence coins in 1 pice, 1.2, one and two annas, 1.4, 1.2
1950
and Rs 1 denominations.

Hindi language features prominently on the new notes, and plural of rupaya was
1953
decided to be rupiye

1954 High denomination notes of Rs 1,000, Rs 5,000, and Rs 10,000 reintroduced.

1957 Rupee is decimalised and divided into 100 naye paise.

1957- Aluminium coins of denomination of one, two-, three-, five- and ten-paise are
67 introduced.

1967 Note sizes reduce due to the lean period of the early Sixties.

New notes issued with symbols of science & tech (Aryabhatta on Rs 2 note),
1980 progress (oil rig on Rs 1 and farm mechanisation on Rs 5) and Indian art forms on
Rs 20 and Rs 10 notes (Konark wheel, peacock).

Oct
Rs 500 note introduced due to the growing economy and fall in purchasing power
1987

1988 Stainless steel coins of 10, 25 and 50 paise introduced.

1992 Rs 1 and Rs 5 coins in stainless steel introduced

The Mahatma Gandhi series of notes issued, starting with Rs 10 and Rs 500
notes. This series has replaced all notes of the Lion capital series. A changed
1996
watermark, windowed security thread, latent image and intaglio features for the
visually handicapped were the new features.

2005-8 New 50 paise, Rs 1, Rs 2 and Rs 5 stainless steel coins introduced.

2009 The printing of Rs 5 notes (which had stopped earlier) resumed.

July
New symbol ‘₹’ is officially adopted
2010

2011 25 paise coin and all paise coins below it demonetised. New series of 50 paise
 coins and Rs 1, Rs 2, Rs 5 and Rs 10 notes with the new rupee symbol introduced.

New ‘₹’ sign is incorporated in notes of the Mahatma Gandhi series in

2012
denominations of Rs 10, Rs 20, Rs 50, Rs 100, Rs 500 and Rs 1,000

Nov Rs 500 and Rs 1,000 notes discontinued and new Rs 500 and Rs 2,000 notes
2016 introduced.

History of Indian Rupee—Demonetisation

Demonetisation is when currency notes and coins are withdrawn. The reasons given in the
past were to curb and control black money or to introduce new notes.

Time
What Happened
Period.

12 Aug Rs 500, Rs 1,000 and Rs 10,000 notes were demonetised to control black
1946 money.

1954 High denomination notes of Rs 1,000, Rs 5,000, and Rs 10,000 reintroduced.

16 Jan Denominations higher than Rs 100 demonetised again to control the menace of
1978 black money.

1987 & While Rs 500 note was issued in 1987, the Rs 1,000 note was reintroduced in
2000 the year 2000

1995 Rs 1 and Rs 2 notes were removed from circulation.

2011 25 paise and all paise coins below this denomination were withdrawn.
 Nov 2016 Rs 500 and 1000 notes were withdrawn.

History of Indian Rupee—Pre-independence (British Era)

Following were the note series that British introduced in India:

1: The pre-independence British series

British Parliament introduces the Paper Currency Act of 1861. This gives the British
government the monopoly to issue notes in India.

2: Victoria portrait series

This series comprised the first British India notes—Rs 10, Rs 20, Rs 50, Rs 100, Rs 1,000.
These were uniface, with two language panels. These notes were printed on a hand-mould
paper.

3: Underprint series

The Victoria Portrait series was withdrawn In 1867, the British Government withdrew
Victoria Portrait series. The main reason for the change was to prevent forgeries. You were
able to encash these notes legally in the Currency Circle in which they were issued. But in
1903-11, Rs 5, Rs 10, Rs 50 and Rs 100 were made available for all.

4: Small denomination notes

The reason to start paper currency of small denominations was due to the World War I. On
30 November 1917, British introduce Rs 1.

5: King’s portrait series

This series carried the portrait of George V and started in May 1923 with Rs 10 note. Other
notes included Rs 5, Rs 10, Rs 50, Rs 100, Rs 500, Rs 1000, and Rs 10,000. This continued
till 1935 when the Reserve Bank of India was set up.