Exchange Rate Management in India

Foreign exchange market is the market in which foreign currencies are bought and sold. Being a member of IMF, India followed the par value system of pegged exchange rate system. But when the Breton Woods system collapsed in 1971, the rupee was pegged to pound sterling for four years after which it was initially linked to the basket of 14 currencies but later reduced to 5 currencies of India’s major trading partners. Currently India has adopted the managed exchange rate system.

Exchange rate is simply value of a currency in terms of another currency. The buyers and sellers of foreign currency includes the, brokers, students,, commercial banks, central banks, individual firms, foreign exchange brokers etc. The system of exchange rate works through the facility provided by the key players of the markets. The major functions of the foreign exchange include:

I. Transferring currency from one market to other where it is needed in the transactions.

II. Providing short-term credit to the importers, and thereby facilitating the smooth flow of goods and services between the countries.

III. Stabilizing the foreign exchange rate through spot and forward market.

Historical Background

Since Independence, the exchange rate system in India has transited from a fixed exchange rate regime where the Indian rupee was pegged to the pound sterling on account of historic links with Britain to a basket-peg during the 1970s and 1980s and eventually to the present form of market-determined exchange rate regime since March 1993. The evolution of exchange management is discussed below:

Par Value System (1947-1971): After gaining Independence, India followed the par value system of the IMF whereby the rupee's external par value was fixed at 4.15 grains of fine gold.

Pegged Regime (1971-1992): India pegged its currency to the US dollar (from August 1971 to December 1991) and to the pound sterling (from December 1971 to September 1975).

The Period Since 1991: A two-step downward adjustment of 18-19 per cent in the exchange rate of the Indian rupee was made on July 1 and 3, 1991.

Liberalised Exchange Rate Management System: The Finance Minister announced the liberalised exchange rate management system (LERMS) in the Budget for 1992- 93. This system introduced partial convertibility of rupee. Under this system, a dual exchange rate was fixed under which 40 per cent of foreign exchange earnings were to be surrendered at the official exchange rate while the remaining 60 per cent were to be converted at a market-determined rate.

Kinds of foreign Exchange Market in India:

A. Spot market: It refers to a market in which the sale and purchase of foreign currency are settled within two days of the deal. The spot sale and purchase of foreign exchange make the spot market. The rate at which the foreign currency is bought and sold is called spot exchange rate. For all practical purposes, spot rate is treated as the current exchange rate.

B. Forward Market: It refers to that market, which deals in the sale and purchase of foreign currency at some future date at a presettled exchange rate. When buyers and sellers enter an agreement to buy and sell a foreign currency after 90 days of the deal, it is called forward transaction. The exchange rate settled between buyer and seller for forward sale and purchase of currency is called forward exchange rate.

Types of exchange rate management

A. Fixed Exchange Rate

B. Flexible Exchange Rate

A. The Fixed Exchange Rate

When the exchange rate between the domestic and foreign currencies is fixed by the monetary authority of a country and is not allowed to fluctuate beyond a limit, it is called fixed exchange rate. Under the IMF system, the monetary authority of a member nation fixes the official value of its currency in terms of a reserve currency (usually the US dollar) or a basket of 'key currencies.' The exchange rate so determined is known as currency's par value. It is also called 'pegged' exchange rate. However, flexibility is allowed within the upper and lower limits prescribed by the IMF, usually 1% up and down, under the normal conditions.

The basic purpose of adopting fixed exchange rate system is to ensure stability in foreign trade and capital movements. Under fixed exchange rate system, the government assumes the responsibility of ensuring stability of exchange rate. To this end, the government undertakes to buy and sell the foreign currency-buy when it becomes weaker and sell when it gets stronger. Private sale and purchase of foreign currency is suspended. Any change in the official exchange rate is made by the monetary authority of the country in-consultation with the IMF.  In practice, however, most countries adopt a dual system: a fixed exchange rate for all official transactions and a market rate for private transactions.

Arguments in Favour of Fixed Exchange Rate:

First, it provides stability in the markets, certainty about the future course of actions in the Foreign Exchange Market, and it eliminates the risk caused by the uncertainty.

Second, it creates a system for a smooth flow of foreign capital between the nations, as it gives assurance of fixed return on investment.

Third, It removes the possibility of speculative transactions in foreign exchange markets.

Lastly, it reduces the possibility of competitive exchange depreciation or devaluation of currencies.

B. Flexible Exchange Rate

When the exchange rate is decided by the market force (demand and supply of currency), it is called the flexible exchange rate.

The advocates of flexible exchange rate have put forward equally convincing arguments in its favour. They have challenged all the arguments against the flexible exchange rate. It is often argued that flexible exchange rate causes destabilization, uncertainty, risk and speculation. The proponents of the flexible exchange rate have not only rebutted these charges but also have put forward strong arguments in favour of flexible exchange rate.

Arguments in favour of Flexible Exchange Rate:

First, flexible exchange rate provides a good deal of autonomy in respect of domestic policies as it does not require any obligatory constraints. This advantage is of great significance in the formulation of domestic economic policies.

Second, flexible exchange rate is self-adjusting and therefore it does not devolve on the government to maintain an adequate foreign exchange reserves to stabilize the exchange rate.

Third, since flexible exchange rate is based on a theory, it has a great advantage of predictability and has the merit of automatic adjustment.

Fourth, flexible exchange rate serves as a barometer of actual purchasing power of a currency in the foreign exchange market.

Finally, some economists argue that the most serious charge against the flexible exchange rate, that is, uncertainty, is not tenable because speculative tendency under this system itself creates conditions for certainty and stability. They argue that the degree of uncertainty under flexible exchange rate system, if any, is not greater than one under the fixed exchange rate

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