Exchange Rate Mechanisms And Regimes In India Finance Essay

switch over lay Mechanisms And Regimes In India Finance EssayIndia has gone through several stages of frugal development ever since it received Independence on the 15th of August, 1947. Most notable of these stages would be the liberalisation of the economy in 1991.Until the liberalization of 1991, India was largely and intentionally isolated from the world markets, to protect its economy and to achieve self-reliance. Foreign trade was theme to mo tariffs, export taxes and quantitative restrictions, while foreign direct coronation (FDI) was restricted by upper-limit equity participation, restrictions on technology transfer, export obligations and government approvals.*Following a Balance of Payments crisis in the year 1991, India was literally forced to out-of-doors its doors to international business, a notion previously held as most evil to the countrys growth by its leaders. It had to change its stance on several aspects of international trade, including the flip-flop Ra te polity adopted.But, in hindsight, we would all agree that liberalisation was a smart, if delayed, move on part of the countrys government. The economy is flourishing like never before. India is like a shot considered a powerhouse on the global stage rather than a Third-World country. The countrys international transactions argon now becoming a worrying cite for yesteryears champions like the United States and Great Britain.Since liberalization, the value of Indias international trade has become more broad- taild and has risen to Rs. 63,080,109 crores in 2003-04 from Rs.1,250 crores in 1950-51. Indias major trading partners argon China, the US, the UAE, the UK, lacquer and the EU. The exports during April 2007 were $12.31 billion up by 16% and import were $17.68 billion with an increase of 18.06% over the previous year.*This document lead give a brief overview of the Exchange Rate policy currently adopted by the countrys central banker, the Reserve Bank of India (RBI), which has made all of this possible.*Source Wikipedia Economy of India (http//en.wikipedia.org/wiki/Economy_of_India)History of Exchange Rate Regimes in India*During the period 1950-1951 until mid-December 1973, India followed an modify wander regime with rupee linked to the Pound Sterling, except for the devaluations in 1966 and 1971. When the Pound Sterling floated on June 23, 1972, the Rupees link to the British wholes was maintained paralleling the Pounds depreciation and effecting a de facto devaluation.On September 24, 1975, the Rupees ties to the Pound Sterling were broken. India conducted a managed float transfer regime with the Rupees effective esteem placed on a controlled, floating basis and linked to a basket of currencies of Indias major trading partners.In early 1990s, the preceding(prenominal) exchange cast regime came nether severe pressures from the increase in trade deficit and net invisible deficit. In the aftermath of a balance of payments crisis in 1991, stabi lization was undertaken simultaneously with structural reforms over wide areas of the Indian economy. This dramatic change in context fundamentally altered the manner in which monetary policy began to be formulated, oddly the forex policy adopted by the country. This shift led the Reserve Bank of India (RBI) to undertake downward adjustment of Rupee in two stages on July 1 and July 3, 1991. This adjustment was followed by the introduction of the Liberalized Exchange Rate Management System (LERMS) in March 1992 and hence the adoption of, for the first time, a dual (official as well as market determined) exchange mark in India. However, such system was characterized by an implicit tax on exports resulting from the contrastiveial in the evaluate of surrender to export proceeds.Subsequently, in March 1993, the LERMS was replaced by the unified exchange say system and hence the system of market determined exchange treasure was adopted. However, the RBI did not relinquish its right to intervene in the market to enable orderly control.In lendition, the foreign exchange market of India was characterized by the earthly concern of both official and black market rates with median grant. However, such black market premium steadily declined during the following decades until 1993.RBIs official position on the current Exchange Rate PolicyThe objective of the exchange rate management has been to ensure that the external value of the Rupee is realistic and credible as evidenced by a sustainable current account deficit and manageable foreign exchange situation. Subject to this predominant objective, the exchange rate policy is guided by the need to reduce speculative activities, help maintain an adequate level of reserves, and develop an orderly foreign exchange market.*Source external Economics Historical Exchange Rate Regimes of Asian Countries (http//intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=15)Exchange RatesIn international transactions, if we ex port goods to other countries, our exporter in India would like to be pay in Indian Rupees whereas the foreign buyer would like to pay in his home currentness. If the buyer is in United States, he forget pay lone slightly(prenominal) in US Dollars. Thus, it becomes necessary to convert this US Dollars into Indian Rupees. The rate at which USD is converted into Indian Rupees is known as Exchange Rate. In short, exchange rate is the ratio used to convert one currency into another.Exchange rates are quoted under two methods channelise method confirmatory method. instantly QuotationsWhile quoting the exchange rate for a currency if the unit of foreign currency is kept constant and its value is expressed in terms of protean home currency the method of quoting exchange rate is known as Direct Quotation. In this case, the unit of home currency depart be vary for every unit of foreign currency.e.g., USD 1 = Rs. 48.85GBP 1 = Rs. 75.2550Effective from August, 6, 1993 we have changed ou r system of quoting exchange rates to Direct Quotations. By adopting this system, we have fallen in line with the International practice. It has become more transparent for the dealing public and it will be easier for them to follow up the movement of exchange rates.Indirect QuotationsWhen the unit of home currency is kept constant and the unit of home currency is expressed in terms of variable units foreign currency, then this method of quoting exchange rate is called Indirect Quotation.Prior to August 1993, we were following this system for quoting exchange rates.e.g., Rs.l00/- = USD 2.2400Rs.l00/- = GBP 1.2400Two Way QuotesIn other commercial transactions whenever we enquire the set of a commodity the seller will immediately quote his interchange price. But in Foreign exchange market exchange rates are al carriages quoted for buying and merchandising i.e., one rate for buying and the other rate for exchange. For example, if Bank X calls for the rates from Bank Y for USD/INR Ba nk Y will quote USD/INR = 42.15/16It means that Bank Y is prepared to buy USD at Rs.42.15 and sell at 42.16. This method of quoting both buying and selling rates is known as Two Way Quotation. For all practical purposes if we treat Foreign Exchange as a commodity, the logic and application of this nonpartisan quotation plenty be understood easily, i.e., a trader will always be willing to buy a commodity at a lesser price and sell at a higher price.The principle or maxim involved in this method of quotation isBUY depleted SELL HIGH (Under Direct Quotation)Different Transactions and Relevant Exchange RatesIn the above examples, (a) is an outward remission of sin, which does not involve any special labor. Bank will be recovering the rupee equivalent from the customer and remit the foreign exchange to their correspondent Bank as per their drawing arrangements with oblige of instructions to pay to the lending fiscal institution on behalf of their customer. If it is a remitment r elating to an import bill, (b), as a banker, bank will be verifying the documents, go into them in their register, presenting the bill to the importer for payment and also check whether all the conditions stipulated by the correspondent bank are complied with. For this nature of involvement of manpower, Bank is eligible for some additional compensation. This compensation will be loaded or adjusted while quoting the exchange rate for this import transaction. In other words, the exchange rate for import transaction will be costlier to the customer when compared to the exchange rate for clean outward remittances. The different rates quoted for these two transactions are TT selling and bill selling.Likewise, Bank will quote different buying rates for export bills and for other clean inward remittances.Following are the different rates, which are quoted to the customer depending upon the nature of transactionBuying RatesA.l. TT Buying Rate (NATURE OF TRANSACTIONS)Clean inward remittance (TT, PO, MT, and DD) for which cover has already been provided in ADs Nostro Account abroad.Conversion of proceeds of instruments sent on collection basis. When proceeds are credited to Nostro AccountCancellation of outward TT, MT, PO, DD etc.Cancellation of beforehand sale contract.Undrawn bunch of an Export Bill realised.A.2. Bill Buying Rate (NATURE-OF TRANSACTIONS)1. Purchase/ negotiation/ discounting of export bills and other instruments.Selling RatesB.l. TT Selling Rate. (NATURE OF TRANSACTIONS)Outward remittance in foreign currency (TT, MT, PO, DD)Cancellation of purchase transactions, i.e., Bill purchased earlier is returned unpaid Bill purchased earlier is transferred to collection account.Inward remittance received earlier (converted into rupees) is refunded to the remitting bank.Cancellation of forrard purchase contract.Remittances relating to payment of import bills, which are directly received by the importer.Crystallisation of overdue export bills.NOTE If the remit tance is a clean remittance i.e. no documents are to be handled by the banks, TT Selling rate will be applied.B.2. Bill Selling Rate.1. Transaction involving remittance of proceeds of import bill (exceptbills received directly by the. importer)NOTE Even if the proceeds of the import bills are to be remitted in foreign Currency by way of DD, MT, TT, and PO rate to be applied will be Bill Selling rate.2. Crystallisation of overdue import bills.Apart from the above, separate rates will be quoted for selling and buying of Travelers Cheques and Foreign currency notes.Calculation of Merchant RatesFEDAI has provided detailed guidelines for calculation of exchange rates for merchant transactions. Following factors are to be taken into account by banks before quoting rates to customersSTEP 1. Arrive at the cover rate i.e. the rate at which ADs will be covering the transaction in the market immediately the customer delivers the instrument. It whitethorn also be treated as the rate at which t he AD can dispose off / acquire the Foreign Exchange in/from the market.STEP 2. Load the prescribed profit margin.EXCHANGE MARGINFEDAI has left the discretion of consignment profit margin to the individual banks.It is now purely at the discretion of the individual Bankers to load the appropriate exchange margin and improve the exchange rate depending upon the volume and nature of the transaction.STEP 3. Rounding off the transaction to the nearest 4 decimals, i.e., .0025/50/75/00.EXAMPLEExporter has submitted a bill for USD 100,000. Inter-bank exchange rate 48.02/03 Profit margin 1.5 paiseSTEP 1 Select the appropriate base rate at which the bank can dispose off the USD against Indian Rupee in the market. In this case, Bank may be able to dispose off USD 100000 at Rs. 48.02 in the Inter Bank market at the market-buying rate.STEP 2 Load the prescribed profit margin Base rate Rs.48.02Deduct the profit margin Rs.48.0200 0.0150 = Rs.48.0050Since Bank will be compensable Indian Rupees to exporter customer, Bank will be deducting their profit margin from the rupee proceeds.STEP 3 Round off to the nearest 4 decimals.In the above transaction, Bank will be quoting the rate as 48.0050 to the customer.Cross Rates / Chain RuleIf a Corporate wants to purchase Euro (EUR) since this currency is not ordinarily quoted in India, AD will procure US Dollars from Inter-bank market against Rupees and will contact any of the overseas market to get Euro by disposing the US Dollars.E.g., A customer wants to retire an import bill for EUR 50,000 and the Inter Bank rate for USD/INR is at 39.02/03 and the overseas market rate for EUR/USD is 0.8920/30. In order to bewilder at the EUR/INR exchange rate Bank will be applying following Chain Rule method. It should be noted that the market quote for EUR/USD is expressed under Indirect quotation i.e., one unit of Euro will be equivalent to how much USD.First leg of the transaction is, Authorised Dealer procures USD against Indian Rupees fr om inter-bank marketUSD $1 = Rs.39.03 i.e. to procure US$ 1, AD will pay Rs.39.03 in the Interbank.With this USD, AD will go to London market and procure EUR paying USD 0.8930 for one EUR.By applying Chain Rule 1 EUR = USD 0.89301 USD = INR 48.03Then 1 EUR will be equivalent to 0.8930*39.03 = INK 39.8907Rounding off to 4 decimals = Rs.39.8925This method of arriving at the value of other currencies through US Dollar or any other third currency is known as Cross Rate or Chain Rule.Card RatesDealing room of all banks as soon as open for that days business, works out the exchange rate for all the major currencies and for all types of transactions. This rate will be communicated to all branches of the bank. This rate will be the indicative rates and this rate will be applicable only for transaction up to the prescribed level i.e., smaller value transactions.Spot Rates Forward RatesWe have learnt that exchange rate is the price at which one currency can be bought or sold for another curr ency.The date on which currencies are exchanged can be any date from the date starting from the date of transaction to any future dates. Transactions may be either Spot or send depending upon the delivery of the Foreign Exchange.Under Spot, we have CASH-SPOT, TOM-SPOT. If the exchange of currencies takes place on the same day of transaction, it is known as CASH DEAL. If the exchange of currencies takes place on the next working day, i.e. tomorrow, it is known as TOM-DEAL. If the exchange of currencies takes place on the second working day after the date of transaction it is known as SPOT DEAL. Normally exchange rates are quoted on percentage point basis i.e., the settlement will take place on the second working day after the date of transaction. Wherever foreign exchange will be delivered after SPOT date, it is known as Forward transactions.Going support to the above Import transaction, if the Importer gets the information that his shipment will be reaching India only after 3 mo nths it is possible that due to exchange fluctuations he may have to pay more in Rupee terms. If he feels that the exchange rate on the third month, at the time of retirement of the import bill, will not be favorable to him, he may like to fix an assured rate for his future transaction. This type of fixing the exchange rate for a future transaction, at the desired time earlier to the date of actual transaction is known as Forward contracts.Premium/Discount on Direct QuotationsIf we are familiar with commodity or share market it would be known that spot rate, prior rates are different, and they need not be the same. This is so because the anticipated demand and supply and the cost situations at the forward date may not necessarily be identical with that of the existing at present. The commodity/share could be quoted at a higher (premium) or lower (discount) rate for future deliveries.We shall illustrate this with an exampleSpot interbank rate of USD 1 = Rs.39.253 months forward USD 1 = Rs.39.95If one has to buy sawhorse three months forward against Rupees, he has to pay 70 paise more for the same dollar, i.e., 3 months dollar will be costlier by 70 paise compared to spot rate. Therefore US Dollar is say to be at premium in forwards loveseat rupee. In direct quotations premium is always added to both the buying and selling spot rates.In another situationSpot interbank rate of USD 1 = JPY 108.503 months forward USD 1 = JPY 106.50From the above illustration it will be seen that the USD/JPY for 3 months forward is available at a cheaper rate as compared to spot. In other words USD is cheaper by 2 JPY forward compared to spot.i.e., USD is at discount in forwards vis-a-vis JPY direct quotations. Discount factor is always deducted from the buying and selling spot rate.From the above it is now clear that if we compare spot and forward rates we are able to arrive at the following three possibilitiesa. If the spot rate and the forward rate are the same they are at par .b. In direct quotations if forward rate is more than the spot rate the basecurrency is said to be at premium.c. In direct quotations if forward rate is less than the spot rate the basecurrency is said to be at discount.Quoting Forward RatesForward differentials are always quoted in two figures like, 15/16 and 15/14. It will be either at ascending or descending order. If the first figure is less than the second figure in ascending order then the base currency is said to be at premium.In direct quotations premium is always added to both the buying and selling rates. If it is a buying transaction for the bank, the quoting bank will add lesser of the two premium figures so as to give minimum rupees. Likewise if it is a selling transaction, the quoting bank, will add higher of the two premium figures to take the maximum list in rupees for selling a foreign currency.EXAMPLEInterbank market ratesSpot USD Rs.39.2025/21001 month forward 15/16a) We have an export bill transaction.Since the forward differentials are in ascending order the base currency, USD is at premium. Hence, it should be added with the spot rate to arrive at the forward rate. Out of the two premium figures (15/16) since Bank will be giving Indian rupees, they will give minimum amount in rupees.Step 1 Spot buying rate USD 1 = Rs.39.2025Step 2 To arrive at the forward rate Since the base currency is at premium and Bank has to give rupees, add the minimum premium, i.e., add 15 paise to the spot rate.Spot buying rate USD 1 = Rs. 39.2025Add premium = Rs. 00.1600Rs. 39.3625Hence, the forward rate for this export transaction will be Rs.39.3625.b) In an import transaction, while recovering rupees from the importer customer, for one-month forward rate, Bank will add the maximum premium i.e. 16 paise and the forward rate for Banks selling transaction would beSpot selling rate USD 1 = Rs. 39.2100Add premium = Rs. 00.1600Forward rate for selling = Rs.39.3700If the forward differentials are on the descending o rder i.e., 25/24, the base currency is said to be at discount.In direct quotations, if the base currency is at a discount, discount factor is always deducted from the spot rate. When two discount figures are quoted if it is a buying transaction (export bills) in which bank will be giving rupees, they will be deducting higher of the two figures and give minimum rupees.EXAMPLEInterbank market Spot USD 1 = Rs.39.2725/001 month forward 25/24 (paise)To arrive at the 1-month forward ratesBuyingSelling(Export bill)(Import bill)Inter-bank Spot39.272539.2800Deduct the discount0.25000.24001 month forward rate39.022539.0400From the above example, in direct quotations, in selling transactions, lesser amount of discount is deducted to take maximum rupees for every dollar.RBI Regulations on Forward ContractsA person resident in India may enter into a forward contract with an authorized dealer to hedge an exposure to exchange risk subject to production of satisfactory documentary evidence about th e genuineness of the underlying exposure.This has been relaxed on 1.12.2001 -vide RBI guidelines EC/CO/FMD/453/18.07.01 /2001-02 wherein Reserve Bank permits Authorized Dealers to book FWD contracts based on a declaration of an exposure subject toFWD contracts booked in aggregate, should not exceed 50%of the average of previous 3 financial years actual import/export turnover subject to a cap of USD 100 Mn or equivalent.Declaration to AD about amount booked with other Authorised DealersUndertaking to produce supporting documentary evidence before maturity of the FWD contract.Substitution of contracts for hedging trade transactions may be permitted on satisfactory reasonsContracts involving rupee as one of the currencies, once cancelled shall not be re-booked although they can be rolled over at ongoing rates on or before maturity. This restriction shall not apply to contracts covering export transactions, which may be cancelled, rebooked or rolled over at on-going rates.