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Introduction:
Every one of us irrespective of his or her job profile wants to know the exchange rates. Whether we are into foreign exchange market or not than also we are concerned about the exchange rates. In general terms exchange rates can be anything or any rate for or with which we can exchange anything. But when talking to foreign exchange rate it can be defined as that rate by which we can exchange the currency of one nation with the another nations currencies Meaning of foreign exchange market: H.E. Evitt has defined foreign exchange market as follows! "that section of economic science which deals with the means and methods by which rights to wealth in one country#s currency are converted into rights to wealth in terms of another country#s currency$. He further observes that "it involves the investigation of the method by which the currency of one country is exchanged for that of another the causes which render such exchange necessary the forms which such exchange may take and the ratios or e%uivalent values at which such exchanges are effected$. &here are different interpretations of the term foreign exchange of which the following two are most important and common! '. (oreign exchange is the system or process of converting one national currency into another and of transferring money from one country to another. ). *econdly the term foreign exchange is used to refer to foreign currencies. (or example the (oreign Exchange +egulation ,ct '-./ 0(E+,1 defines foreign exchange as "foreign currency and includes all deposits and balance payable in any foreign currency and any drafts traveler2s che%ues letters of credits and bills of exchange expressed or drawn in Indian currency but payable in any foreign currency. FUNC ION! OF FOREIGN EXCHANGE MAR"E &he foreign exchange market is a market in which foreign exchange transactions take place. In other words it is a market in which national currencies are bought and sold against one another. , foreign exchange market performs three important functions! ran#fer of $%rcha#ing $o&er &he primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. &he international clearing function performed by foreign exchange 1
markets plays a very important role in facilitating international trade and capital movements. $ro'i#ion of Cre(it &he credit function performed by foreign exchange markets also plays a very important role in the growth of foreign trade for international trade depends to a great extent on credit facilities. Exporters may get pre3 shipment and post shipment credit. 4redit facilities are available also for importers. &he Eurodollar market has emerged as a major international credit market. $ro'i#ion of He(ging Faci)itie# &he other important function of the foreign exchange market is to provide hedging facilities. Hedging refers to covering of export risks and it provides a mechanism to exporters and importers to guard themselves against losses arising from fluctuations in exchange rates. ME HO*! OF AFFEC ING IN ERNA IONA+ $A,MEN ! &here are five important methods to effect international payments. e)egra-hic ran#fer
By this method a sum can be transferred from a bank in one country to a bank in another part of the world by cable or telex. It is thus the %uickest method of transmitting funds from one centre to another. Mai) ran#fer
5ust as it is possible to transfer funds from a bank account in one centre to an account in another centre within the country by mail international transfers of funds can be accomplished by 6ail &ransfer. &hese are usually made by air mail. Che.%e# an( /ank *raft# International payments may be made by means of che%ues and bank drafts. &he latter is widely used. , bank draft is a che%ues drawn on a bank instead of a customer#s personal account. It is an acceptable means of payment when the person tendering is not known since its value is dependent on the standing of a bank which is widely known and not on the credit3worthiness of an individual known only to a limited number of people. Foreign /i)) of Exchange , bill of exchange is an unconditional order in writing addressed by one person to another re%uiring the person to whom it is addressed to pay a certain sum on demand or on a specified future date. &here are two important differences between inland and# foreign bills. &he date on which an inland bill is due for payment is calculated from the date on which it was drawn but the period of a foreign bill runs from the date on 2
which the bill was accepted. &he reason for this is that the interval between a foreign bill being drawn and its acceptance may be considerable since it may depend on the time taken for the bill to pass from the drawer#s country to that of the acceptor. &he second important difference between the two types of bill is that the foreign bill is generally drawn in sets of three although only one of them bears a stamp and of course one of them is paid. 7owadays it is mostly the documentary bill that is employed in international trade. &his is nothing more than a bill of exchange with the various shipping documents3the bill of lading the insurance certificate and the consular invoice3attached to it. By using this the exporter can make the release of the documents conditional upon either 0a1 payment of the bill if it has been drawn at sight or 0b1 its acceptance by the importer if it has been drawn for a period. *oc%mentar0 1or reim2%r#ement3 Cre(it 8nder this method a bill of exchange is necessarily employed but the distinctive feature of the documentary credit is the opening by the importer of a credit in favour of the exporter at a bank in the exporter#s country. I))%#tration: &o illustrate the use of the documentary credit let us assume that 6r. 6enon of 4ochin intends to purchase goods from 6r +onald of 7ew 9ork and that the terms of the deal have been agreed upon #by them. &hen the transaction would be carried through the following stages. 0a1 6r 6enon the importer instructs his bank say the *tate Bank of India 0*BI1 to open a credit in favour of 6r +onald the exporter at the 7ew 9ork branch of the *BI 0if the *BI has no branch in 7ew 9ork it will appoint some other bank to act as its agent there1. &he *BI will then inform 6r +onald by a letter of credit that it will pay him a specified sum in exchange for the bill of exchange and the shipping documents. 0b1 6r +onald may now despatch the goods to 6r 6enon at 4ochin drawn bill of exchange on the *BI and then present the documentary bill to the 7ew 9ork branch of the *BI. If all the documents are in order the bank will pay 6r +onald. &he bank will charge for its services and will also charge interest if the bill is not payable at sight. 0c1 &he 7ew 9ork branch of the *BI then sends the documentary bill to its 4ochin office for payment or acceptance as the case may be by 6r 6enon. When the bill is paid 6r 6enon#s account will be debited by that amount. Everything being in order the banker will release the bill of lading from the bill to enable 6r 6enon to claim the goods on their arrival at the 4ochin port. RAN!AC ION! IN HE FOREIGN EXCHANGE MAR"E 3
, very brief account of certain important types of transactions conducted in the foreign exchange market is given below. !-ot an( For&ar( Exchange# &he term spot exchange refers to the class of foreign exchange transaction which re%uires the immediate delivery or exchange of currencies on the spot. In practice the settlement takes place within two days in most markets. &he rate of exchange effective for the spot transaction is known as the spot rate and the market for such transactions is known as the spot market. &he forward transaction is an agreement between two parties re%uiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties against payment in domestic currency by the other party at the price agreed upon in the contract. &he rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market. &he foreign exchange regulations of various countries generally regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India for example commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions. (orward exchange facilities obviously are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations by entering into an appropriate forward exchange contract. For&ar( Exchange Rate With reference to its relationship with the spot rate the forward rate may be at par discount or premium. At $ar If the forward exchange rate %uoted is exactly e%uivalent to the spot rate at the time of making the contract the forward exchange rate is said to be at par. At $remi%m &he forward rate for a currency say the dollar is said to be at a premium with respect to the spot rate when one dollar buys more units of another currency say rupee in the forward than in the spot market. &he premium is usually expressed as a percentage deviation from the spot rate on a per annum basis. At *i#co%nt
&he forward rate for a currency say the dollar is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. &he discount is also usually expressed as a percentage deviation from the spot rate on per annum basis. &he forward exchange rate is determined mostly by the demand for and supply of forward exchange. 7aturally when the demand for forward exchange exceeds its supply the forward rate will be %uoted at a premium and conversely when the supply of forward exchange exceeds the demand for it the rate will be %uoted at discount. When the supply is e%uivalent to the demand for forward exchange the forward rate will tend to be at par. !&a- O-eration 4ommercial banks who conduct forward exchange business may resort to a swap operation to adjust their fund position. &he term swap means simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency. &he spot is swapped against forward. :perations consisting of a simultaneous sale or purchase of spot currency accompanied by a purchase or sale respectively of #the same currency for forward delivery are technically known as swaps or double deals as the spot currency is swapped against forward. Ar2itrage ,rbitrage is the simultaneous buying and selling of foreign currencies with the intention of making profits from the differences between the exchange rate prevailing at the same time in different markets. (or illustration assume that the rate of exchange in ;ondon is < I = > ) while in 7ew 9ork < ' = > ).'?. &his presents a situation where in one can purchase one pound sterling in ;ondon for two dollars and earn profit of > ?.'? by selling the pound sterling in 7ew 9ork for > ).'?. &his situation would hence lead to an increase in demand for sterling in ;ondon and conse%uently an increase in the supply of sterling in 7ew 9ork. *uch operations i.e. arbitrage could result in e%ualising the exchange rates in different markets 0in our example ;ondon and 7ew 9ork1. ,rbitrage in foreign currencies is possible because of the ease and speed of modern means of communication between commercial centers throughout the world. &hus an operator in 7ew 9ork might buy dollars in ,msterdam and sell them a few minutes later in ;ondon. &he effect of arbitrage as has already been mentioned is to iron out differences in the rates of exchange of currencies in different centres thereby creating theoretically speaking a single3world market in foreign exchange. *E ERMINA ION OF EXCHANGE RA E! 5
How are exchange rates between different currencies determined under the paper currency standard@ &here are two important theories which attempt to explain the mechanism of exchange rate determination namely the purchasing power parity theory and the balance of payments or the demand and supply theory
*iagrammatica) exchange
re-re#entation
of
exchange
rate
an(
.%antit0
of
foreign
(or example assume that a particular bundle of goods in India costs +s DE.?? and the same in 8*, costs > '. &hen the exchange rate will be in e%uilibrium if the exchange rate is > ' = +s DE.??. :nce the e%uilibrium is established the market forces will operate to restore the e%uilibrium if there are some deviations. (or example if the exchange rate changes to > ' = +s DF.E? when the purchasing powers of these currencies remain stable dollar holder will convert dollars into rupees because by doing so they can save +s '.E? when they purchase a commodity worth > '. &his will increase the demand for the Indian currency and the supply of dollars will increase in the foreign exchange market and ultimately the e%uilibrium rate of exchange will be re3established. , change in the purchasing power of currencies will be reflected in their exchange rates. &he index number of prices may be made use of to determine the purchasing power parity. If there is a change in prices 0i.e. the purchasing power of the currencies1 the new e%uilibrium rate of exchange can be found out by the following formula.
0vi1 &he theory is rendered further unrealistic by ignoring the cost of transport in international trade. 0vii1 ,nother very unrealistic assumption made by the theory is that international trade is free from all barriers. 0viii1 &he purchasing power parity theory ignores the effects of international capital movements on the foreign exchange market. International capital movements may cause changes in the exchange rate. (or example if there is capital inflow to India from 8*, the supply of the dollar and the demand for rupees increases in the foreign exchange market causing an appreciation in the value of the rupee and depreciation in the value of the dollar. 0ix1 ,nother defect of the theory is that it ignores the impact of changes in the exchange rates on the prices. (or example if as a result of large capital inflows to India Indian currency appreciates in terms of foreign currencies Indian exports may decline and as a result the supply of goods in India may exceed the demand and may cause a fall in prices. 0x1 &he theory does not explain the demand for supply of foreign exchange. When the exchange rate is determined largely by demand and supply conditions any theory that does not pay ade%uate attention to these aspects proves to be unsatisfactory. 0xi1 &he purchasing power parity theory starts with a given rate of exchange but rails to explain how that particular rate of exchange is arrived at. &hus the theory only tells us how with a given rate of exchange changes in the purchasing powers or two currencies affect the exchange rate. 0xii1 &he theory is based on the wrong assumption that the elasticity of demand for exports and imports is e%ual to unity i.e. this theory is valid only if the exports and imports change in the same proportion as the change in prices. But this is a very rare occurrence. 0xiii1 7o satisfactory explanation of short term changes in exchange rates is provided by the theory. 0xiv1 ;astly the purchasing power parity theory goes contrary to general experience. 4ritics point out that there has hardly been any case when the rate of exchange between two currencies has been e%uivalent to the ratio of their purchasing powers. Gespite its many defects and deficiencies the purchasing power parity theory exposes some very important aspects of exchange rate determination. 0i1 It indicates the relationship between the internal price levels and exchange rates. 0ii1 It explains the state of the trade of a country as well as the nature of its balance of payments at a particular time. 8
0iii1 (urther the theory is applicable to some extent to all sorts of monetary standards.
FOREIGN EXCHANGE 4
EXCHANGE CON RO+
Introduction:
Exchange control is one of the important means of achieving certain national objectives like an improvement in the balance of payments position restriction of inessential imports and conspicuous consumption facilitation of import of priority items control of outflow of capital and maintenance of the external value of the currency. 8nder the exchange control the whole foreign exchange resources of the nation including those currently occurring to it are usually brought directly under the control of the exchange control authority 0the 4entral Bank treasury or a specially constituted agency1. Gealings and transactions in foreign exchange are regulated by the exchange control authority. Exporters have to surrender the foreign exchange earnings in exchange for home currency and the permission of the exchange control authority have to be obtained for making payments in foreign exchange. It is generally necessary to implement the overall regulations with a host of detailed provisions designed to eliminate evasion. &he allocation of foreign exchange is made by the exchange control authority on the basis of national priorities. &hough the exchange control is administered by a central authority like the central bank the day3to3day business of buying and selling foreign exchange is ordinarily handled by private exchange dealers largely the exchange department of commercial banks. (or example in India there are authorised dealers and money changers entitled to conduct foreign exchange business.
&he main objective of foreign exchange regulation in India as laid dawn in the (oreign Exchange +egulation ,ct 0(E+,1 '-./ is the conservation of the foreign exchange resources of the country and the proper utilisation thereof in the interest of the national development. &his is one of the important objectives of foreign exchange regulation of many other countries too.
% To
Gue to the non3availability of or scarcity within the country the developing countries generally have to import capital goods knowhow and certain essential inputs and consumer goods. By giving priority to such imports in the allocation of foreign exchange exchange control may ensure availability of foreign exchange far these imports.
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business in the country for carrying on any activity of a trading commercial or industrial revenue without the permission of the +eserve Bank of India.
ercial !argaining
Exchange control offers scope for discrimination between different countries. It would be used to accord exchange concessions on a reciprocal basis between different countries.
/$ To Obtain )evenue
Bovernments may use exchange control to obtain some revenue. &he govern3 mentJgovernment agency can make profit out of the foreign exchange business by keeping certain margin between the average purchase price and the average selling price of the foreign exchange. Metho(# of Exchange Contro) &he various methods of exchange control may be broadly classified into 0'1 8nilateral methods and 0)1 BilateralJmultilateral methods. Uni)atera) Metho(#
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8nilateral measures refer to those methods which may be adopted by a country unilaterally i.e. without any reference to or understanding with other countries. &he important unilateral methods are outlined below. Reg%)ation of /ank Rate 5 , change in the bank rate is usually followed by changes in all other rates of interest and this may affect the flow of foreign capital. (or example when the internal rates of interest rise foreign capital is attracted to the country. &his causes an increase in the supply of foreign currency and the demand for domestic currency in the foreign exchange market and results in the appreciation of the external value of the currency. , lowering of the bank rate is expected to produce the opposite results. Reg%)ation of Foreign ra(e &he rate of exchange may be controlled by regulating the foreign trade of the country. (or example by encouraging exports and discouraging imports a country can increase the demand for in relation to supply its currency in the foreign exchange market and thus bring about an increase in the rate of exchange of the country#s currency. Rationing of Foreign Exchange By rationing the limited foreign exchange resources a country may restrict the influence of the free play of market forces of demand and supply and thus maintain the exchange rate at a higher level. Exchange $egging Exchange pegging refers to the policy of the government of fixing the exchange rate arbitrarily either below or above the normal market rate. When it is fixed above the free market rate it is known as pegging up and when it is fixed below the free market rate it is known as pegging down. Exchange pegging is resorted to generally during war times to prevent violent fluctuations in the exchange rate. M%)ti-)e Exchange Rate 6ultiple exchange rates refer to the system of the fixing by a country of the different rates of exchange for the trade or different commodities andJor for transactions with different countries. &he main object of the system is to maximise the foreign exchange earning of country by increasing exports and reducing imports. &he entire structure of the exchange rate is devised in a manner that makes imports cheaper and exports more expensive. &he multiple exchange rate system has been severely condemned by the I6(. Exchange E.%a)i#ation F%n( &he main object of the Exchange E%ualisation (und also known as the Exchange *tabilisation ,ccount is to stabilise the exchange rate of the national currency through the sale and purchase of foreign currencies. When the demand for domestic currency exceeds its supply the fund starts purchasing foreign currency with the help of its own resources. &his results in an increase in the demand for foreign currency and increases the supply of the national currency. &he tendency of the rate of exchange of the national currency to rise can thus be checked. When the supply of the national currency exceeds demand and the exchange rate tends to fall the (und sells the foreign currencies and this increases the supply of foreign currencies and arrests the tendency of the exchange rate of the domestic currency to fall. &his sort of an operation may be resorted to eliminate short term fluctuations.
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/)ocke( Acco%nt# In the case of blocked accounts foreigners are prevented from withdrawing money from their deposits with banks for the purpose of remitting abroad. &his measure makes the foreign exchange position of the country more comfortable. &his is generally regarded as a wartime measure. 8nder this method domestic debtors may be re%uired to deposit their dues to foreign creditors into specifically designated bank accounts.
!ilateral78ultilateral 8ethods
he im-ortant 2i)atera)6m%)ti)atera) metho(# are the fo))o&ing: $ri'ate Com-en#ation Agreement 8nder this method which closely resembles barter a firm in one country is re%uired to e%ualise its exports to the other country with its imports from that country so that there will be neither a surplus nor a deficit. C)earing Agreement 7ormally importers have to make payments in foreign currency and while exporters are paid in foreign currency. 8nder the clearing agreement however importers make payments in domestic currency to the clearing account and exporters obtain payments in domestic currency from the clearing fund. &hus under the clearing agreement the importer does not directly pay the exporter and hence the need for foreign exchange does not arise except for settling the net balance between the two countries. !tan(#ti)) Agreement &he standstill agreement seeks to provide debtor country some time to adjust her position by preventing the movement of capital out of the county through a moratorium on the outstanding short3term foreign debts. $a0ment# Agreement 8nder the payments agreement concluded between a debtor country and a creditor country provision is made for the repayment of the principal and interest by the debtor country to the creditor country. &he creditor country refrains from imposing restrictions on the imports from the debtor country in order to enable the debtor to increase its exports to the creditor. :n the other hand the debtor country takes necessary measures to encourage exports to and discourage imports from the creditor country. EXCHANGE RA E !,! EM! Broadly there are two important exchange rate systems namely the fixed exchange rate system and flexible exchange rate system. Fixe( Exchange Rate# 4ountries following the fixed exchange rate 0also known as stable exchange rate and pegged exchange rate1 system agree to keep their currencies at a fixed pegged rate and to change their value only at fairly infre%uent intervals when the economic situation forces them to do so. 8nder the gold standard the values of currencies were fixed in terms of gold. 8ntil the breakdown of the Bretton Woods *ystem in the early '-.? each member country of the I6( defined the value of its currency in terms of gold or the 8* dollar and agreed to maintain 0to peg1 the market value of its currency within I per cent of the defined 0par1 value. (ollowing the breakdown of the
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Bretton Woods *ystem some countries took to managed floating of their currencies while a number of countries still embraced the fixed exchange rate system. Arg%ment# for the !ta2)e Exchange Rate !0#tem &he relative merits and demerits of the fixed and flexible exchange rate systems have long been a topic for debate. , number of arguments have been put forward for and against each system. &he important arguments supporting the stable exchange rate system! 0i1 Exchange rate stability is necessary for orderly development and growth of foreign exchange. If exchange rate stability is not assured exporters will be uncertain about the amount they will receive and importers will be uncertain about the amount they will have to pay. *uch uncertainties and the associated risks adversely affect foreign trade. , great advantage of the fixed exchange rate system is that it eliminates the possibilities of such uncertainties and risks. 0ii1 Especially the developing countries which have a persistant balance of payment deficits should necessarily adopt the stable exchange rate system. 0Iii1 Exchange rate stability is necessary to attract foreign capital investment as foreigners will not be interested to invest in a country with an unstable currency. &hus exchange rate stability is necessary to augment resources and foster economic growth. 0iv18nstable exchange rates may encourage the flight of capital. Exchange rate stability is necessary to prevent its outflow. 0v1 , stable exchange rate system eliminates speculation in the foreign exchange market. 0vi1, stable exchange rate system is a necessary condition for the successful functioning of regional groupings and arrangements among nations. 0vii1 (oreign trade plays a very important role in case of a number of countries. (or certain countries the value of foreign trade exceeds B7A while for others the value of foreign trade is more than E? percent of their B7A. Exchange rate stability is especially important for such countries to ensure the smooth functioning of the economy. Its absence will give rise to uncertainties and this would disturb the foreign trade sector and thereby the economy. 0viii1 , stable exchange rate system is also necessary for the growth of international money and capital markets. Gue to the uncertainties associated with unstable exchange rates individuals firms and institutions may shy away from lending to and borrowing from the international money and capital markets.
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F)exi2)e Exchange Rate# 8nder the flexible exchange rate system exchange rates are freely determined by open market primarily by private dealings and they like other market prices vary from day3to3day. 8nder the flexible exchange rate system the first impact of any tendency toward a surplus or deficit in the balance of payments is on the exchange rate. *urplus in the balance of payments will create an excess demand for the foreign currency and the exchange rate will tend to rise. :n the other hand deficit in the balance of payments will give rise to an excess supply of the country2s currency and the exchange rate will hence tend to fall. ,utomatic variations in the exchange rates in accordance with the variation in the balance of payment position tend to automatically restore the balance of payments e%uilibrium. , surplus in the balance of payments increases the exchange rate. &his makes foreign goods cheaper in terms of the domestic currency and domestic goods more expensive in terms of the foreign currency &his in turn encourages imports and discourages exports resulting in the restoration of the balance of payments e%uilibrium. :n the other hand if there is a payments deficit the exchange rate falls and this makes domestic good cheaper in terms of the foreign currency and foreign goods more expensive in terms of the domestic currency. &his encourages exports discourages imports and thus helps to establish the balance of payments e%uilibrium! &heoretically this is how the flexible exchange rate system works.
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one without in any way interfering with the pursuit by each nation of domestic economic stability according to its own rights. , number of economists however point out that certain serious problems are associated with the system of flexible exchange rates. We present here some important arguments against and for flexible exchange rates. '. (lexible exchange rates present a situation of instability creating uncertainty and confusion. (riedman disputes this view and argues that a flexible exchange rate need not be an unstable exchange rate. If it is primarily because there is underlying instability in the economic conditions governing international trade. ,nd a rigid exchange rate may while itself remaining nominally stable perpetuate and accentuate other elements of instability in the economy. &he mere fact that a rigid official exchange rate does not change while a flexible rate does is no evidence that the former means greater stability in any more fundamental sense. ). &he system of flexible exchange rates with its associated uncertainties makes it impossible for exporters and importers to be certain about the price they will have to pay or receive for foreign exchange. &his will have a dampening effect on foreign trade. (riedman encounters this objection by pointing out that under flexible exchange rates traders can almost always protect themselves against changes in the rate by hedging in the future market. *uch markets in foreign currency readily develop when exchange rates are flexible. However as *odersten points out it is certainly true that no market exists today that can protect against all the risks connected with a system of flexible exchanges and it is doubtful if such a market can be established in the future if a system of flexible exchanges were introduced. , system of flexible exchanges might 0therefore have a considerably dampening effect on the volume of foreign trade. /. 8nder flexible exchange rates there will be widespread speculation which will have a destabilising effect. ,gainst this it is argued that normally speculation has a stabilising influence on exchange rates. (riedman observes that if speculation is supposed to be destablising it implies that speculators lose money on their activity. However (arrell %uestion this argument and shows that it might be possible under what seems to be fairly general assumptions that speculation can be at the same time profitable and destabiliIing. D. &he system of flexible exchange rates gives an inflationary bias to an economy. When the currency depreciates due to payments deficit imports become costlier and this stirs up an inflationary spiral. &he supporters of the flexible exchange rates however counter this criticism by stating that when Imports become costlier the demand for them falls compelling foreign suppliers to reduce prices. &hough it is theoretically possible it may not be realised. &he general feeling is that flexible exchange rates may have an infla3 tionary impact on the economy. We have reviewed the arguments for and against the fixed and flexible systems. Which system then should a country adopt@
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&he answer will depend on circumstances. It will depend on the characteristics of the economy and it will change with time as the economy changes. Kalue judgements are also involved and ultimately the answer could depend on values and views of a political nature.
CON8ER I/I+I , OF
HE RU$EE
(ree convertibility of a currency means that the currency can be exchanged for any other convertible currency without any restriction at the market
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determined exchange rates. 4onvertibility of the rupee thus means that the rupee can be freely converted into dollar pound sterling# yen Geutsche mark etc. and vice versa at the rates of exchange determined by the demand and supply forces. ,fter the collapse of the Bretton Woods *ystem in '-.' the rupee was pegged to pound sterling for four years after which it was linked to a basket of 'D and later E major currencies. In '-M' a rise in dollar due to high interest rates in the 8* led to rupee appreciation which adversely affected India#s exports due to fall in the export profitability. It prompted the +eserve Bank of India to experiment with a managed float pegging the rupee to dollar and pound sterling alternatively depending on which was going down to guard against the appreciation of the rupee that would adversely affect the exports. , considerable exchange rate adjustment 0devaluation1 was made in 5uly '--'. ,s a part of the economic policy reforms partial convertibility of the rupee on the current account was announced by the (inance 6inister in his Budget speech for '--)3-/ and the rupee became partially convertible since 6arch '--). &he move towards convertibility of the rupee was in line with the worldwide trend towards currency convertibility. ,ccording to the I6( .? countries accepted current account convertibility by '--? while another '? joined them in '--'. 6any other countries including the East European countries and +ussia have been contemplating the convertibility move. ,ccording the ;iberalised Exchange +ate 6anagement *ystem 0;E+6*1 introduced in 6arch '--) F? per cent of all receipts under current transactions 0merchandise exports and invisible receipts1 could be converted at the free market exchange rate %uoted by the authorised dealers. &he rate applicable for the remaining D? per cent was the official rate fixed by the +eserve Bank of India. &his D? per cent of the total foreign exchange receipts under the current account was exclusively meant to cover government needs and to import essential commodities. In addition foreign exchange at official rate was to be made available to meet D? percent of the value of the advance licenses and special import licenses. In short it was a dual exchange rate system.
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&he fact that the free market rate was ruling fairly stable at a reasonable level might have encouraged the government to introduce full convertibility. +upee was showing remarkable stability in the months which followed the Introduction of the full convertibility.
6erits of 4onvertibility
&he convertibility or the floating of the +upee has certain avowed merits. 0i1 It gives an indication of the real value of the rupee. 0ii1 It encourages exports by increasing the profitability of the exports 0iii1 profitability increases as the free market rate is higher than the official exchange rate. 0iv1 It encourages those exports with no or less import intensity. ,s the proportion of the imported inputs in the exportables increases the profitability clause of the higher free market exchange rate gets correspondingly reduced. &his could encourage import substitution in export production. 0v1 &he high cost of foreign exchange could encourage import substitution in other areas also It provides incentives for remittances by 7+Is. 0vi1 &he convertibility and the liberalisation of gold imports have been expected to make illegal remittances and gold smuggling less attractive. thereby increasing the remittances through proper channels. 0vii1 It is described as a self balancing mechanism because the total imports and other current account payments will be confined to the total current account receipts unless there are imports financed by foreign currency loans. Aoints 0ii1 to 0v1 :f above on the assumption that +upee will not appreciate.
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$ro2)em#: &he convertibility would cause some problems unless certain conditions are satisfied. 0i1 4onvertibility could cause an increase in prices because of the increase in the import prices. 0ii1 8nder full convertibility if the tree market exchange rate is very high the cost of essential imports will correspondingly increase. 0III1 If the current account balance is not kept under control the free market rate would rise very high. $re5re.%i#ite# (or the successful functioning of the convertible system conditions will have to be satisfied. &hese include! certain essential
0i1 6aintenance of domestic economic stability 0ii1 ,de%uate foreign exchange reserves iii1 +estrictions on inessential imports as long as the foreign exchange position is not very comfortable 0iv1 4omfortable current account position 0v1 ,n appropriate industrial policy and a conducive investment climate 0vi1 ,n outward oriented development strategy and sufficient incentives for export growth. Ex-erience# of Other Co%ntrie# &he experiences of other countries with currency convertibility present a fixed picture. Britain which introduced full convertibility in 5uly '-D. had to beat a hasty retreat the very next month because of large scale flight of capital. In '-EM Britain introduced restricted convertibility. *outh Horea which faced problems with partial convertibility in the beginning rescinded it in '-ME but ultimately restored it in '-M- and succeeded. (iji which introduced current account convertibility in '-ME made a retreat in '-M.. ,lthough Aakistan#s balance of payments crisis was more severe than that of India after the convertibility their rupee more or less stabilised. &he experience of countries like 6exico ,rgentina Aeru and 4hile have also been encouraging.
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