Exchange Rate and Types

EXCHANGE RATE

The value of one nation’s currency stated in terms of another nation’s currency is known as the foreign exchange rate, sometimes abbreviated as Forex Rate or just Exchange Rate. It’s the value of exchanging one currency for another. The local currency and the foreign currency are the two parts of an exchange rate. Interest rates, market speculation, geopolitical events and economic conditions are some of the factors that affect foreign currency rates. The nation’s central bank employs a variety of tools and monetary policies to maintain control over the foreign exchange rate and prevent a decline in the value of the national currency.

Factors influencing Exchange Rates

• Inflation Rates

• Low rate of Inflation: Appreciation in the value of currency

• High rate of Inflation: Decline in the worth of money.

• Interest Rate: Any increase in a nation’s interest rate raises the value of its currency since higher interest rates translate into higher rates for lenders, which draws in more foreign investment and drives up exchange rates.

• Recession: A recession causes a country’s economy to drop interest rates, reducing its ability to acquire foreign capital, weakening its currency, and lowering its exchange rates.

• Current Account/Balance of Payments: The trade balance and earnings from foreign investments are displayed in a nation’s current account. When a nation spends more on imports than its exports, it creates a deficit, which lowers its exchange rate and increases exports and domestic sales.

• Terms of Trade: A ratio that compares export and import prices is called terms of trade. An increase in export prices indicates higher demand, leading to increased revenue and currency value. Conversely, a lower price of exports decreases the currency’s value compared to its trading partners.

• Government Debt: Central government-owned government debt lowers inflation and foreign capital acquisition in nations with significant public deficits, which lowers the value of the nation’s exchange rate.

• Political Stability and Performance: The strength of a country’s currency is influenced by its political state

and economic performance. Countries with low political risk attract foreign investors, while those with high risk experience a depreciation in currency value. Increased foreign capital leads to currency appreciation.

TYPES OF FOREIGN EXCHANGE RATE SYSTEMS

Fixed Versus Floating Exchange Rates

The exchange rate between the currencies of two countries can be found using one of two fundamental systems: fixed exchange rates and floating exchange rates, often known as flexible exchange rates.

Fixed Exchange Rate

A fixed exchange rate system is implemented by a central bank or government, which links the official currency exchange rate of a nation to the value of gold or another nation’s currency. Some of the key features of this system are:-

Credibility is Paramount: In a fixed system, governments peg their currency to another strong currency (often the US dollar) or an asset like gold. This peg requires the government to be credible and maintain sufficient foreign reserves.

Vulnerable to Speculation: If market participants doubt the government’s ability to maintain the peg, they might speculate on a devaluation by selling the currency in large quantities. This can trigger a “speculative attack” forcing the government to devalue to avoid depleting reserves.

Fixed Exchange rate history through the Bretton Woods Agreement

The Bretton Woods system, set up in 1944, was a system of fixed exchange rates. Countries pegged their currencies to the US dollar, which in turn was pegged to gold at a fixed

price of $35 per ounce. This meant that countries had to buy and sell dollars to maintain this peg.

• The system started to show cracks in the 1960s. The US, which was running trade deficits, found it difficult to maintain its gold reserves. Other countries, like West Germany, were accumulating dollars due to their trade surpluses. This put pressure on the system.

• The final blow came in 1971 when US President Richard Nixon ended the convertibility of the dollar to gold. This effectively ended the Bretton Woods system and ushered in a new era of floating exchange rates, where currencies fluctuate based on supply and demand in the foreign exchange market.

Floating Exchange Rate

• A floating exchange rate system bases a nation’s currency’s

value on supply and demand in a private market run by large international banks, where one currency can be exchanged for another.

Countries (through Central Banks) still try to intervene and manipulate the price of their currency, as governments and central banks regularly work to keep it favourable for international trade.

In a system with floating exchange rates, long-term fluctuations in currency prices are a reflection of the relative strength of each nation’s economy and the differences in interest rates between them. Short-term fluctuations in a currency with a floating exchange rate are a reflection of speculative activity, rumours, calamities, and normal supply and demand. In the event that supply exceeds demand, the currency will depreciate, and vice versa.

Difference between Fixed and Flexible Exchange Rate

Managed Float Exchange Rate

The globe has transitioned to what is best referred to as a controlled floating exchange rate system without the need for any official international agreement. It combines elements of a fixed rate system (the managed component) and a flexible exchange rate system (the float part). This technique, often known as “dirty floating,” allows central banks to purchase and sell foreign currencies whenever they see fit in an effort to control fluctuations in exchange rates.

A central bank may interfere in a currency market that is typically free to float for a number of reasons.

Market Uncertainty: Central banks with a dirty float sometimes intervene to steady the market at times of widespread economic uncertainty.

Speculative Attack: Central banks sometimes intervene to support a currency that is under attack by a hedge fund or other speculator. For instance, a central bank might

discover that a hedge fund is accumulating speculative short positions because it is betting that its currency would decline significantly. To reduce how much the hedge fund devalues the currency, the central bank can buy a lot of its own money.

Nominal Effective Exchange Rate (NEER)

Nominal Effective Exchange Rate, or NEER is the precise quantity of local currency needed to purchase a foreign currency. In the Foreign Exchange Market (FOREX), the NEER measures a country’s competitiveness. FOREX traders often refer to it as the Traded Weight Currency Index. It illustrates the value of one domestic currency in relation to several foreign currencies. It is not calculated individually for each country. It indicates the performance of a currency compared to other foreign currencies. It can be influenced by many factors, but majorly it’s influenced by the international trade of a nation. There are no standard baskets of currency that are being used to evaluate NEER, different organizations put different currencies in the basket. However, some of the major currencies in the world are US Dollar, British Pound, Euro, Japanese Yen, Canadian Dollar, Australian Dollar, and the Swiss Franc.

• Calculation: An easy way to calculate the value of a foreign currency in a basket is to take the average of the entire value of imports and exports between two countries. The home currency is thought to be worth more than the comparative foreign currency if the NEER coefficient is higher. However, the value of the local currency in the basket is lower than the foreign currency if the NEER coefficient is lower.

Real Effective Exchange Rate (REER)

The Real Effective Exchange Rate (REER) indicates the competitiveness of the domestic currency with its major international trading currencies. It can be simply determined by the relative trade balance of domestic currency with other currencies in the basket. An increase in REER indicates that a nation is losing its competitiveness in international trade as its exports become expensive while imports get cheaper. For example, if the INR exchange rate gets weaker against the USD, then America will get cheaper exports. If an individual consumer or a business in the US buys goods from India, then they need to convert their USD into INR. Consequently, Americans receive more INR for each USD if the INR is weaker than the USD, which causes the INR’s value relative to the USD to decrease.

Purchasing Power Parity (PPP)

It aims to find the rate at which a basket of identical goods costs in both countries. India’s economy ranks third after China and USA globally in PPP terms.

Applications

“Basket of Goods” Approach: PPP uses a hypothetical basket of goods to compare currencies. It represents the exchange rate needed to buy the same basket in both countries.

International Income Comparison: PPP facilitates understanding and interpreting national income statistics by adjusting for purchasing power differences.

Economic Analysis: Economists leverage PPP to compare economic productivity and living standards between countries.

Example: Assume that the price of a pair of shoes in India is Rs. 2,500. When the dollar and rupee exchange rates reach 50, the price in America should be $50.

History of exchange rate regime of India

India’s exchange rate system has undergone a significant transformation since independence. Prior to joining the International Monetary Fund (IMF) in 1947, the rupee was

firmly linked to the British pound sterling. This “sterling exchange standard” ensured stability but limited flexibility.

Following IMF membership, the rupee’s value was initially tied to gold and then indirectly pegged to the US dollar through the Bretton Woods system. However, devaluations in 1949 and 1966 weakened the rupee against both the pound and gold. The collapse of the Bretton Woods system in the early 1970s ushered in a period of experimentation. The rupee transitioned from a dollar peg to a temporary peg with the pound, followed by a basket peg system that compared the rupee to currencies of India’s major trading partners.

In 1991, India embarked on economic liberalization. As part of this process, the basket peg was abandoned and replaced with a dual exchange rate system in 1992, also known as “Liberalized Exchange Rate Management” (LERM). This system featured both an official and a market-determined rate, with the US dollar becoming the intervention currency. Finally, in 1993, India transitioned to a fully floating exchange rate system called “Unified Exchange Rate System” where the rupee’s value fluctuates based on market forces. However, the Reserve Bank of India (RBI) still intervenes occasionally to manage volatility and curb excessive speculation.

Foreign Exchange Swap

A foreign exchange swap (also known as an FX swap) is an agreement to simultaneously borrow one currency and lend another at an initial date, then exchanging the amounts at maturity. It is useful for risk-free lending, as the swapped amounts are used as collateral for repayment. It has the following procedure:-

Leg 1 at the Initial Date: Parties swap currencies at the prevailing exchange rate on the initial date (i.e. Spot Rate).

Leg 2 at Maturity: Parties swap currencies at a predetermined forward rate at maturity so that each party receives the currency they loaned and returns the currency they borrowed at the forward rate. determined by consent based on the expectations of the relative appreciation/depreciation of the currencies.

Expectations stem from the interest rates offered by the currencies, as demonstrated in the interest rate parity. If currency A offers a higher interest rate, it is to compensate for expected depreciation against currency B and vice versa.

Foreign Exchange Swap vs Cross Currency Swap

The major difference between the two is interest payments. Every party to a cross-currency swap is required to make recurring interest payments in the currency that they are borrowing. Cross-currency swap parties lend the amount from their local bank and then swap the loans, in contrast to a foreign exchange swap where the parties own the amount they are switching.

Cross-currency swaps are therefore marginally riskier than foreign exchange swaps, which are riskless since the swapped amount serves as collateral for repayment. There is a risk of default if the counterparty fails to make interest payments or the required lump sum payment when the loan matures, which would mean the party is unable to repay the loan.

Currency Appreciation, Depreciation & Devaluation

The value of a currency, like any tradable good, can fluctuate.

Currency Depreciation: Means a decrease in the value of a domestic currency relative to foreign currencies. Exports become affordable as domestic goods become cheaper however imports become costlier. It is caused because:-

Easy Monetary Policy: Low interest rates and increased money supply can lead to inflation, weakening the currency.

High Inflation: Rising domestic prices erode the purchasing power of the currency.

Trade Deficit: A country consistently importing more than it exports can weaken its currency.

Political Unrest: Can cause unease in foreigners to invest in a country.

• Currency Appreciation: It is the increase in the value of a domestic currency relative to foreign currencies. Exports become less attractive as they become expensive, but foreign goods become affordable boosting imports. This is caused due to:

• Tight Monetary Policy: High interest rates attract foreign investment, strengthening the currency.

• Low Inflation: Stable prices maintain the purchasing power of the currency.

• Trade Surplus: A country consistently exporting more than it imports can strengthen its currency.

• Currency Devaluation: A deliberate government action to lower the value of its currency (often in a fixed or semi-fixed exchange rate system). It is done to boost exports which would help reduce trade deficit or to manage a debt burden as a weaker currency can make debt repayments (denominated in foreign currency) less expensive. However, it can have negative impacts like rise in inflation, loss of foreign investment due to loss of confidence in currency and possible currency war due to increase exports.

Hence, while depreciation and appreciation are natural market movements in a floating exchange rate system, Devaluation is a government intervention to achieve specific economic goals.

Currency War

Currency wars involve countries devaluing their currencies to gain a competitive advantage over other countries, it is also called competitive devaluation. When your country’s currency is devalued, exports become cheaper, and imports become more expensive. This might boost exports and discourage imports causing their trade balance to improve.

Case Study: In 2008, the US housing bubble burst and

triggered the Great Recession. Economies all around the world were affected. There was a need to stimulate economic growth by lowering interest rates. A by-product of lowering interest rates is a currency depreciating. Other nations retaliated by devaluing their own currencies because this was not in their best interests.

Currency Convertibility

Currency convertibility refers to the ease with which a domestic currency can be exchanged for foreign currency. It exists on a spectrum, ranging from:

Total convertibility: Freely exchange domestic currency for any other currency at market-determined rates. There are no restrictions on foreign transactions.

Total inconvertibility: Complete inability to exchange domestic currency for foreign currency since all foreign transactions are restricted.

Along this spectrum, the degree of convertibility of a currency can be identified by the effectiveness of exchange controls and restrictions and of quantitative or financial barriers to external transactions. It facilitates international trade and investment. Currency convertibility includes current account convertibility and capital account convertibility.

Current Account Convertibility: Means freedom to convert domestic currency into foreign currency and vice versa for trade in goods and invisibles (services, transfers or income from investment). Since 1993, India has had complete current account convertibility. It has the following advantages:-

Encouragement to exports: Market rate remains generally higher than the officially determined exchange rate. This implies that from given exports, exporter can get more rupee against foreign exchange. This will help to increase exports

• Encourages import substitution: Imports become expensive due to convertibility of rupee. So, it discourages imports and boosts import substitution.

• Incentive to remittances from abroad: Earlier, NRIs used to send money illegally to India such as Hawala money and gold etc. But due to removal of restrictions, NRIs can easily remit money to India. It will help to improve Balance of payment.

• Reduction in Malpractices: The malpractices like under- invoicing of exports may not arise as rupee is fully convertible and they will get full value for their exports

• A self– balancing mechanism: Another important merit of currency convertibility lies in its self-balancing mechanism. When balance of payments is in deficit due to over-valued exchange rate, under currency convertibility, the currency of the country depreciates which gives boost to exports by lowering their prices on the one hand and discourages imports by raising their prices on the other.

Capital Account Convertibility:

The Committee on Capital Account Convertibility (chaired by Dr. S. S. Tarapore), 1997 described it as the flexibility to convert domestic financial assets into international financial assets and vice versa at exchange rates fixed by the market is referred to as CAC.

• Advantages: There are many benefits of it as it attracts foreign investment, allows easy domestic investment abroad domestic companies can raise funds from international markets, while individuals can invest in a wider range of financial instruments.

• Disadvantages: However, it has some negatives as well since during the times when the financial markets of an economy are doing good, a country may receive huge foreign investment but they might just leave as quickly in bad creating instability in exchange rates and financial markets.

• Moving towards Full Capital Account Convertibility (CAC): There is partial capital account convertibility in India. The Tarapore Committee in 1997 laid out many preconditions and specific targets for India before moving to full capital account convertibility:-

• Fiscal Consolidation: Lowering government budget deficits to ensure fiscal responsibility.

• Inflation Targeting: Implementing a framework to maintain stable inflation levels.

• Strengthening the Financial System: Enhancing the robustness of banks and other financial institutions to manage potential risks associated with CAC. This includes reducing gross Non Performing Assets (NPA) etc.

• Adequate Forex Reserves: evaluating adequacy of foreign exchange reserves to safeguard against any contingency. Plus, a minimum net foreign asset to currency ratio should be maintained.

Monitoring Exchange Rate Band: By RBI of plus minus 5% around a neutral Real Effective Exchange Rate

Nostro & Vostro Accounts

Nostro Account: A bank that holds an account in a foreign currency with another bank is said to have a nostro account. The word “nostro” comes from Latin and means “our,” indicating that it is the bank’s own account abroad.

Vostro Account: When a local bank maintains an account denominated in its domestic currency for another bank. This bank (or an intermediary) facilitates wire transfers, conducts business, accepts deposits, and gathers documentation on behalf of the other bank. It facilitates domestic banks’ increased access to international financial markets and allows them to serve clients worldwide without physically being abroad.

Essentially, a Nostro account for one bank becomes a Vostro account for the other. They are two sides of the same coin, facilitating transactions between banks and their international clients.

Foreign Exchange Management Act (FEMA)

With India’s economy shifting in the wake of liberalization, the Foreign Exchange Regulation Act, or FERA of 1973, was replaced in 1999 by the Foreign Exchange Management Act.

Aims: It aims to boost economic growth, keep the currency stable, and stop illegal financial activities such as money laundering. FEMA regulates both current account transactions, involving routine activities like

trade and remittances, and capital account transactions, including investments.

• Improved Law: While FERA was perceived as a barrier to foreign investment in India, FEMA aims to encourage it by streamlining the laws and procedures pertaining to foreign exchange transactions. FEMA replaces erstwhile criminal jail time with civil monetary penalties for defaulters. FEMA harmonises India’s foreign exchange management practices with global standards, promoting international trade and collaboration.

AUTHORITIES

The Enforcement Directorate(ED) in Delhi serves as FEMA’s head office, overseeing its implementation.

Zonal Offices: Five zonal offices located in Delhi, Chennai, Mumbai, Jalandhar and Kolkata, each headed by a Deputy Director, coordinate enforcement activities regionally.

The Act also gives the RBI the authority to enact rules and regulations to implement its provisions. Penalties and fines may follow violations of FEMA’s regulations.