foreign exchange control and rates

Foreign Exchange Control: Definition, Objectives, Types and Conditions

1. Definition of Foreign exchange control 2. Objectives of Foreign Exchange Control 3. Types of Foreign Exchange Control 4. Conditions Necessitating Foreign Exchange Control.

Definition of Foreign Exchange Control:In modern times various devices have been adopted to control international trade and regulate international indebtedness arising out of international workings and dealings.

The spirit of economic nationalism induces every country to look primarily to its own economic interests. Foreign Exchange control is one of the devices adopted for the purpose.

Foreign Exchange control is a system in which the government of the country intervenes not only to maintain a rate of exchange which is quite different from what would have prevailed without such control and to require the home buyers and sellers of foreign currencies to dispose of their foreign funds in particular ways.

Definition:(1) “Foreign Exchange Control” is a method of state intervention in the imports and exports of the country, so that the adverse balance of payments may be corrected”. Here the government restricts the free play of inflow and outflow of capital and the exchange rate of currencies.

2. According to Crowther:

“When the Government of a country intervenes directly or indirectly in international payments and undertakes the authority of purchase and sale of foreign currencies it is called Foreign Exchange Control”.

3. According to Haberler:

“Foreign Exchange Control in the state regulation excluding the free play of economic forces for the Foreign Exchange Market”. The Government regulates the Foreign Exchange dealings by Consideration of national needs.

To be more clear, “Foreign Exchange Control means the monopoly of the government in the purchase and sale of foreign currencies in order to restore the balance of payments equilibrium and disregard the market forces in the decision of monetary authority”. When tariffs and quotas do not help in correcting the adverse balance of trade and balance of payments the system of Foreign Exchange Control is restored to by Governments.

Objectives of Foreign Exchange Control:Important objectives of Exchange Control are as follows:

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1. Correcting Balance of Payments:The main purpose of exchange control is to restore the balance of payments equilibrium, by allowing the imports only when they are necessary in the interest of the country and thus limiting the demands for foreign exchange up to the available resources. Sometimes the country devalues its currency so that it may export more to get more foreign currency.

2. To Protect Domestic Industries: The Government in order to protect the domestic trade and industries from foreign competitions, resort to exchange control. It induces the domestic industries to produce and export more with a view to restrict imports of goods.

3. To Maintain an Overvalued Rate of Exchange:This is the principal object of exchange control. When the Government feels that the rate of exchange is not at a particular level, it intervenes in maintaining the rate of exchange at that level. For this purpose the Government maintains a fund, may be called Exchange Equalization Fund to peg the rate of exchange when the rate of particular currency goes up, the Government start selling that particular currency in the open market and thus the rate of that currency falls because of increased supply.

On the other hand, the Government may overvalue or undervalue its currency on the basis of economic forces. In over valuing, the Government increases the rate of its currency in the value of other currencies and in under-valuing; the rate of its over-currency is fixed at a lower level.

4. To Prevent Flight of Capital:When the domestic capital starts flying out of the country, the Government may check its exports through exchange control.

5. Policy of Differentiation:The Government may adopt the policy of differentiation by exercising exchange control. If the Government may allow international trade with some countries by releasing the required foreign currency the Government may restrict the trade import and exports with some other countries by not releasing the foreign currency.

6. Other Objectives:Apart from the above there may be certain other objectives of exchange control.

They are:

(i) To earn revenue in the form of difference between selling and purchasing rates of foreign exchange;(ii) To stabilise the exchange rates;(iii) To make imports of preferable goods possible by making the necessary foreign exchange available; and(iv) To pay off foreign liabilities with the help of available foreign exchange resources.

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Types of Foreign Exchange Control:There may be five types of Exchange Control:

1. Mild System of Exchange Control:Under mild system of exchange control, also known as exchange pegging, the Government intervenes in maintaining the rate of exchange at a particular level. Under this system, the Government maintains on ‘Exchange Equalization Fund’ in foreign currencies.

The British Exchange Equalization Account and U.S. Exchange Stabilisation Fund were two examples of mild control. In case the demand for dollar goes up and as a result the value of pound falls, the U.K. Government would sell dollars for pounds and thus restrict the fall in the value of pound by increasing the supply of dollars.

2. Full Fledged System of Exchange Control:Under this system, the Government does not only Peg the Rate of Exchange but have complete control over the entire foreign exchange transactions. All receipts from exports and other transactions are surrendered to the control authority i.e., Reserve Bank of India. The available supply of foreign exchange is then allocated to different buyers of foreign exchanges on the basis of certain pre-determined criteria. In this way the Government is the sole dealer in foreign exchange.

3. Compensating Arrangement:A compensating arrangement per-takes of the character of the old-fashioned barter deal. An example would be the sale by India of cotton goods of a particular value to Pakistan, the latter agreeing to supply raw cotton of the same value to India at a mutually agreed exchange rate. Imports thus compensate for exports, leaving no balance requiring settlement in foreign exchange.

4. Clearing Agreement:A clearing agreement consists of an understanding by two or more countries to buy and sell goods and services to each other, at mutually agreed exchange rates against payments made by buyers entirely in their own currency.

The balance of outstanding claims are settled as between the central banks at the end of stipulated periods either by transfers of gold or of an acceptable third currency, or the balance might be allowed to accumulate for another period, pending an arrangement whereby the creditor country works of the balance by extra purchases from the other country.

5. Payments Arrangements:In a payments arrangement the usual procedure of making foreign payments through the exchange market is left intact. But each country agrees to establish a method of control whereby its citizens are forced to purchase goods and services from the other country in amounts equal to the latter’s purchase from the first country. Another type of payments agreement is one designed to collect past debts.

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Conditions Necessitating Foreign Exchange Control:The exchange control device is not effective in all cases. Only in selective cases, this measure of curbing imports is effective.

The following are conditions where exchange control can be resorted:

1. The exchange control is necessary and should be adopted to check the flight of capital. This is especially important when a country’s currency is under speculative pressure. In such cases tariffs and quotas would not be effective. Exchange control being direct method would successfully present the flight of capital of hot money.

2. Exchange control is effective only when the balance of payment is disturbed due to some temporary reasons such as fear of war, failure of crops or some other reasons. But if there are some other underlying reasons, exchange control device would not be fruitful.

3. Exchange Control is necessary when the country wants to discriminate between various sources of supply. Country may allow foreign exchange liberally for imports from soft currency area and imports from hard currency areas will be subject to light import control. This practice was adopted after Second World War due to acute dollar shortage.

Even in India, many import licenses were given for use in rupee currency areas only, i.e., countries with which India had rupee-trade arrangements. Thus in above cases, the exchange control is adopted. In such cases quotas and tariffs do not help in restoring balance of payment equilibrium.

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Foreign Exchange Rate: Meaning and Exchange Rate Determination

1. Meaning:If a Kashmiri shawl maker sells his goods to a buyer in Kanyakumari, he will receive in terms of Indian rupee.

This suggests that domestic trade is conducted in terms of domestic currency. But if the Indian shawlmaker decides to go abroad, he must exchange Indian rupee into franc 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 required in 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 cur-rency 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 exchange rate, say from 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, external value of the 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 all exchange rates but 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 US dollars and euros.

2. Exchange Rate Determination:Now two pertinent questions that usually arise in the foreign exchange market are to be answered now. Firstly, how is equilibrium exchange rate determined and, secondly, why exchange rate moves 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

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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 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.

A. Demand-Supply Approach of Foreign Exchange, Or BOP Theory of Foreign Exchange:

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

(a) Demand for foreign exchange:

When Indian people and business firms want to make payments to the US nationals for buying 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 is the sources of demand for foreign exchange. The larger the volume of imports the 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 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 price of dollar rises (i.e., dollar appreciates) then foreign goods will 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 direction, the importing country’s demand curve for foreign exchange is downward sloping from left to right.

In Fig. 5.4, 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

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foreign currency (i.e., dollar per rupee) on the vertical axis. This makes demand curve for foreign exchange negative sloping.

If exchange rate is expressed in terms of foreign currency that could be purchased with 1 unit of domestic currency (i.e., dollar per rupee), the demand curve would then exhibit positive slope. Here we have chosen the former one.

(b) Supply of foreign exchange:

In a similar fashion, we can determine supply of foreign exchange. Supply of foreign currency comes from its 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 demand and supply curves together to determine foreign ex-change rate. The equilibrium exchange rate is determined at that point where demand for foreign exchange equals supply of foreign exchange. In Fig. 5.4, DD1 and SS1 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.

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Suppose that at the rate OP, Rs. 50 = $1, demand for foreign exchange is matched by the supply of foreign exchange. If the current exchange rate OP1 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., OP2. Thus, banks would experience a shortage of dollars to meet the demand. 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 change in supply forces is, thus, illustrated in Fig. 5.5.

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Let us assume that national income rises. This results in an increase in the 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 from OP1 to OP2 determined by the intersection of new demand curve and supply curve. Note that dollar appreciates from Rs. 50 = $1 to Rs. 53 = $1, while rupee depreciates from $1 = Rs. 50 to $1 = Rs. 53.

Similarly, if supply curve shifts from SS1 to SS2, as shown in Fig. 5.6, new exchange rate thus determined would be OP2. 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.

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This is the balance of payments theory of exchange rate determination. Wherever government does not intervene in the market, a floating or a flexible exchange rate prevails. Such system may not necessarily be ideal since frequent changes in demand and supply forces cause frequent as well as violent changes in 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 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 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 demand for and 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.

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Foreign Exchange Rate and Foreign Exchange Market in India

The article provides an explanation of foreign exchange rate and foreign exchange market in India.

Introduction:It may be noted that the foreign exchange is the name given to any foreign currency.

Thus US dollars or British pounds are foreign exchange for India. Further, the exchange rate is the price of a country’s currency in terms of another country’s currency. Thus, at present (Aug. 30, 2013) one US dollar is exchanged for about 65.70 rupees of India (the spot exchange rate). Thus 65.70 Indian rupees for one US at present dollar is the exchange rate of a dollar in terms of rupees.

In the above table we give the exchange rates of Indian rupee in terms of currencies of some important countries of the world. It will be seen from the above table that there has been a lot of volatility in the exchange rate of rupee. There had been 15 per cent appreciation of Indian rupee vis-a-vis US Dollar between Oct. 2006 and Dec. 2007. Beyond Jan.2008, rupee started depreciating under pressure of capital outflows by FIIs and it fell to Rs.49.44 to a US dollar on Nov. 27, 2008.

From later half of2009-10 to Aug. 2011, as a result of return of capital flows to India, rupee started appreciating and its value rose to around Rs. 45 to a US dollar at end-Aug. 2011. However, again from Sept. 2011 due to Eurozone sovereign debt crisis there had been large capital outflows by FIIs from India (and other emerging economies) resulting in drastic depreciation of Indian rupee which fell to even Rs. 54 to a US dollar on Dec. 15, 2011.

But due to intervention of RBI by way of selling dollars in the foreign exchange market from its foreign exchange reserves, the value of rupee fluctuated within range of Rs 52 to Rs.53 to a US dollar between December 16, 2011 and January 13, 2012. It will be seen that Indian rupee depreciated against currencies of all countries in

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March 5, 2013 except Japan. On March 5, 2013, value of rupee was 54.9 rupees per US dollar.

However, a very large depreciation of rupee has occurred since May 22, 2013. In the month of June 2013, the rupee fell from to around Rs. 56 to a US dollar in the first week of June 2013 to Rs. 60 to a dollar in the end of June 2013 and hit very level of Rs.61.21 to a dollar on July 8, 2013. The RBI intervened by selling US dollars from its foreign exchange reserves and took steps to discourage the import of gold so as to reduce the demand for dollars.

The Finance Minister also raised the duty on gold, first from 6% to 8% and then to 10% to restrict the imports of gold to check further depreciation of rupee. However, despite these measures, depreciation of rupee continued and the value of rupee hit a record of Rs. 68.83 to a US dollar on Aug. 28, 2013. Then with aggressive intervention by the RBI through sale of dollars from its foreign exchange reserves and as a result the value of rupee rose to Rs.65.70 to a dollar on Aug. 30, 2013. That is, about 18% fall in the value of rupee from early June 2013.

Both domestic and external factors are responsible for this sharp depreciation of rupee since May 2013. The domestic factor responsible for this steep slide of rupee has been the emergence of large current account deficit (CAD) which was estimated at $ 88 billion in 2012-13 (4.8% of GDP of the year) due to sluggish exports and rise in imports causing a net increase in demand for US dollars over their supply.

The external factor which triggered the sharp depreciation of rupee was the an-nouncement by the governor of the US Reserve System in May 2013 that since the US economy had recovered, he would start the unwinding of the policy of quantitative easing (QE) under which it was purchasing bonds worth $ 85 billion per month from the market to revive the US economy. This triggered capital outflows by FIIs from the emerging economies including India. These capital outflows on a large scale from India contributed to the sharp slide in the exchange rate of rupee.

Floating (Flexible) and Fixed Exchange Rate System:Since exchange rate is a price, its determination can be explained through demand for and supply of currencies. Suppose we consider the transactions between two countries, India and USA. In this case therefore the demand for and supply of dollar is the demand for and supply of foreign exchange from the Indian perspective and the price of a US dollar in terms of Indian rupees or a number of dollars per Indian rupee is the exchange rate.

The system of exchange rate in which the value of a currency is allowed to adjust freely or to float as determined by demand for and supply of foreign exchange is called a flexible exchange system which is also known as floating exchange system.

On the other hand, if the exchange rate instead of being determined by demand for and supply of foreign exchange is fixed by the Government, it is called the fixed exchange rate system which prevailed in the world under an agreement reached at Bretton Woods in New Hampshire in July 1944. It may be noted that under the fixed exchange rate system, exchange rate is not determined by demand for and supply of foreign exchange but is pegged at a certain rate.

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At the fixed exchange rate, if there is disequilibrium in the balance of payments giving rise to either excess demand or excess supply of foreign exchange, the Central Bank of the country has to buy and sell the required quantities of foreign exchange to eliminate the excess demand or supply.

In 1977 USA decided to float its dollar and switched over to the flexible exchange system resulting in the collapse of Bretton Woods System of fixed exchange rate. Both the floating (flexible) and fixed exchange rate system have their merits and demerits.

Appreciation and Depreciation of Currencies:It is important to explain the meanings of the terms, appreciation and depreciation, of currencies which are often mentioned in the discussion of foreign exchange rate. Let us consider the exchange rate of rupee for dollar. Appreciation of a currency is the increase in its value in terms of another foreign currency.

Thus, if the value of a rupee in terms of U S dollar increases from Rs. 45.50 to Rs. 44 to a dollar, Indian rupee is said to appreciate. This indicates strengthening of the Indian rupee. Note that when Indian rupee in dollar terms appreciates, the dollar would depreciate.

On the other hand, if the value of Indian rupee in terms of US dollars falls, say from Rs. 45.5 to Rs. 46 to a dollar, the Indian rupee is said to depreciate which shows the weakening of Indian rupee. Thus, under a flexible exchange system, the exchange value of a currency frequently appreciates or depreciates depending upon the demand for and supply of a currency.

In a fixed exchange rate system the government has to buy or sell foreign exchange in order to maintain the rate at the controlled level. However, even under the fixed exchange rate system, the value of one’s currency can be changed only occasionally. For instance, in June 1966, the value of rupee in terms of US dollar and U.K’s, pound sterling was lowered. Again in July 1991 India reduced its value of rupee in terms of dollar by about 20 per cent.

Such a one-time lowering of value of its currency in terms of foreign exchange occasionally by a country is called devaluation as distinguished from depreciation which can often take place under the influence of changes in demand for and supply of a currency.

On the other hand, with a fixed rate exchange system if a country raises the value of its currency in terms of foreign currency, it is called revaluation. It should be noted that since March 1993 India has also now made its rupee convertible into a foreign currency and allowed its value to adjust freely depending upon demand and supply forces.

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Foreign Exchange Rate in India

This article provides an essay on foreign exchange rate in India.

Introduction:Related to the problem of balance of payments is the macro issue of foreign exchange rate.

The balance of payments is influenced by the foreign exchange rate. Exchange rate is the value of national currency in terms of a foreign currency. Thus, currently (September 20,2013) one US dollar is exchanged for around Rs. 62.

Thus Rs. 62 to a dollar is the foreign exchange rate of rupee in terms of US dollars. Changes in foreign exchange rate affect the prices of exports and imports which in turn determine their volume and thereby determine balance of payments of a country. Since exchange rate is a price, its determination can be explained through demand for and supply of foreign exchange.

However, in the long run the foreign exchange rate between the two currencies is determined by the purchasing powers of the two currencies in the domestic economies. In the short run, the demand for imports and exports of goods and services (that is, both visible and invisible items), magnitude of capital flows between the countries affects demand for and supply of foreign exchange and thereby determine the exchange rate between the currencies.

The system of exchange rate in which the value of a currency is allowed to adjust freely or to float as determined by demand for and supply of foreign exchange is called a flexible exchange rate system. The flexible exchange rate system is also called floating exchange system. At present, in most of the countries of the world (including India), the flexible exchange rate system prevails.

On the other hand, if foreign exchange rate, instead of being determined by demand for and supply of foreign exchange, is fixed by the government, it is called the fixed exchange rate system which prevailed in the world under an agreement reached at Bretton Woods in New Hampshire in July 1944. Therefore, fixed exchange rate is also often called Bretton Woods System.

Under the Bretton Woods fixed exchange rate system, exchange rate is not determined by demand for and supply of foreign exchange but is pegged at a certain rate. At the fixed exchange rate, if there is disequilibrium in the balance of payments giving rise to either excess demand or excess supply of foreign exchange, the Central Bank of the country has to buy or sell the required quantifies of foreign exchange to eliminate the excess demand or supply. But in the mid seventies Bretton Woods system of fixed exchange rate system in which US dollar played a key role collapsed as the USA could not keep constant the price of US dollar in terms of gold.

In a fixed exchange rate system the government has to buy or sell foreign exchange in order to maintain the rate at the controlled level. However, under the fixed exchange rate system, the value of one’s currency can be changed occasionally. For

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instance, in June 1966, the value of rupee in terms of US dollar and U.K’s pound sterling was lowered.

Again in July 1991 India reduced its value of rupee in terms of US dollar by about 20 per cent. Such a one-time lowering of value of its currency in terms of foreign exchange occasionally by a country is called devaluation as distinguished from depreciation which under flexible exchange rate system can often take place under the influence of changes in demand for and supply of a currency.

On the other hand, with a fixed rate exchange system if a country raises the value of its currency in terms of foreign currency, it is called revaluation. It should be noted that since March 1993 India has adopted flexible exchange rate system and has also now made its rupee convertible into a foreign currency.

In fact, at present the Indian rupee can appreciate or depreciate every day depending on the demand for and supply of US dollar and other foreign currencies and demand for and supply of the Indian rupee.

Foreign Exchange Rate, Balance of Payments and Capital Inflows and Outflows:Changes in foreign exchange rate have an important effect on the balance of payments of a country. When there is depreciation or devaluation in the currency of a country, its exports become cheaper and imports costlier than before.

This causes exports to increase and imports to decrease causing reduction in deficit in balance of payments. Thus in order to check increase in deficit in balance of payment and to restore equilibrium in it, devaluation or depreciation of the domestic currency against foreign currencies is often undertaken.

Besides, the foreign exchange inflows in various forms such as those resulting from rising exports, portfolio investment by FIIs (Foreign Institutional Investors), foreign direct investment (FDI) not only causes appreciation of exchange rate of the domestic currency but also leads to the increase in money supply in the economy and therefore inflationary situation in the country.

Thus higher appreciation in the value of rupee against US dollar in 2007-08 in India was the direct result of large capital inflows in India. The price of Indian rupee against US dollar rose from around Rs. 45 in January 2007 to 39.5 in Sept. 2007, that is, over 11 per cent appreciation in the year 2007 alone.

This appreciation of rupee was driven by foreign exchange inflows partly by rising software exports but more importantly inflows by FIIs coming in large quantity to take advantage of the stock market boom in India. Besides, foreign exchange inflows through NRI deposits lured by higher interest rates in India than those prevailing in their country of residence took place. Further, large capital inflows through foreign direct investment (FDI) in India also increased in 2006-07 and 2007-08.

These large inflows of foreign exchange in India through its effect on the supply of dollars in foreign exchange market would have caused a very high appreciation of rupee vis-a-vis US dollar but RBI did buy some dollars from market from time to time

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to prevent it and built up reserves of foreign exchange. But RBI could not buy dollars as fast as the large inflows came in. This resulted in appreciation of rupee in 2007-08. RBI could not ensure foreign exchange rate stability in situation of large capital inflows by buying sufficient amount of dollars from the market.

Again in Sept. 2011 there had been large capital outflows from the Indian economy resulting in increase in demand for US dollars and therefore depreciation of Indian rupee. The value of Indian rupee which was Rs. 43 to a US dollar in July 2011 declined to around Rs. 53 to a US dollar in the second week of December 2011. To prevent excessive depreciation of the Indian rupee RBI intervened and sold US dollars from its foreign exchange reserves.

Further from May 2013 FIIs started withdrawing capital from debt market and capital markets as a result of which demand for US dollars rose for sending it for investment in the US. This was triggered by the statement of the governor Ben Bernanke of the US Federal Reserve that as the US economy had revived; it would start unwinding the quantitative easing (QE) which was adopted to give stimulus to the US economy.

This led to capital outflows from the emerging economies including India to the US. Besides, India’s large current account deficit which was estimated at a very high level of 4.8 per cent of GDP in 2012-13 was caused by rapid growth of imports, especially of gold and crude oil on the one hand and stagnant exports on the other also lead to the net increase in demand for US dollars. In the months of May and June 2013 about 9 billion US dollars were withdrawn from India and contributed to capital outflows from India.

Thus large capital outflows by FIIs and large current account deficit (CAD) led to the sharp depreciation of the value of Indian rupee which was around Rs. 56 to a US dollar in the first week of June 2013 fell to 61.21 to a US dollar on July 8, 2013 and further hit a record low level Rs. 68.83 to a US dollar on August 28, 2013. This prompted Reserve Bank of India to take steps to squeeze liquidity in the Indian banking system whose funds were being used for speculative activities in the foreign exchange market.

Though depreciation of a currency is considered to be desirable as it boosts exports and reduces imports. But a sharp depreciation of rupee in the present macro-economic situation has a serious consequence. Not only will it make imports costlier and fuel another round of inflation, it will also restrain the RBI from pushing through the cuts in repo rate and cash reserve ratio urgently needed for kick-starting investments and boosting growth Breaking out of this policy logjam requires that the government should curtail current account deficit (CAD) by taking steps to boost exports by increasing its competitiveness and undertaking its diversification and also cut imports by imposing high tariffs on luxury imports, as it has already raised imports duty on gold from 6% to 10%. Besides, it should make reforms in foreign direct investment policy so that stable capital inflows are attracted to the Indian economy.

It follows from above that portfolio capital flows result in a lot of instability in foreign exchange rate of rupee which adversely affects our real economy through its effects on our exports and imports. Dr. Manmohan Singh who is considered as votary of

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globalisation in its address to the United Nations General Assembly in Sept. 2011 called the attention of world leaders to its risks. He said, “Today we are being called upon to cope with negative dimension of globalisation and global inter-dependence”.

He further said that US, Europe and Japan faced with economic slowdown are affecting confidence in world financial and capital markets creating a lot of economic instability which has a negative impact on emerging economies like India. He added that world had taken for granted the benefits of globalisation and it is time that UN asks its development agencies (World Bank, IMF) to ensure inclusive and sustainable development for vast sections of humanity.

He rightly warned against protectionist measures as a response to the global economic crisis, which he said has “deepened even further since 2008, in many respects.” Calling for better coordination of macroeconomic policies of major economies, Singh said: “We should not allow the global economic slowdown to become a trigger for building walls around ourselves through protectionism or erecting barriers to movement of people, services and capital.”

Another conclusion which follows from above is that there is a clash between foreign exchange rate stability and domestic price stability and RBI has been attempting to strike a balance between foreign exchange rate stability and domestic price stability. If in order to ensure foreign exchange rate stability RBI mops up sufficient dollars, it will result in pumping large sum of Indian rupees into the economy which will lead to the large increase in money supply causing a high rate of inflation.

If to check inflation and ensure price stability, it does not mop up dollars from the market and let dollar inflows, this will result in appreciation of rupee. Thus it has to strike a balance in buying dollars from the market so as to check inflation one the hand and to prevent too much appreciation of rupee. It is important to note that appreciation of rupee adversely affects India’s exports and leads to loss of jobs.

Appreciation of rupee also makes imports cheaper causing increase in them. Fall in exports and rise in imports adversely affects balance of payments on current account. However, more imports brought in through appreciation of rupee adds to aggregate supply of output and help in controlling inflation. On the other hand, too much depreciation of rupee is also bad because it makes imports costlier, especially of fuel oil. Higher value of imports also adversely affects balance payments.

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foreign exchange control and rates

Law