Economics Project Class 12 (Foreign Exchange Markets)
1. 1) COVER PAGE
2) CERTIFICATE
3) ACKNOWLEDGMENT
I am extremely overwhelmed in all the humbleness and
gratefulness to acknowledge my depth to all those who have
helped me put all those ideas well above the level of simplicity
and into something concrete.
I would like to express my special thanks of gratitude to my
teacher Mrs. Modini Srinivas who gave me the golden opportunity
to do this wonderful project which helped me in a lot of research
and made me more knowledgeable on the topic than before. To
complete this project without the help of my teachers and friends
& family’s support was next to impossible. Thank you for
everything.
2. INTRODUCTION
The foreign exchange market is a global decentralized or over-
the-counter market for the trading of currencies. This market
determines foreign exchange rates for every currency. It includes
all aspects of buying, selling and exchanging currencies at current
or determined prices. In terms of trading volume, it is by far the
largest market in the world with an average daily volume of above
5 trillion US Dollars.
Foreign exchange market is the market in which foreign
currencies are bought and sold. One sells goods abroad on a rate
which is completely determined by this market. The buyers and
sellers include individuals, firms, foreign exchange brokers,
commercial banks and the central bank. Like any other market,
foreign exchange market is a system, not a place. The currencies
are sold in the market like any other securities. The transactions
in this market are not confined to only one or few foreign
currencies. In fact, there are a large number of foreign currencies
which are traded, converted and exchanged in the foreign
exchange market. Tonnes of people make a living out of the
trading in the foreign exchange markets.
3. 1.1 AIM & OBJECTIVES
1.2 RELEVANCE TO THE SUBJECT
Foreign exchange is the trading of different currencies or units of
account. It is important because the exchange rate, the price of one
currency in terms of another, helps to determine a nation’s economic
health and hence the well being of all the people residing it.
1.3 METHODOLOGY OF THE STUDY
2.0 PROJECT DETAILS:
2.1 HISTORY
The Foreign Exchange Market was evolved from the Bretton
Woods System, which was a system of payments based on USD,
which defined all the currencies in relation of the USD. It was
towards the end of the World War II which made the US Dollar
more stable and was effectively the world currency, a currency to
which other currencies were pegged. The US Dollar was serving
as the price of gold as it was considered “as good as gold”.
This system went on from 1944 to 1971 when the Bretton Woods
Agreement broke down and the modern foreign exchange was
born.
4. 2.2 TYPES OF FOREIGN EXCHANGE RATES:
[A]Floating rates:
The floating rate is one of the
primary reasons for fluctuation of
currency in foreign exchange
market. This is one of the most
important common and main type of
exchange rate. Under this all the
economies of developed countries
allow their currency to flow freely.
When the value of the currency
becomes low it makes the imports
more as it becomes cheaper for the exporters, so the countries
domestic goods and services are demanded more in foreign
buyers. The country can withstand the fluctuation only if the
economy is strong. When the country’s economy is able to meet
the demand, only then it can adjust between the Foreign trade
and domestic trade automatically.
[B]Fixed Rates
Fixed exchange rates are used to attract the foreign investments
and to promote foreign trade. This type of rate is used only by
small developed countries. The purpose of fixed exchange rate
system is to keep a currency’s value
within a narrow band. Fixed
exchange rates provide greater
certainty for exporters and importers
and help the government maintain
low inflation. On the other hand,
monetary policy of the country
becomes ineffective. The exchange
value of the currency does not move.
This Normally reduces the country’s
currency against foreign currencies.
5. [C]Pegged Rates
Pegged exchange rates are common for underdeveloped
countries and developing countries. It
means that the currency of that
particular economy is pegged to
some other currency or a bunch of
other currencies. This makes
their currency more stable as
the other currencies. The Indian
Rupee was once pegged to the
British Pound Sterling and the US dollar as
well.
[D]Managed Floating
A managed floating exchange rate is a regime that allows an
issuing central bank to intervene regularly in Foreign Exchange
markets in order to change the direction of the currency's float
and shore up its balance of payments in excessively volatile
periods. This regime is also known as a “dirty float”.
6. 2.3WHY IS THE FOREIGN EXCHANGE MARKET UNIQUE?
1) Its huge trading volume is one of the highest in the whole
world and is representing the largest asset class in the
world leading to high liquidity.
2) It’s geographical dispersion- it is spread across each and
every economy in the world.
3) It is functioning 24 hours except for the weekends
4) A variety of factors affect the exchange rates.
5) As such, it is considered the closest to the ideal market of
perfect competition.
2.4 ADVANTAGES AND DISADVANTAGES OF FOREIGN
EXCHANGE MARKET.
Advantages
1) The forex market is extremely liquid; hence it’s rapidly
growing popularity. Currencies may be converted when
bought or sold without causing too much movement in the
price and keeping losses to a minimum.
2) As there is no central bank, trading can take place anywhere
in the world and operates on a 24-hour basis apart from
weekends.
3) An investor needs only small amounts of capital compared
with other investments. Forex trading is outstanding in this
regard.
4) It is an unregulated market, meaning that there is no trade
commission overseeing transactions and there are no
restrictions on trade.
7. 5) In common with futures, forex is traded using a “good faith
deposit” rather than a loan. The interest rate spread is an
attractive advantage.
Disadvantages
1) The major risk is that one counterparty fails to deliver the
currency involved in a very large transaction. In theory at
least, such a failure could bring ruin to the forex market as a
whole.
2) Investors need a lot of capital to make good profits because
the profit margins on small-scale trades are very low.
2.5 FINANCIAL INSTRUMENTS FOR FOREIGN
EXCHANGE MARKETS
Simply stated, a Financial Instrument is any type of a financial
medium such as bills of exchange, bonds, currencies, stocks,
etc., that are used for borrowing purposes in financial markets.
When you are discussing the forex market, the following entities
are designated as financial instruments:
[A]Forwards: It the agreement established between two parties
wherein they purchase, sell, or trade an asset at a pre-agreed
upon price is called a forward or a forward contract. Normally,
there is no exchange of money until a pre-established future date
has been arrived at. Forwards are normally performed as a
hedging instrument used to either deter or alleviate risk in the
investment activity.
8. [B]Futures: It is a forward transaction that contains standard
contract sizes and maturity dates are considered futures. Futures
are traded on exchanges that have been created for that purpose
exclusively. Just like with commodity markets, a future in the forex
market normally designates a contract length of 3 months in
duration. Interest amounts are also included in a futures contract.
[C]Options: Options are derivatives (financial instruments whose
values fluctuate based on underlying variables) wherein the
owner has the right to, but is not necessarily obligated to,
exchange one currency for another at a pre-agreed upon rate and
a specified date. When you talk about options in any form (stock
market, forex, or any other market), the forex market is the
deepest and largest, as well as the most liquid market of any
options in the world.
[D]Spot: Where futures contracts normally employ a 3-month
timeframe, spot transactions encompass a 48-hour delivery
transaction period.
[E]Swap: Currency swaps are the most common type of forward
transactions. A swap is a trade between two parties wherein they
exchange currencies for a pre-determined length of time. The
transaction then is reversed at a pre-agreed upon future date.
Currency swaps can be negotiated to mature up to 30 years in the
future, and involve the swapping of the principle amount. Interest
rates are not "netted" since they are denominated in different
currencies.
All of these instruments are used by almost each exporter or
importer one way or other in order to assist the hedging activities.
Let us understand this with the help of an example:
A is an Importer from India and imports goods worth of $10000
from The United States of America.
A doesn’t want to bear any foreign exchange rate fluctuation risk.
9. A goes to a bank(say HDFC Ltd.) and buys $10000 from there.
The bank will charge a nominal fee in exchange of the service
and A will have to pay the amount according to the current
exchange rate i.e. 75 amounting to Rs. 7,50,000.Let us assume
that the payment terms are of 3 months.
News are that the rupee might get depreciated in the next few
moths to Rs 80 a Dollar. But as A has bought $10000 from HDFC
Ltd. from say futures market, He doesn’t have to worry about the
fluctuation. After three months, A’s client will receive money from
the importer and get the money booked as per the exchange rate
earlier, i.e. 750,000 Rs.
This is the way people hedge their Accrued Incomes…
2.6 VARIOUS PARTICIPANTS OF THE FOREIGN
EXCHANGE MARKET:
Governments:
Governments have requirements for foreign currency, such as
paying staff salaries and local bills for embassies abroad, or for
arraigning a foreign currency credit line, most often in dollars, for
industrial or agricultural development in the third world, interest on
which, as well as the capital sum, must periodically be paid.
Foreign exchange rates concern governments because changes
affect the value of product and financial instruments, which affects
the health of a nation’s markets and financial systems.
Banks:
There are different types of banks, all of which engage in the
foreign exchange market to greater or lesser extent. Some work
to signal desired movement in the market without causing overt
change, while some aggressively manage their reserves by
10. making speculative risks. The vast majority, however, use their
knowledge and expertise is assessing market trends for
speculative gain for their clients.
Brokerage Houses:
These exist primarily to bring buyer and seller together at a
mutually agreed price. The broker is not allowed to take a position
and must act purely as a liaison. Brokers receive a commission
from both sides of the transaction, which varies according to
currency handled. The use of human brokers has decreased due
mostly to the rise of the interbank electronic brokerage systems.
International Monetary Market:
The International Monetary Market (IMM) in Chicago trades
currencies for relatively small contract amounts for only four
specific maturities a year. Originally designed for the small
investor, the IMM has grown since the early 1970s, and the major
banks, who once dismissed the IMM, have found that it pays to
keep in touch with its developments, as it is often a market leader.
Money Managers:
These tend to be large New York commission houses that are
often very aggressive players in the foreign exchange market.
While they act on behalf of their clients, they also deal on their
own account and are not limited to one time zone, but deal
around the world through their agents.
Corporations:
Corporations are the actual end-users of the foreign exchange
market. With the exception only of the central banks, corporate
players are the ones who affect supply and demand. Since the
corporations come to the market to offset currency exposure they
permanently change the liquidity of the currencies being dealt
with.
11. Retail Clients:
This includes smaller companies, hedge funds, companies
specializing in investment services linked by foreign currency
funds or equities, fixed income brokers, the financing of aid
programs by registered worldwide charities and private
individuals. Retail investors trade foreign exchange using highly
leveraged margin accounts. The amount of their trading in total
volume and in individual trade amounts is dwarfed by the
corporation’s anointer bank markets.
Exchange Brokers:
Services of brokers are used to some extent, Forex market has
some practices and tradition depending on this the residing in
other countries are utilised. Local brokers can conduct Forex
transactions as per the rules and regulations of the Forex
governing body of their respective country.
Overseas Forex market:
The Forex market operates all around the clock and the market
day initiates with Tokyo and followed by Bahrain Singapore, India,
Frankfurt, Paris, London, New York, and Sydney before things are
back with Tokyo the next day
Speculators:
In order to make profit on the account of favourable exchange
rate, speculators buy foreign currency if it is expected to
appreciate and sell foreign currency if it is expected to depreciate.
They follow the practice of delaying covering exposures and not
offering a cover till the time cash flow is materialized.
Other financial institutions involved in the foreign exchange
market include:
1. Stock brokers Commodity
2. Firms Insurance
3. Companies Charities
4. Private Institutions & Individuals
12. 2.7CHARACTERISTICS OF THE FOREX MARKETS:
Changing Wealth:
The ratios between the currencies of two countries are exchange
rates in forex. If one currency loss its value in the market and at
the same time the value of the currency increases this causes the
fluctuations in the exchange rate in foreign exchange market.
For Example, over 20 years ago a single US dollar bought 360
Japanese Yen, whereas at present 1 US dollar buys 110
Japanese Yen; this explains that the Japanese Yen has risen in
value, and the US dollar has decreased in value (relative to the
Yen). This is said to be a shift in wealth, as a fixed amount of
Japanese Yen can now purchase many more goods than two
decades ago.
No Centralized Market:
The foreign exchange market does not have a centralized market
like a stock exchange. Brokers in the foreign exchange market
are not approved by a governing agency. Business network and
operation market of foreign exchange takes place without any
unification in transaction. Foreign exchange currency trading has
been reformed into a non-formal and global network organization
it consists of advanced information system. Trader of forex should
not be a member of any organization.
Circulation of work:
Foreign exchange market has member from all the countries,
each country has different geographical positions so forex
operates all around the clock on working days (i.e.) Monday to
Friday every week. Because the time in Australia is different than
in European countries, this kind of 24 hours operation, free from
any time is an ideal environment for investors. For instance, a
13. trader may buy the Japanese Yen in the morning at the New York
market, and in the night if the Japanese Yen rises in the Hong
Kong market, the trader can sell in the Hong Kong market. More
number of opportunities is available for the forex traders. In
FOREX market most trading takes place in only a few currencies;
the U.S. Dollar ($), European Currency Unit (€), Japanese Yen
(¥), British Pound Sterling (£), Swiss Franc
2.8 FACTORS AFFECTING MOVEMENT OF
EXCHANGE RATES
Aside from factors such as interest rates and inflation, exchange
rate is one of the most important determinants of a country's
relative level of economic health. Exchange rates play a vital role
in a country's level of trade, which is critical to every free market
economy in the world. For this reason, exchange rates are among
the most watched analyzed and governmentally manipulated
economic measures. But exchange rates matter on a smaller
scale as well: they impact the real return of an investor's portfolio.
Here we look at some of the major forces behind exchange rate
movements. Before we look at these forces, we should sketch out
how exchange rate movements affect a nation's trading
14. relationships with other nations. A higher currency makes a
country's exports more expensive and imports cheaper in foreign
markets; a lower currency makes a country's exports cheaper and
its imports more expensive in foreign markets. A higher exchange
rate can be expected to lower the country's balance of trade,
while a lower exchange rate would increase it. Numerous factors
determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates
are relative, and are expressed as a comparison of the currencies
of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note
that these factors are in no particular order; like many aspects of
economics, the relative importance of these factors is subject to
much debate.
Differentials in Inflation:
As a general rule, a country with a consistently lower inflation rate
exhibits a rising currency value, as its purchasing power
increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan,
Germany and Switzerland, while the U.S. and Canada achieved
low inflation only later. Those countries with higher inflation
typically see depreciation in their currency in relation to the
currencies of their trading partners. This is also usually
accompanied by higher interest rates.
Differentials in Interest Rates:
Interest rates, inflation and exchange rates are all highly
correlated. By manipulating interest rates, central banks exert
influence over both inflation and exchange rates, and changing
interest rates impact inflation and currency values. Higher interest
rates offer lenders in an economy a higher return relative to other
countries. Therefore, higher interest rates attract foreign capital
15. and cause the exchange rate to rise. The impact of higher interest
rates is mitigated, however, if inflation in the country is much
higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing
interest rates - that is, lower interest rates tend to decrease
exchange rates.
Current-Account Deficits:
The current account is the balance of trade between a country
and its trading partners, reflecting all payments between countries
for goods, services, interest and dividends. A deficit in the current
account shows the country is spending more on foreign trade than
it is earning, and that it is borrowing capital from foreign sources
to make up the deficit. In other words, the country requires more
foreign currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand for its
products. The excess demand for foreign currency lowers the
country's exchange rate until domestic goods and services are
cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests.
Public Debt:
Countries will engage in large-scale deficit financing to pay for
public sector projects and governmental funding. While such
activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors.
The reason? A large debt encourages inflation, and if inflation is
high, the debt will be serviced and ultimately paid off with cheaper
real dollars in the future. In the worst case scenario, a
government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation.
Moreover, if a government is not able to service its deficit through
domestic means (selling domestic bonds, increasing the money
supply), then it must increase the supply of securities for sale to
foreigners, thereby lowering their prices. Finally, a large debt may
16. prove worrisome to foreigners if they believe the country risks
defaulting on its obligations. Foreigners will be less willing to own
securities denominated in that currency if the risk of default is
great. For this reason, the country's debt rating (as determined by
Moody's or Standard& Poor's, for example) is a crucial
determinant of its exchange rate.
Terms of Trade:
Trade of goods and services between countries is the major
reason for the demand and supply of foreign currencies. A ratio
comparing export prices to import prices, the terms of trade is
related to current accounts and the balance of payments. If the
price of a country's exports rises by a greater rate than that of its
imports, its terms of trade have favourably improved. Increasing
terms of trade shows greater demand for the country's exports.
This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an
increase in the currency's value). If the price of exports rises by a
smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners. This is a typical case
for underdeveloped countries which rely on imports for
development needs. The current account balance (deficit or
surplus) thus reflects the strength and weakness of the domestic
currency.
17. FUNDAMENTAL FACTORS VIZ. POLITICAL
STABILITY AND ECONOMIC
PERFORMANCE:
Fundamental factors include all such events that
affect the basic economic and fiscal policies of the
concerned government. These factors normally
affect the long-term exchange rates of any
currency. On short-term basis on many occasions,
these factors are found to be rather inactive unless
the market attention has turned to fundamentals.
However, in the long run exchange rates of all the
currencies are linked to fundamental causes. The
fundamental factors are basic economic policies
followed by the government in relation to inflation, balance of
payment position, unemployment, capacity utilization, trends in
import and export, etc. Normally, other things remaining constant
the currencies
of the countries that follow the sound economic policies will
always be stronger. Similar for the countries which are having
balance of payment surplus, the exchange rate will always be
favorable. Conversely, for countries facing balance of payment
deficit, the exchange rate will be adverse. Continuous and ever
growing deficit in balance of payment indicates over valuation of
the currency concerned and the dis-equilibrium created can be
remedied through devaluation. Foreign investors inevitably seek
out stable countries with strong economic performance in which to
invest their capital. A country with such positive attributes will
draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for
example, can cause a loss of confidence in a currency and a
movement of capital to the currencies of more stable countries.
18. Political and Psychological factors:
Political and psychological factors are believed to have an
influence on exchange rates. Many currencies have a tradition of
behaving in a particular way for e.g. Swiss Franc as a refuge
currency. The US Dollar is also considered a safer haven
currency whenever there is a political crisis anywhere in the
world.
Speculation:
Speculation or the anticipation of the market participants many a
times is the prime reason for exchange rate movements. The total
foreign exchange turnover worldwide is many times the actual
goods and services related turnover indicating the grip of
speculators over the market. Those speculators anticipate the
events even before the actual data is out and position themselves
accordingly in order to take advantage when the actual data
confirms the anticipations. The initial positioning and final profit
taking make exchange rates volatile. These speculators many
times concentrate only on one factor affecting the exchange rate
and as a result the market psychology tends to concentrate only
on that factor neglecting all other factors that have equal bearing
on the exchange rate movement. Under these circumstances
even when all other factors may indicate negative impact on the
exchange rate of the currency if the one factor that the market is
concentrating comes out positive the currency strengthens.
Capital Movement:
The phenomenon of capital movement affecting the exchange
rate has a very recent origin. Huge surplus of petroleum exporting
countries due to sudden spurt in the oil prices could not be utilized
by these countries for home consumption entirely and needed to
be invested elsewhere productively. Movement of these Petro
19. dollars, started Affecting the exchange rates of various
currencies. Capital tended to move from lower yielding to higher
yielding currencies and as a result the exchange rates moved.
International investments in the form of Foreign direct investment
(FDI) and Foreign Institutional Investments (FII) have become
the most important factors affecting the Exchange rate in today’s
open world economy. Countries which attract large capital Inflows
through foreign investments, will witness an appreciation in its
domestic currency as its demand rises. Outflow of capital would
mean a depreciation of domestic currency.
Intervention:
Exchange rates are also influenced in no small measure by
expectation of changes in regulation relating to exchange markets
and official intervention. Official intervention can smoothen an
otherwise disorderly market but it is also the experience that if the
authorities attempt half-heartedly to counter the market
sentiments through intervention in the market, ultimately more
steep and sudden exchange rate swings can occur. In the second
quarter of 1985 the movement of exchange rates of major
currencies reflected the change in the US policy in favour of
coordinate exchange market intervention as a measure to bring
down the value of dollar.
Stock Exchange Operations:
Stock exchange operations in foreign securities, debentures,
stocks and shares, influence the demand and supply of related
currencies, thus influencing their exchange rate.
Political Factors:
Political scenario of the country ultimately decides the strength of
the country. Stable efficient government at the centre will
encourage positive development in the country, creating success
up investor confidence and a good image in the international
market. An economy with a strong, positive image will obviously
20. have a strong domestic currency. This is the reason why
speculations raise considerably during the parliament elections,
with various predictions of the future government and its policies.
In 1998, the Indian rupee depreciated against the dollar due to the
American sanctions after India conducted the Pokhran nuclear
test.
Others:
The turnover of the market is not entirely trade related and hence
the funds placed at the disposal of foreign exchange dealers by
various banks, the amount which the dealers can raise in various
ways, banks' attitude towards keeping open position during the
course of a day, at the end of the day, on the eve of weekends
and holidays ,window dressing operations as at the end of the half
year to year, end of the month considerations to cover operations
for the returns that the banks have to submit the central monetary
authorities etc. all affect the exchange rate movement of the
currencies. Value of a currency is thus not a simple result of its
demand and supply, but a complex mix of multiple factors
influencing the demand and supply. It’s a tight rope walk for any
country to maintain a strong, stable currency, with policies taking
care of conflicting demands like inflation and export promotion,
welcoming foreign investments and avoiding an appreciation of
the domestic currency, all at the same time.
21. 2.9 SOME IMPORTANT CURRENCIES:
No doubt, all currencies are important but some of the currencies
are the ones which are traded the most around the world. These
include:
The US Dollar ($)- It is the most traded currency on the
planet and it is paired with every other major currency in
the world and often used as an intermediary in triangular
(three way) transactions. It is unofficially the global
currency.
Some countries even use USD as their official currency
(termed as dollarization of their currency).
In 1991- 1 USD=22.74 and currently 1 USD = 74
The Euro ()- It is the second most traded currency in the
world and it serves most of the eurozone nations. Many
nations in Africa and Europe peg their currencies to Euro.
A key feature of this currency is that in forex market euro
adds liquidity to any currency pair which it trades.
The Japanese Yen- It is the most traded Asian Currency
and it measures the overall health of the pan Pacific
Region.
In late 1999 and 2000s Japan had a very low inflation rate
leading to more and more FDIs and FIIs and traders borrowed the
Japanese Yen and then invested in other higher yielding
currencies.
The British Pound- It is the fourth most traded currency in
the world. Although the U.K. was an official member of the
European Union, the country never adopted the euro as its
official currency for a variety of reasons, namely historic
pride in the pound and maintaining control of domestic interest
$
€
¥
£
22. rates. Forex traders will often estimate the value of the British
pound based on the overall strength of the British economy and
political stability of its government.
The Canadian Dollar:
Also known as loonie, the Canadian Dollar is
probably the world's foremost commodity
currency, meaning that it often moves in step with
the commodities markets—notably crude oil, precious metals, and
minerals. With Canada being such a large exporter of such
commodities, the loonie often reacts to movements in underlying
commodities prices, especially that of crude oil.
The Swiss Franc:
Last is the Swiss franc, which, much like Switzerland, is
viewed by many as a "neutral" currency. More accurately,
the Swiss franc is considered a safe haven within the
forex market, primarily due to the fact that the franc tends
to move differently than more volatile commodity currencies, such
as the Canadian and Australian dollars. The Swiss National
Bank has actually been known to be quite active in the forex
market to ensure that the franc trades within a relatively tight
range, to reduce volatility, and to keep interest rates in check.
C$
₣
23. 3.0 FOREIGN EXCHANGE IN 1991 IN INDIA
AFTER LIBERALIZATION, GLOBALIZATION
AND PRIVATIZATION.
In 1991, India faced huge economic crises which led India to
adapt the new economic policy.
The crises made India under poor economic policies and resulted
in huge trade deficits. The value of the Indian Rupee was very low
in the foreign exchange market due to the same reason. The
economy’s foreign exchange reserves had dried up and the
country was about to go into debt.
The reserves were supportive for 3 weeks’ worth of imports.
Pledging the gold reserves of a country was a thing to do of the
last resort but we had no other option. In an attempt to seek an
economic bailout from the IMF, the Indian government airlifted its
national gold reserves.
To understand more deeply the change in foreign exchange
reserves from 1991 to 2018, let us compare the value of rupee in
1990(before liberalisaiton),1991(aftfer liberalisation) and 2018
with the respective value of a U.S. Dollar.
On the back of the page, a chart is fixed comparing different
values of INR and USD.
In 1991 (before liberalisation) the trade deficits with the other
economies like China and US and Britain were very high. To
correct the adverse Balance of Payments, devaluation of the
Indian Rupee was taken into consideration. Devaluation means
reduction in the external value of the domestic currency while
internal value of the domestic currency remains constant.
24. The economic crisis of 1991 is claimed to be the toughest time in
the Indian economy.
The fiscal deficit during this time was 7.8% of the GDP and nearly
40% of total revenue collected by the government was spent on
paying the interest on the debt. In addition, the inflationary rate
was 14% and that made the situation even worse.
The value of the Rupee had been devalued to Rs. 24.58 per one
US Dollar which at that time was a very high value for a dollar.
India had faced a great amount to economic regression in the
years 1990-91 and had to adapt the new economic policy as well
as the foreign trade policy. The license raj was no more.
The economy was now open for all types of foreign investments.
The Gulf war also had a huge impact as the prices of oil touched
the sky. India was still dependent on the Arab countries for Oil
and it imported a lot of Oil from there. Due to the war, India had to
spend 700 crores more on oil than it usually did and the foreign
exchange reserves were about to get over in about only seven
days.
The value of the Indian Rupee was very low as it depreciated a
lot. But after the pledging of gold reserves as well as the help
given to the US Army during the Gulf War made us eligible for
borrowing money from International Institutions such as the IMF
(because US has an 80% vote in the IMF) and other central
banks from countries like Japan.
On the other hand, In 2018, India had a very high trade deficit but
is comparatively much more stable than that in the 1991
economic crisis.
India imports from 173 countries in 2018 and exports in 126
countries.
25. 1972-92
With the breaking down of the Bretton Woods System, India
moved towards the pegged exchange rate system. The Indian
Rupee was linked (Pegged) to U.K. Pound Sterling.This pegging
of currency to another country’s currency results in a fixed
exchange rate system. It maintains stability among the trading
partners. However, although a currency peg can minimize
fluctuation, at the same time it increases the imbalances between
countries. Therefore, in 1975, Rupee was pegged to a basket of
currencies. This was done to ensure the stability of Rupee and
avoid weaknesses associated with a single currency.
During 1990 and 1991, India faced a major Balance of Payment
(BoP) crisis. The Soviet Union was an important trade partner of
India in 1960s. As the Soviet Union started to crack in the 1980s,
India’s exports went down significantly. Also, due to the Gulf crisis
in 1990, the prices of crude oil (an important import for India)
started touching the skies in prices. Those are two of many
reasons that led India to the BoP crisis of 1991. As our exports to
the Soviet Union declined rapidly and the prices of imports
including Crude Oil rose sharply, India faced huge BoP deficits -
i.e. Imports were way higher than the Exports- This led the
country to near bankruptcy. Therefore, India was forced to borrow
money from the International Monetary Fund (IMF) against the
country’s gold reserves.
The crisis certainly did not develop overnight. It is believed that
the roots of this crisis in India developed during 1979-81. During
that period, India suffered a severe drought as well as the tremors
of the global oil shock caused by the Islamic revolution in Iran.
As a result of the BoP crisis, foreign exchange reserves had fallen
to low levels that weren’t enough to pay for even a month of
imports. The policymakers discussed various ways to deal with
the crisis that eventually led to liberalization of the economy.
Another way to deal with the situation was devaluation of the
rupee.
26. Devaluation implies to a decrease in exchange rate. This leads to
an increase in exports and hence the inflow of foreign currency
increases. Therefore, on July 1 1991, as a part of its daily
adjustments to the currency, RBI decreased the exchange rate by
9%. Two days later, i.e. on 3rd July 1991, it was pegged down by
another 11%. In an article in the Indian Express on 10 November
2015, C. Rangarajan, the then deputy governor of RBI, explained
that this move of was planned and well documented and the
project was code-named ‘hop, skip, and jump’. With this, the
pegged exchange rate system ended and India moved towards a
market determined exchange rate system.
1992-Today
There was a two-step devaluation of Rupee in 1991 by the RBI
which ended the pegged exchange rate system and marked the
beginning of the market determined exchange rate system. The
Liberalized Exchange Rate Management System (LERMS) was
introduced to ease the transition from one system to another.
LERMS began from March 1, 1992. Under this system, Rupee
was made partially convertible. This partial convertibility of Rupee
is known as the dual exchange system. Since India was going
through a period of deficit, it was risky to impose full convertibility
of the Rupee. LERMS was set up to boost the foreign exchange
earnings to improve the BoP. The RBI made foreign exchange
available at a low price and hence it was used for essential
imports like crude oil. All other imports were financed at the
market-based exchange rate.
Since LERMS was only a transitional mechanism, it was removed
in 1993 and the market exchange rate system was introduced.
That means that the 60:40 ratio was removed and 100% of the
foreign exchange receipt was now converted at the market based
exchange rate. Also, in 1994, the current account was made fully
convertible. Thus when Rupee became a floating currency, the
27. current account of India was made fully convertible, but the capital
account was only partially convertible. This was done to protect
the domestic market from foreign competition. Since, most of the
developed countries have fully convertible capital
accounts, India is also planning to move towards it. There is an
ongoing discussion on the pros and cons of moving towards full
capital account convertibility to ensure that India benefits from this
move.