Fixed and Floating exchange rate

2021
Fixed
and
Flexible
Exchange Rate
Classroom Deliberations
CA Dr. Prithvi Ranjan Parhi
1
CA DR Prithvi Ranjan Parhi

703- INTERNATIONAL TRADE AND BUSINESS
MODULE- I
International Trade: Concept, Importance, Benefits of International Trade, international
Marking vs. Domestic Marking (differences).
Theory of International Trade: theory of comparative Cost, factor proportion Theory.
MODULE-II
Multinational corporations (MNCs): Definition, Role of MNCs in International marking.
International Trade barriers: Meaning, tariff and non-Tariff Barriers, Impact of Non-tariff
barriers.
MODULE-III
Organizational and Agreements: WTO (Functions, Principle, agreements), IMF (Purposes,
Facilities Provided by IMF), World Bank (Purpose, Principle, Policies).
MODULE-IV
Foreign Trade of India: Organizational Setup (Autonomous Bodies, Attached and
subordinate offices), Major Export and Imports, Concept of Export House, EXIM Policy
(2002-2007) of India (Features and Objectives of the Policy).
MODULE-V
Foreign Exchange market: Concept, Functions, Methods of international Payment, concept
of Balance of Payment, Concept of Fixed and Flexible Exchange Rate and Convertibility of
Rupee.
CA DR Prithvi Ranjan Parhi 2

Forex
• Importing country pays money to exporting countries in
return of goods either in domestic currency or in hard
currency.
• This currency which facilitates the payment to complete
the transaction is called Foreign Exchange.
• So foreign exchange is the money in one country for
money or credit of goods or services in another country.
• Foreign exchange includes: Foreign currency, Foreign
cheques and foreign drafts.
3

Exchange Rate Determination
• Exchange rate is the price paid in the home
currency for a unit of foreign currency.
• Exchange rate can be quoted in two ways: Direct
Quote, Indirect Quote.
• Exchange rate in a free market is determined by
the demand for and supply of foreign currency of
a particular market.
• The equilibrium exchange rate is the rate at which
demand for foreign exchange and supply of foreign
exchange are equal.
4

5
Exchange Rate Drivers
International
Trade
Speculation
Balance of
Payment
Intervention by
Central Bank
Economic
Fundamentals
Political
Stability
Interest rate
Parity
Inflation rate
Self fulfilling
prophesy
© CA. Prithvi R Parhi, M Com, FCA,DISA(ICAI)
5:59 PM © CA Dr Prithvi R Parhi

Demand & Supply

Demand for Foreign Exchange
1. Import of goods and services
2. Investment in Foreign Countries(FDI Outward)
3. Payment made by Indian Govt to other foreign
Govt (interest, loan etc)
4. Other type of outflow of foreign capital like
giving donations etc
7

Supply of Foreign Exchange
1. Country’s exports of goods and services to foreign
countries
2. Inflow of Foreign Capital
3. Payment made by the foreign governments to
Indian governments for settling their transactions
4. Other type of inflow of foreign capital like
Remittances by NRI, Donations received
8

Exchange Rate Regimes
1. Commodity Specie Standard
2. Gold Standard
3. The Bretton Woods System of Exchange Rates
4. Exchange Rate Regimes Since 1973
a. Floating Rate System
b. Pegging of Currency
c. Crawling Peg
d. Target-zone Arrangements
9

Commodity Specie Standard
• Initially the exchange rates were determined
on the basis of the value of metal contained in
the coins of two countries.
• This system was referred as the commodity
specie standard.
• With the introduction of paper currency this
system ceased to exist.
10

Gold Standard
• Gold Standard was prevalent between 1870s
and 1914,which was suspended during the
great world war.
• However it was readopted, but was finally
abandoned by 1930s.
• Gold Standard was initially adopted by Britain.
Later ,Germany, Japan,USA and other
countries adopted Gold Standard.
11

Gold Standard
• In this system Central Bank was maintaining
official parity between its currency and gold
and as such needed an adequate stock of gold
reserves.
• Banknotes were exchanged for gold on
demand.
• The price of gold was officially set at which it
was bought and sold.
12

Gold Standard
• Gold standard allowed free flow of gold
among countries and for automatic
adjustment in exchange rate and in balance of
payments.
• In this case Deficit in balance of trade led to
outflow of gold and vice versa.
• The fixed supply of gold led to the demise of
gold standard.
13

The Bretton woods system of
Exchange Rates
• The collapse of gold standard led to the conduct of the Bretton
Woods conference in July 1944 and the establishment of IMF in 1945
and evolution of a new system of exchange rate, which is known as
Bretton woods system of exchange rate.
• Bretton Woods system represented a fixed parity system with
adjustable pegs.
• Under this system each country was to fix the par value of its
currency in term of gold or US dollar.
• The monetary authorities were allowed to make adjustment to the
extend +/-1% of fixed par value.
• This system could bring about stability in exchange rate ,it could not
sustain for long time.
14

Exchange Rate Regimes Since 1973
• In the wake of collapse of Bretton woods system of
exchange rate the committee appointed by IMF suggested
four options for exchange rate.
• These suggestions were accepted by IMF and
incorporated in its 2nd amendment to the Article of
agreement.
• These options are:
1. Floating rate system
2. Pegging of Currency
3. Crowling Peg
4. Target-Zone Arrangement
15

1. Floating Rate System:
• Market forces determine the exchange rate of
currencies under floating rate system.
2. Pegging of Currencies:
• Here developing countries pegs its currencies either to
a strong currency or to a currency of a country with
which it has a large share of trade.
• Pegging system provide for fixed exchange rate
between two currencies. However, the exchange rate
float with respect to other currencies.
16

Major Fixed Currencies (Pegged to USD)
Country Region Currency Code
Bahrain Middle East Dollar BHD
Belize Central America Dollar BZ$
Cuba Central America Convertible Peso CUC
Djibouti Africa Franc DJF
Eritrea Africa Nakfa ERN
Hong Kong Asia Dollar HKD
Jordan Middle East Dinar JOD
Lebanon Middle East Pound LBP
Oman Middle East Rial OMR
Panama Central America Balboa PAB
Qatar Middle East Riyal QAR
Saudi Arabia Middle East Riyal SAR
United Arab Emirates Middle East Dirham AED

3. Crawling Peg:
• It is a hybrid of fixed rate and floating rate.
• Here, the exchange rate of a currency with
which it is pegged is stable in the short run ,but
it changes gradually over a period of time in
order to reflect the changes in the market.
• This system has the advantages of stability and
flexibility.
18

4. Target-Zone Arrangement:
• Under this system the exchange rates are fixed
with respect to the currencies of the countries
of a particular zone and the exchange rate float
with respect to countries outside the zone.
• Example: Eastern Caribbean Currency Union,
Central African Economic and Monetary
community and Western African Economic and
Monetary Union.
19

Fixed/Pegged Exchange Rate
• A fixed exchange rate, sometimes called a pegged
exchange rate, is a type of exchange rate regime
where a currency's value is fixed against either the
value of another single currency, to a basket of
other currencies, or to another measure of value,
such as gold.
• In a fixed exchange-rate system, a country’s central
bank typically uses an open market mechanism
and is committed at all times to buy and/or sell its
currency at a fixed price in order to maintain its
pegged ratio.
20

Fixed/Pegged Exchange Rate (Advantages)
1. Promotes International Trade:
Fixed or stable exchange rates ensure certainty about the foreign
payments and inspire confidence among the importers and
exporters. This helps to promote international trade.
2. Necessary for Small Nations:
Fixed exchange rates are even more essential for the smaller
nations like Denmark, Belgium, in whose economies foreign trade
plays a dominant role. Fluctuating exchange rates will seriously
affect the process of economic growth in these economies.
3. Promotes International Investment:
Fixed exchange rates promote international investments. If the
exchange rates are fluctuating, the lenders and investors will not
be prepared to lend for long-term investments.
21

Fixed/Pegged Exchange Rate(Advantages)
4. Removes Speculation:
Fixed exchange rates eliminate the speculative
activities in the international transactions. There is no
possibility of panic flight of capital from one country
to another in the system of fixed exchange rates.
6. Necessary for Developing Countries:
Fixed exchanges rates are necessary and desirable for
the developing countries for carrying out planned
development efforts. Fluctuating rates disturb the
smooth process of economic development and
restrict the inflow of foreign capital.
22

7. Suitable for Currency Area:
A fixed or stable exchange rate system is most suitable to a world of currency
areas, such as the sterling area. If the exchange rates of the countries in the
common currency area are flexible, the fluctuations in the leading country, like
England (whose currency dominates), will also disturb the exchange rates of
the whole area.
8. Economic Stabilization:
Fixed foreign exchange rate ensures internal economic stabilization and checks
unwarranted changes in the prices within the economy. In a system of flexible
exchange rates, the liquidity preference is high because the businessmen will
like to enjoy wind fall gains from the fluctuating exchange rates. This tends to
Increase price and hoarding activities in country.
9. Not Permanently Fixed:
Under the fixed exchange rate system, the exchange rate does not remain fixed
or is permanently frozen. Rather the rate is changed at the appropriate time to
correct the fundamental disequilibrium in the balance of payments.
23

10. Other Arguments:
Besides, the fixed exchange rate system is also beneficial
on account of the following reasons.
i. It ensures orderly growth of world's money and capital
markets and regularizes the international capital
movements.
ii. It ensures smooth functioning of the international
monetary system. That is why, IMF has adopted pegged or
fixed exchange rate system.
iii. It encourages multilateral trade through regional
cooperation of different countries.
iv. In modern times when economic transactions and relations
among nations have become too vast and complex, it is
more useful to follow a fixed exchange rate system.
24

Fixed/Pegged Exchange Rate(Disadvantages)
1. Outmoded System:
Fixed exchange rate system worked successfully under the
favorable conditions of gold standard during 19th century
when
a) the countries permitted the balance of payments to influence the
domestic economic policy;
b) there was coordination of monetary policies of the trading
countries;
c) the central banks primarily aimed at maintaining the external
value of the currency in their respective countries; and
d) the prices were more flexible.
Since all these conditions are absent today, the smooth
functioning of the fixed exchange rate system is not possible.
25

2. Discourage Foreign Investment:
Fixed exchange rates are not permanently fixed or rigid. Therefore, such
a system discourages long-term foreign investment which is considered
available under the really fixed exchange rate system.
3. Monetary Dependence:
Under the fixed exchange rate system, a country is deprived of its
monetary independence. It requires a country to pursue a policy of
monetary expansion or contraction in order to maintain stability in its
rate of exchange.
4. Cost-Price Relationship not Reflected:
The fixed exchange rate system does not reflect the true cost-price
relationship between the currencies of the countries. No two countries
follow the same economic policies. Therefore the cost-price
relationship between them go on changing. If the exchange rate is to
reflect the changing cost-price relationship between the countries, it
must be flexible.
26

5. Not a Genuinely Fixed System:
The system of fixed exchange rates provides neither the
expectation of permanently stable rates as found in the gold
standard system, nor the continuous and sensitive adjustment
of a freely fluctuating exchange rate.
6. Difficulties of IMF System:
The system of fixed or pegged exchange rates, as followed by
the International Monetary Fund (IMF), is in reality a system of
managed flexibility.
It involves certain difficulties, such as deciding as to
a) when to change the external value of the currency,
b) what should be acceptable criteria for devaluation; and
c) how much devaluation is needed to reestablish equilibrium in the
balance of payments of the devaluing country.
27

7.Inflationary Nature
A common element with all fixed or pegged foreign
exchange regimes is the need to maintain the fixed
exchange rate.
This requires large amounts of reserves as the
country's government or central bank is constantly
buying or selling the domestic currency.
The problem with huge currency reserves is that the
massive amount of funds or capital that is being
created can create unwanted economic side effect –
namely higher inflation.
The more currency reserves there are, the wider the
monetary supply– causing prices to rise.
28

Floating/Flexible Exchange Rate
• Under the flexible exchange rate system, exchange rate
between different currencies, like the prices of
commodities are freely determined by market forces, that
is, by demand and supply forces.
• With the change in economic conditions underlying
demand and supply, the exchange rate will automatically
change without any intervention by the Government.
• That is why it is called flexible or variable exchange rate
system.
• This is also called Free Float of currency.
• Example: US Dollar, Euro,Japanese Yen
29

Floating/Flexible Exchange Rate(Advantages)
1. No need for international management of exchange
rates: Unlike fixed exchange rates based on a metallic
standard, floating exchange rates don’t require an
international manager such as the International
Monetary Fund to look over current account
imbalances. Under the floating system, if a country has
large current account deficits, its currency depreciates.
2. No need for frequent central bank intervention: Central
banks frequently must intervene in foreign exchange
markets under the fixed exchange rate regime to protect
the gold parity, but such is not the case under the
floating regime. Here there’s no parity to uphold.
30

3. No need for elaborate capital flow
restrictions:
It is difficult to keep the parity intact in a fixed
exchange rate regime while portfolio flows are
moving in and out of the country. In a floating
exchange rate regime, the macroeconomic
fundamentals of countries affect the exchange
rate in international markets, which, in turn,
affect portfolio flows between countries.
Therefore, floating exchange rate regimes
enhance market efficiency.
31

4.Greater insulation from other countries’
economic problems: Under a fixed exchange rate
regime, countries export their macroeconomic
problems to other countries. Suppose that the
inflation rate in the U.S. is rising relative to that of
the Euro-zone.
Under a fixed exchange rate regime, this scenario
leads to an increased U.S. demand for European
goods, which then increases the Euro-zone’s price
level. Under a floating exchange rate system,
however, countries are more insulated from other
countries’ macroeconomic problems. A rising U.S.
inflation instead depreciates the dollar, curbing
the U.S. demand for European goods.
32

5. Correction of balance of payments deficits -
When, there is deficit in the balance of
payments, the external value of a country's
currency falls. As a result, exports are
encouraged, and imports are discouraged
thereby, establishing equilibrium in the balance
of payment.
6. Eliminates Cost of FOREX reserves-This system
eliminates the expenditure of maintenance of
official foreign exchange reserve.
33

Floating/Flexible Exchange Rate(Disadvantages)
1. Unstable conditions:
Flexible exchange rates create conditions of instability
and uncertainty which, in turn, tend to reduce the
volume of international trade and foreign investment.
Long-term foreign investments are greatly reduced
because of higher risks involved.
2. Adverse Effect on Economic Structure:
The system of flexible exchange rates has serious
repercussion on the economic structure of the economy.
Fluctuating exchange rates cause changes in the price of
imported and exported goods which, in turn, destabilize
the economy of the country.
34

Floating/Flexible Exchange Rate(Disadvantages)
3. Unnecessary Capital Movements:
The system of fluctuating exchange rates leads to
unnecessary international capital movements. By
encouraging speculative activities, such a system causes
large-scale capital outflows and inflows, thus, seriously
disturbing the economy of the country.
4. Depression Effects of Capital Movements:
Speculative capital movements caused by fluctuating ex-
change rates may lead to the problem of extremely high
liquidity preference. In a situation of high liquidity
preference, people tend to hoard currency, interest rates
rise, investment falls and there is large-scale
unemployment in the economy.
35

Managed Float/Dirty Float
• It is a floating currency exchange rate system which is not
controlled entirely by the market forces of demand and
supply but at least partially controlled by government
intervention that limits depreciation or appreciation of the
currency with in a range.
• Hence,' Dirty Float' is a system of floating exchange rates
in which the government or the country's central bank
occasionally intervenes to change the direction of the
value of the country's currency.
• Example: In 2013, 82 countries and regions used the
system, or 43%, according to a survey of 191 countries by
the International Monetary Fund.
36

Convertibility of a currency
• Currency convertibility is the ease with which a country's
currency can be converted into gold or another currency.
Convertibility is extremely important for international
commerce. When a currency is inconvertible, it poses a risk
and barrier to trade with foreigners who have no need for
the domestic currency.
• Government restrictions can often result in a currency with
a low convertibility. For example, a government with low
reserves of hard foreign currency often restrict currency
convertibility because the government would not be in a
position to intervene in the foreign exchange market (i.e.
revalue, devalue) to support their own currency if and
when necessary.
37

Convertibility of Rupee
• Currency convertibility is of two types:
1.Current Account Convertibility
2.Capital Account Convertibility
• Current account convertibility allows free inflows
and outflows for all purposes other than for
capital purposes.
• Capital purpose means dealing the investments in
foreign currency and obtaining loans in foreign
currency, acquiring any plant and machinery from
abroad by making payments in foreign exchange.
38

Convertibility of Rupee(Indian
Experience)
• After the BoP crisis of 1990-91 and change in the central Government,
the LERMS was introduced as a first measure towards making foreign
exchange a free commodity.
• Thus, when LERMs was introduced, there were two exchange rates in
India: Official Rate for select items of exports and imports Market Rate
for all others.
• The Government said that now onwards, anyone who deals in current
account means international trade of goods and services will be able to
convert them to Indian Rupees as follows: 40 % of the receipts at
Official rate 60% of the receipts at Market Rate.
• This means that only part of the current account receipts were made
convertible at market rates and that is why it was called Partial
Convertibility of Rupee on Current Account.
39

------Convertibility of Rupee(Indian
Experience)
• Encouraged with the success of the LERMS,
the government introduced the full
convertibility of Rupee in Trade account
(means only merchandise trade no service
trade)from March 1993 onwards.
• With this the dual exchange rate system got
automatically abolished and LERMS was now
based upon the open market exchange.
40

--------Convertibility of Rupee(Indian
Experience)
• In August 1994, the Government of India declared full
convertibility of Rupee on Current account .(Trade and
invisibles)
• Capital account convertibility (CAC) or a floating
exchange rate means the freedom to convert local
financial assets into foreign financial assets and vice
versa at market determined rates of exchange.
• The Committee on Capital Account Convertibility (CAC)
or Tarapore Committee was constituted by the Reserve
Bank of India for suggesting a roadmap on full
convertibility of Rupee on Capital Account.
• The committee submitted its report in May 1997.
41

Experience)
• However, some partial convertibility of Rupee on Capital
Account was introduced later. Today we have Partial
convertibility of Rupee on Capital Account.
• Reserve Bank of India appointed the second Tarapore
committee to set out the framework for fuller Capital
Account Convertibility.
• The report of this committee was made public by RBI on 1st
September 2006.
• In this report, the committee suggested 3 phases of
adopting the full convertibility of rupee in capital account.
– First Phase in 2006-7
– Second phase in 2007-09
– Third Phase by 2011.
42

Experience)
Following were some important recommendations of this
committee:
• The ceiling for External Commercial Borrowings (ECB)
should be raised for automatic approval.
• NRI should be allowed to invest in capital markets NRI
deposits should be given tax benefits.
• Improvement of the Banking regulation.
• FII (Foreign Institutional Investors) should be prohibited
from investing fresh money raised to participatory notes.
• Existing PN holders should be given an exit route to phase
out completely the PN notes.
43

Are We moving towards fuller capital
account convertibility?
• Though there are certain risks associated with full capital
account convertibility, we cannot avoid it for longer period
as it may become counter-productive.
• But how early are we moving to full capital account
convertibility depend on various pre-conditions like low and
sustained current account deficit, fiscal-consolidation,
controlled inflation, low level of NPAs, resilient financial
markets, prudent supervision of financial institutions etc.
• Already India is making progress on these fronts.
• Today we have Partial convertibility of Rupee on Capital
Account and slowly moving towards fuller capital account
convertibility.
44

THANK YOU
45

Thank You
47

Fixed and Floating exchange rate

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