Forex Market

2021
Forex
Market
(FX Market)
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

Meaning of 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

Foreign Exchange Market
• Foreign Exchange is bought and sold in FOREX
market.
• FOREX market is a physical, online and institutional
structure through which money of one country is
exchanged for that of other country- at a rate
determined either mutually or by market forces.
• Foreign exchange transactions are completed
either physically or on-line.
4

Nature of FOREX market
• Widespread Geographically(All countries, All
geographical areas)
• All Time Operation (24*7*365days market,
working hours differ globally)
• Two Levels: Wholesale market(Interbank market),
Retail Market(Client Market)
• Size of the market: The volume of foreign
exchange traded in the market is very very
large.(Trillions of dollar a day)
5

Participants in FOREX Market
• Bank & Non bank FOREX Dealers (operate
both in interbank(Wholesale) & Client(Retail )
Market. They act as market maker. (Bid rate,
Ask rate & Bid-Ask Spread)
• Individuals, Firms conducting personal,
commercial and investment transactions-
importers, exporter, international portfolio
investors, MNCs,Tourists etc.
6

------Participants in FOREX Market
• Forex Brokers/Agents-trade on behalf of their
principals in lieu of commission.
• Speculators-to earn profit by trading in forex.
• Arbitragers-To earn profit from simultaneous
buying and selling in different markets.
• Central banks and treasuries-to acquire and spend
forex reserves and to influence the price in the
market.
7

Functions of Forex Market
 The Foreign Exchange Market provides:
–The physical and institutional structure
through which the money of one country is
exchanged for that of another country
–The determination rate of exchange
between currencies
CA Dr Prithvi Ranjan Parhi 9

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.
11

Demand for Foreign Exchange
• Import of goods and services
• Investment in Foreign Countries(FDI Outward)
• Payment made by Indian Govt to other foreign
Govt (interest, loan etc)
• Other type of outflow of foreign capital like
giving donations etc
12

Supply of Foreign Exchange
• Country’s exports of goods and services to
foreign countries
• Inflow of Foreign Capital
• Payment made by the foreign governments to
Indian governments for settling their
transactions
• Other type of inflow of foreign capital like
Remittances by NRI, Donations received
13

14
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)
5:54 PM © CA. Prithvi R Parhi

15
What drives Xch rate ?
• Currency is a commodity ~ Forces of demand & supply determine the price of a
commodity. Factors that drive exchange rates are;
1. International Trade : Demand & supply of currencies emanates from import &
export of goods & services, raising money from global market.
2. Speculation : Players in Forex market wait to seize opportunities to buy or sell foreign
currency. Thrust of movement of rates comes more from speculators than from
international trade. This may have stabilizing/ dis-stabilizing effect.
3. Balance of Payment : Healthy BoP leads to strengthening of the currency, Levered
BoP would lead to weakening of the currency. A very adverse BoP would mean the
country have to buy foreign currency to meet its obligation which would lead to
greater demand for foreign currency , pushing its price up. This would mean
weakening domestic Currency.
4. Intervention by Central Bank : Central bank of the country would be interested in
some kind of stability in the exchange rate.~ If INR strengthens it would be adverse
for the exporter & if INR weakens it would be adverse for the importer. RBI may step
in to keep the currency rate within a certain zone.~ Pure floating rate / Dirty floating
rate.

16
What drives Xch rate ?
5. Economic Fundamentals : Country blessed with rich natural resources would
automatically benefit from a net surplus on its current account. Further it would
attract long term capital investment from overseas. Hence on account of
advantageous fundamentals, the currency of such country going to be strong.
6. Political Stability : Uncertain political stability or an uncertain economic future
would weaken countries currency since international investors would not be
showing interest in investing in these countries.
7. Interest rate Parity : According to IRPT, a high interest rate ( in real terms) in one
country would lead to depreciation in the currency of that country.
8. Inflation rate : According to IRPT, if inflation is higher in 1 country than another,
the former currency will tend to weaken against the other country’s currency.
9. Self fulfilling prophesy : Expectations of the players in the market also drives
the exchange rate.

17
Thanks
© CA. Prithvi R Parhi
5:54 PM

Exchange Rate Regimes
• Commodity Specie Standard
• Gold Standard
• The Bretton Woods System of Exchange Rates
• Exchange Rate Regimes Since 1973
a. Floating Rate System
b.Pegging of Currency
c.Crawling Peg
d.Target-zone Arrangements
18

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.
19

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.
20

-------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.
21

-------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.
22

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.
23

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
24

-----Exchange Rate Regimes Since 1973
Floating Rate System:
• Market forces determine the exchange rate of
currencies under floating rate system.
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.
25

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.
26

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.
27

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.
28

List of Counties Having Fixed Exchange
Rate(Peg to USD)
Country Region
Currency
Name
Code Peg Rate Rate Since
Bahrain Middle East Dollar BHD 0.376 2001
Cuba
Central
America
Convertible
Peso
CUC 1.000 2011
Dijibouti Africa Franc DJF 177.721 1973
Eritrea Africa Nakfa ERN 15.000 2005
Hong Kong Asia Dollar HKD 7.75-7.85 1998
Jordan Middle East Dinar JOD 0.709 1995
Lebanon Middle East Pound LBP 1507.5 1997
Oman Middle East Rial OMR 0.3845 1986
Panama
Central
America
Balboa PAB 1.000 1904
Qatar Middle East Riyal QAR 3.64 2001
Saudi Arabia Middle East Riyal SAR 3.75 2003
United Arab
Emirates
Middle East Dirham AED 3.6725 1997
Venezuela South AmericaBolivar VEB 6.3 2013
29

----------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.
30

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.
31

Rate(Advantages)
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.
32

Rate(Advantages)
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.
33

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.
34

Rate(Disadvantages)
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.
35

Rate(Disadvantages)
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.
36

Rate(Disadvantages)
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.
37

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
38

-------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.
39

Rate(Advantages)
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.
40

Rate(Advantages)
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.
41

Rate(Advantages)
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.
42

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.
43

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.
44

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.
45

Definition of BOP-----------
• BOP is the statistical record of a country’s
international transaction over a certain period
of time presented in the form of double entry
book keeping.
• BOP is a statement listing receipts and
payments in international transactions of a
country.

---------Definition of BOP
• It is a systematic accounting record of all
economic transactions during a given period
of time between the residents of the country
and residents of foreign country.
• It is a statement showing a country’s
commercial transaction with the rest of the
world.

Importance of BOP
• BOP provides detailed information concerning the
demand and supply of foreign currency.(If
Export>Import, Domestic currency will appreciate
where as if Import>Export domestic currency will
depreciate)
• A country’s BOP data may signal its potential as a
business partner for the rest of the world.BOP deficit
country more likely to impose control on FOREX.BOP
surplus country more likely to encourage imports.
• BOP data can be used to evaluate the performance of
the country in international economic competition.

BOP Accounting
• BOP is presented in a system of double entry
book keeping.(Every credit in the account is
balanced by a matching debit and vice versa)
• Any transaction that results in a receipt from
foreigners will be recorded as credit.
• Any transaction that give rise to payment to
foreigner will be recorded as debit.
• Credit entries give rise to supply of foreign
currency(demand for domestic currency),where
as debit entries give rise to demand for foreign
currency(supply of domestic currency)

Balance of Payment
• All types of international transactions can be
grouped in to Four heads:
1.Current Account
2.Capital Account
3.Other Account(Error & Omission)
4.Official Reserve Account

Current Account----------
• Current account records the following four
categories of transactions:
• Merchandise Trade: Represents exports and
imports of tangible goods/visibles (Trade
balance/Trade deficit/Balance of trade)
• Services/Invisibles: It includes payment and
receipt for following services:(Transport, Travel,
construction, Insurance and pension, financial,
telecommunication, computer & IT, personal,
cultural & recreational services, other services,
charges for use of intellectual property right)

---------Current Account
• Factor Income: It consists largely of payments
and receipts of interest, dividend and other
income on foreign investments that were
previously made.
• Unilateral Transfers: it involves unreciprocated
payments and receipts. These are only one
directional flow.(Foreign Aid, official and
Private Grant,Gifts,Remittances etc)
• Current Account may show balance or deficit.

Current A/C Balance & Exchange Rate
• A Balance in Current A/C---More supply of
Foreign Currency----More Demand for Home
Currency---Appreciation of Domestic
Currency----Affect Positively Imports and
Negatively Exports.
• A Deficit in Current A/C----More Demand for
Foreign Currency---Depreciation of Domestic
Currency---Positively affects exports and
negatively Imports.

Capital Account----------
• Foreign Direct Investment(Inward/Outward)
• Foreign Portfolio Investment (Inward/
Outward)
• Loans:(External Assistance, Commercial
Borrowing{Lt/Mt},Short term loans)
• Banking Capital(Assets & Liabilities)
• Rupee Debt Service
• Other Capital

---------Capital Account
• Hence current account deals with trade in goods
and services, but capital account deals with trade
in financial assets and liabilities.
• Increase in foreign financial Assets=Debit items
• Decrease in foreign financial Assets=Credit items
• Increase in Foreign Financial liabilities=Credit
items
• Decrease in Foreign Financial liabilities=Debit
items.

Error & Omission
Error and omission are put in BOP due to:
• Difficulties involved in collecting BOP data
• Different sources of BOP data
• Movement of capital may precede or follow
the transaction that they are supposed to
finance before or after 31st march.
• Some figures are based on estimates only
• Unrecorded illegal transactions

Deficit Adjustment-------
• If the overall balance is found to be in deficit,
Central Bank(RBI)arranges capital flows to
cover deficit by official borrowing and/or
drawing from the IMF. This sort of capital flow
is accommodating or compensatory capital
flow. This also put in capital account.
• Hence capital inflows is of two types:
1.Autonomous Capital flow
2.Accommodating/Compensatory Capital Flow

--------Deficit Adjustment
• If overall BOP is negative/deficit and
accommodating capital is not sufficient, the
official reserve account is debited by the
amount of deficit.(It means there will be
decrease in official reserve)
• If overall BOP is surplus, the surplus amount
adds to the official reserve account.(It means
there will be increase in official Reserve)

Official Reserve Account
• It is held by the central bank of the country. (RBI)
• It consists of the following
– Gold
– Foreign Currency Assets
– Special Drawing Rights(SDR)
• This account is used for balancing the BOP.
• If a country do not have sufficient Official Reserve
it leads to BOP crisis and the country goes for
policy reforms.

BOP always Balances?
• Since the balance of payment is based upon
system of double-entry book-keeping, the total
debits must equal to total credits.
• This is because two aspects of each transaction
recorded are equal in amount but appear on
opposite sides of the balance of payments
account.
• In this accounting sense, balances of payments
for a country must always balance.
• But in economic sense/real sense there may be
disequilibrium in BOP.

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.
63

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.
64

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.
65

------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.
66

--------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.
67

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.
68

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.
69

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.
70

THANK YOU
71

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