International Finance FOREIGN EXCHANGE MANAGEMENT IN INDIA

International Finance FOREIGN EXCHANGE MANAGEMENT IN INDIA

Learning Objectives After completing this chapter, you should be able to understand: Retail vs. Wholesale Foreign Exchange Market Capital Account Convertibility Reserve Management Foreign Exchange Dealers Association of India (FEDAI)

Structure 4.1 Introduction to Indian Foreign Exchange Market 4.2 Structure of Indian Foreign Exchange Market 4.3 Management of Foreign Exchange in India 4.4 The components of the Indian Foreign Exchange Market 4.5 Retail vs. Wholesale Foreign Exchange market 4.6 Capital Account Convertibility

Structure 4.7 Reserve Management 4.8 Role of FEDAI in the Foreign Exchange Market 4.9 The Liberalized Exchange Rate Management System (LERMS) 4.10 Pro s and Con s of Currency Convertibility 4.11 Summary 4.12 Self assessment questions

4.1 Introduction to Indian Foreign Exchange Market Foreign Exchange Management Act, 1999 (FEMA) provides the Central Government powers to execute the provisions of this Act, and provides the RBI the powers to make regulations for executing the provisions of the Act in terms of section 46 and 47 of the Act. Section 41 provides that the central Government may direct or instruct the RBI who shall comply with such directions and instructions. The RBI, therefore, has the sole authority as well as responsibility to administer foreign exchange business in the country.

4.2 Structure of Indian Foreign Exchange Market Foreign Exchange Management Act 1999 RBI Central Government Authorized Persons Foreign Exchange Dealers Assn. of India (FEDAI) Offshore Bank s Units Authorized Money Changers Authorized Dealers OBU s AMC s AD s Fully Fledged Money Changers Restricted Money Changers FFMC s RMC s

4.2 Structure of Indian Foreign Exchange Market contd. 1. Authorized Person The Reserve Bank provides licenses to three categories of persons to transact with public at different levels. They are Authorized Dealers Authorized Money Changers Offshore Banking Units Their transactions are governed by the Exchange Control Regulations provided by the Reserve Bank of India.

4.2 Structure of Indian Foreign Exchange Market contd. 2. Authorized Dealers The bulk of the foreign exchange transactions undertaken in the country involve end-users and banks. Banks and select entities licensed by the Reserve Bank of India to undertake these transactions are called Authorized Dealers. They are permitted to undertake all categories of transactions pertaining to both Current and Capital accounts of the Balance of Payments.

4.2 Structure of Indian Foreign Exchange Market contd. 3. Authorized Money Changers Authorized money changers are sub-classified as full fledged and restricted money changers. Full fledged money changers are permitted to both buy as well as sell foreign exchange; e.g. travel agencies. Restricted money changers can purchase foreign exchange in the form of travellers cheques or currency notes, but they are not allowed to sell; e.g. five star hotels.

4.2 Structure of Indian Foreign Exchange Market contd. 4. Offshore Banking Units Branches of banks in India established in Special Economic Zones (SEZ s) are accorded the status of Offshore Baking Units (OBU s) The OBUs are allowed to undertake banking operations only in designated foreign currencies essentially with non-residents. Each such OBU has a minimum start up capital of US $ ten million and its balance sheet is prepared in designated foreign currencies.

4.3 Management of Foreign Exchange in India Foreign exchange is a scarce commodity and was subject to strict control in almost all countries till 1970s. In India, keeping with the policy of liberalization the focus has changed to exchange management and not exchange control. The term exchange control can be described as the quantitative control, by the government or centralized agency of transactions involving foreign currencies. Effectively, any directive or regulation which restricts the free play of demand supply forces in foreign exchange market can be termed as exchange control.

4.4 The components of the Indian Foreign Exchange Market A. Retail Market In this segment end-users of foreign currencies (individuals, exporters, importers, travellers and tourists) approach AD s for their requirements. AD s provide committed rates for such transactions. These rates are called Merchant Rates. Total turnover and individual transaction size is very small i.e. transactions are customized in terms of amount and maturity. Transactions here are governed by the Exchange Control Regulations of RBI. Tariffs and commissions are maintained as per FEDAI. Brokers are not allowed.

4.4 The components of the Indian Foreign Exchange Market B. Wholesale Market 1. This market is also called interbank market. It includes transactions between AD s as also between AD s and the RBI. 2. Transactions are conducted in standard market lot andvolumeislarge;theyarecarriedatinterbank rates. The rates are determined in this market. 3. A large part of transactions are undertaken through approved/authorized brokers. 4. They are governed by guidelines from RBI and FEDIA.

4.5 Retail vs. Wholesale Foreign Exchange Market

4.6 Capital Account Convertibility (CAC) The first step in the direction of CAC was taken in 1997 by constituting a committee headed by the Deputy Governor of RBI. Its recommendations could not be implements because of South East Asia crisis, currency failures in Brazil and Russia and air strikes on the US on 11.09.01. A second committee was appointed thereafter and its recommendations are to be implemented by RBI. Meanwhile RBI has progressively allowed greater freedom in capital transactions.

4.6 Capital Account Convertibility (CAC) Individual investors are permitted to invest up to US $ 100,000 in international securities. Individuals are allowed to open non-interest bearing accounts in specified cu RBI has allowed Indian corporate entities to raise resources and invest overseas in larger quantities. Branches of Indian banks in SEZ s are permitted to accept deposits, grant loans in foreign currencies. At present Indian Rupee is fully convertible for current account transactions and partially for capital account transactions.

4.6 Capital Account Convertibility (CAC) Pre-requisites Maintenance of domestic economic stability. Adequate foreign exchange reserves. Restrictions on non-essential imports. Comfortable current account position. An appropriate industrial policy and friendly investment climate.

4.7 Reserve Management Foreign Currency Reserve Management can be described as a process that ensures adequate foreign assets are readily available to the authorities for meeting identified liabilities and a defined range of objectives for a country. These objectives are: i] Exchange rate management represented by the capacity to intervene in support of the domestic currency.

4.7 Reserve Management - objectives ii] Maintaining adequate foreign currency liquidity to absorb shocks during times of crisis. iii] Providing confidence to the international community that the country can meet its external obligations / liabilities. iv] Ensuring that the domestic currency is largely backed by external assets. v] Managing Foreign Currency Lines of Credit for promoting high value exports.

4.8 Role of FEDAI in the Foreign Exchange Market The FEDAI was set up in 1958 as an association of banks dealing in foreign exchange. It s a regulatory body incorporated under section 25 of the Companies Act 1956. Its main functions are framing rules governing the conduct of foreign exchange business between banks and the public and liaison with RBI for reforms and development of foreign exchange market.

4.8 Role of FEDAI in the Foreign Exchange Market It trains bank personnel in the areas of foreign exchange business. It accredits foreign exchange brokers and reviews their operations. Advises and assists members in settling issues in their dealings. Represents member banks in discussions with the Government / RBI and other bodies. Provides a common platform for authorized dealers to interact with the Government and RBI.

4.8 Role of FEDAI in the Foreign Exchange Market It announces daily and periodical rates to member banks. Announcesspotrateatthestartofthetradingday to ensure uniformity in settlement among different market participants. It circulates guidelines for quotations of rates, charging of commissions etc. It uses its synergy for smooth functioning of markets and develops new customized products, benchmarks against international standards on accounting, market practices, risk management systems etc.

4.9 The Liberalized Exchange Rate Management System (LERMS) In March 1992, India adopted a dual exchange rate system called LERMS. Under the scheme exporters were required to sell 40% of their export proceeds to RBI at fixed price to build foreign exchange reserve. The component of 40% sold to RBI ensured a corpus of foreign currency that can be used for import of essential raw materials, defense equipment etc. Balance60%couldbesoldbythematrulingmarket price.

4.10 Pros and Cons of Currency Convertibility Pros It represents confidence of the country in maintaining stable balance of payments position. It assures international investors about being able to exit their investments without any restrictions. This promotes Foreign Direct and Portfolio Investments. It provides domestic entities with access to international financial markets and wider avenues for investment.

4.10 Pro s and Con s of Currency Convertibility It ensures Interest Parity Condition in the market and provides depth to domestic foreign exchange and derivatives market. Cons It makes economy vulnerable to withdrawal of capital by both residents an non-residents. Exchange rates tend to be more volatile due to larger volume transactions. The economy becomes susceptible to international Hot Money.

4.11 Summary ForeignexchangemarketinIndiaistotallystructured, well regulated both by RBI and also by voluntary association (FEDAI) Only dealers authorized by RBI can undertake foreign exchange transactions. All inter-bank dealings in the same centre must be effected through accredited brokers, who are the second arms in the market structure, however, between the authorized dealers and RBI and also between ADs and Overseas Banks are effected directly without the intervention of brokers.

4.12 Self assessment questions 1. Enumerate the role of participants in the Indian foreign exchange market. 2. Discuss the issue of convertibility of INR 3. Describe the role of FEDAI in the Indian Forex market. 4. What do you mean by LERMS?

Foreign Exchange Management In India THANKS Let us now move to chapter 05 Foreign Exchange Quotations