CONCEPTS
It is important to understand terms such as ‘foreign exchange’, ‘exchange rate’, and ‘exchange
rate regime’ as they are central to understanding the economy around.
Foreign Exchange: ‘Foreign exchange’ refers to money denominated in a currency other than
the domestic currency. Foreign exchange can be cash, funds available on credit cards and debit
cards, and bank deposits.
Exchange rate: The rate at which a currency of one country exchanges for another country's
currency is called the ‘exchange rate'. The exchange rate can either be expressed in terms of
the number of units of domestic currency per unit of foreign currency (direct quotation) as in
the case of most currencies such as the Indian rupee. For example, if the exchange rate between
the rupee and the US dollar (USD) is quoted as Rs.65, this means that Rs.65 is required to
purchase US$1.00. Or the number of units of foreign currency per unit of domestic currency
(indirect quotation) as in the case of some major trading currencies such as the pound sterling
and the Australian dollar. When the value of the domestic currency increases in terms of another
currency, it is referred to as a nominal appreciation of the domestic currency. In contrast, a
decrease in the value of the domestic currency in terms of a foreign currency is known as
nominal depreciation.
Exchange rate regime: An exchange rate regime is the process by which a country manages
its currency with respect to foreign currencies. Exchange rate regimes can broadly be
categorized into two extremes: fixed and floating. Between these, there are several
combinations of the two. The exchange rate system refers to the arrangement for the movement
of the exchange rate. Countries in the world operate under different exchange rate regimes.
1. Fixed exchange rate
Under a fixed exchange rate system, a country's monetary authority agrees to manage its affairs
to maintain a fixed ratio between the value of its own currency and that of other countries. A
country's currency, therefore, has a definite objective value in terms of the other currencies into
which it can be freely converted. The domestic currency is tied to another foreign currency,
mostly more widespread currencies such as the U.S. dollar, the euro, the Pound Sterling or a
basket of currencies. The government (or the central bank acting on the government's behalf)
intervenes in the foreign exchange market to ensure that the exchange rate stays close to a
predetermined target.
Under this system, exchange rate stability is achieved but if the exchange rate is fixed at the
wrong rate, it may be at the expense of domestic economic stability. In a fixed exchange rate
system, a rise in the exchange rate of the domestic currency vis-à-vis another foreign currency
is called a devaluation. This means that more of the domestic currency is needed to buy 1 unit
of a given foreign currency. On the other hand, when the exchange rate falls, it is termed as a
revaluation. These terms imply a deliberate decision on the government's part to change the
exchange rate level. For example, a government's policy decision to devalue the domestic
currency vis-à-vis the US dollar from Rs.65 to Rs.70.
It is important to realize that fixity cannot be achieved by simple government decree. There are
powerful economic forces at work in the foreign exchange markets; restricting the movement
of currencies requires equally decisive countervailing action by the authorities. This can take
two broad forms: direct intervention in the foreign exchange using so-called open market
operations, or the less direct option of interest rate manipulation. Fixing an exchange rate very
rarely involves establishing a single point away from which a currency is not permitted to
move. The usual approach is to define a target zone for the currency.
The authorities then respond with appropriate measures when market forces threaten to move
the currency above or below the zone. Theoretically, then, it is possible to hold a currency at
any given rate, so long as the associated excess demand or supply of the currency at that rate
can be met. The other policy measure that can be used as an alternative or supplement to open
market operations involves the noted use of interest rates.
Advantages
i) Provides greater certainty for exporters and importers as there are no or limited
exchange rate risks. Hence it promotes long-term capital flows.
ii) There is no fear of the adverse effect of speculation on the exchange rate.
iii) Businesses have the knowledge that the price is fixed and therefore not going to change;
it is relatively easier for them to plan.
iv) Encourages international trade by making prices of goods involved in trade more
predictable. It leads to low inflation.
v) Imposes the discipline necessary for exchange rate stability; monetary policy must be
coordinated. Keynes was a chief architect of Bretton Woods and a strong proponent of
fixed rates. Many Keynesians agree that government intervention is necessary to
promote exchange rate stability. However, the question remains how to attain a stable
exchange rate system?
Disadvantages
i) Have a high administration cost. Needs a complicated exchange control mechanism
which may lead to the misallocation of resources.
ii) A significant gap between the official rate and that determined by the market can
promote black markets. In a black market, most foreign exchange transactions are
carried out outside the banking system.
iii) This may force the government to draw down on reserves to meet its obligations and
cause a scarcity of foreign exchange.
iv) Restricts the ability of countries to conduct policy autonomously.
v) Inimical to the very desirable objective of free trade.
vi) May achieve exchange rate stability but at the expense of domestic economic stability.
Floating exchange rate
A flexible system follows free market principles. Exchange rate determination is left entirely
to the currency supply and demand processes, and governments do not attempt to manipulate
the market to have particular exchange rate outcomes. Popular regimes run the gamut from
currency boards and traditional pegs to crawling pegs, target zones and floats with varying
degrees of intervention. It is closely related to monetary policy and the two are generally
dependent on many of the same factors. The broad system of flexible exchange rates prevailing
in the world economy since 1973.
Since market forces determine the exchange rate, the upward and downward movements in the
value of the rupee are appreciation and depreciation. Depreciation of the rupee refers to the
decrease in the external value of the domestic currency that occurred due to the operation of
market forces. Example: If the value of 1 U.S dollar increases from Rs 70 to Rs 75,
the change will be termed depreciation of the Rupee.
Appreciation of the rupee refers to the increase in the external value of the domestic currency
that occurred due to the operation of market forces. Example: If the value of 1 U.S dollar
decreases from Rs 75 to Rs 70, the change will be termed an appreciation of the
Rupee. The exchange rate is determined in the open market through the pressure of buying
and selling foreign currencies.
Advantages
i) A flexible exchange rate system confers several advantages upon economies that adopt
it:
ii) Continuous changes are easier to adjust to.
iii) Less likely to permit a payments crisis to develop. Appropriate corrective exchange rate
movements will swiftly dissipate any early or ‘incipient’ deficit or surplus that might
arise. This system automatically provides for a balance of payments stability without
the need for any action whatsoever by policymakers.
iv) Less politicized and authorities do not intervene in the market for foreign exchange and
there is minimal need for international reserves.
v) Less likely to have adverse domestic repercussions. Provides fewer incentives for
destabilizing speculation. Financial instruments are available to hedge the risks posed
by a fluctuating exchange rate.
vi) Allows nations to pursue their own independent economic goals in respect of the other
objectives of macro policy. Gives the government/monetary authorities flexibility in
determining interest rates. This is because interest rates do not have to be set to keep
the value of the exchange rate within predetermined bands.
vii) Offers the most appropriate framework for the international allocation of resources
through the trade process.
Disadvantages
i) Market forces may fail to determine the appropriate exchange rate; hence, the floating
exchange rate regime may not provide the desired results and may lead to the
misallocation of resources.
ii) It is impossible to have an exchange rate system without official intervention. The
government may not intervene, however domestic monetary policy and fiscal policy
would influence the exchange rate.
iii) A wildly fluctuating exchange rate is at the mercy of national and international currency
speculators. A volatile exchange rate introduces considerable uncertainty in export and
import prices and consequently to economic development. At the same time, the
abolition of exchange controls causes capital flight.
Managed floating
Many countries are practising a system of the managed floating exchange rate at present. The
central banks have been trying to control fluctuations of exchange rates around some ‘narrow
band’, however, the demand and supply forces determine the exchange rate. The decision to
vary exchange rates can occur in the context of a variety of international monetary payment
schemes. Countries may operate at a fixed rate but allow occasional variations for fundamental
disequilibria. This is the adjustable peg system whereby rates can be pegged at new levels.
Countries may allow rates to vary freely within agreed bands. Countries may allow unrestricted
variation of rates. This allows a country to dispense with holding foreign reserves which
represent a sacrifice of consumption.
In this hybrid exchange rate system, the exchange rate is determined in the foreign exchange
market through the operation of market forces. Market forces mean the selling and buying
activities by various individuals and institutions. The management of a floating rate is
sometimes referred to in the literature as a 'dirty float’. It is unlikely that the authorities in any
country could remain completely indifferent to the behaviour of the exchange rate, and yet this
is what the advocate of completely flexible rates recommends. Managed or dirty floating is the
more usual alternative to participation in a fixed exchange rate system. In practice, a managed
fiat permits the authorities to intervene in the foreign exchange markets, using direct open
market operations, interest rates, or some combination of both.
The principal features of the current exchange rate regime in India can be stated as follows:
The rates of exchange are determined in the market.
The freely floating exchange rate regime continues to operate within the exchange
control framework.
RBI can intervene in the market to modulate the volatility and sharp depreciation of the
rupee.
The US dollar is the principal currency for RBI transactions.
The RBI also announces a Reference Rate based on the quotations of select banks in
Bombay at noon every day. The Reference Rate applies to SDR transactions and
transactions routed through the Asia Clearing Union.
