Currency Mechanism Flashcards
Exchange Rate
An exchange rate is the price at which one currency is converted into or exchanged for another currency
Floating Rate
Role of monetary authority is nil. Except through indirect ways like OMO, interest rate etc.
Demand and supply determines the exchange rate.
Dirty Float
Market determined but central bank keeps the rate in a specified band that suits national interest
Band= Target zone
AKA Managed float. India follows this system
Fixed exchange rate
Central bank artificially and arbitrarily fixes the exchange rate
India had this system till 1992
India had this system as India did not need FDI or exports
Pegged System
Country’s currency is pegged to a hard currency. Meant for imparting stability and credibility to domestic currency to attract investors. But for this the country need to have huge forex.
Crawl Peg
Currency will crawl up or down by certain rate.
India’s History in currency mechanism
Fixed rate with respect to Pound Managed by RBI
Basket of currencies USD
1993-LERMS- 40% fixed and 60% market rate as determined by FEDAI
End of 90s- discontinuance of Fixed rate. Totally market dependent
Managed float- now
Depreciation
In foreign exchange market, it is a situation when domestic currency loses its value in front of a foreign currency which is market-driven
Devaluation
In the foreign exchange market when exchange rate of a domestic currency is lowered by its government, it is called devaluation.
Official depreciation is devaluation.
Appreciation
In foreign exchange market, if a free floating domestic currency increases its value against the value of a foreign currency, it is appreciation.
Market Driven
Revaluation
A term used in foreign exchange market which means a government increasing the exchange rate of its currency against any foreign currency,
It is official appreciation
NEER
Nominal effective exchange rate: The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country’s currency exchanges for a basket of multiple foreign currencies.
REER
Real effective exchange rate: Weighted average of volume of trades and Inflation adjusted exchange rate.
Difference in inflation between India and trading partner is factored into to arrive at REER
NEER always tend towards REER, although there may be time lag to suit the macro requirements of country.
N tends to R, because R comes After N…O…P..O..R
Foreign Reserve
RBI holds foreign exchange reserves which are made up of foreign currency, bank deposits, government securities, gold reserves, special drawing rights of IMF.
How much forex is neccessary
Forex is required for following reasons:
To check the appreciation/depreciation of currency
To gain external account security
To import essentials for economic and social security
To enable the country to globalise further
Whether forex is adequate, depends upon
Composition of our flows
Debt composition
Food Position
Sufficiency of Forex
Quantitative measures to check sufficiency of reserves:
Import cover: Recommended 3 months. India > 9 months
External Debt Cover: recommended 75% India: 75%
Guidotti Rule Average reserve holding should be equal to short term external debt. India-5 times
Liquidity at Risk: Given by Greenspan. Likely outflows using weighted average of volumes and also taking into account the probability of occurrence
Problem with huge forex
Cost of acquisition is high
Sterilization cost is high
Returns are miniscule
Forex in dollar or US security is risky
How can foreign reserve be used?
Liquidate external debt: Not advisable because
• All high cost debt is already been paid
• Will increase domestic debt
Lowering import duty: Could hurt domestic market
RBI cannot lend commercially as RBI will lend it to banks which will then again lend and inflation will increase
Government has set up Infrastructure finance Co Lts
• Wholly owned subsidiary (WOS) in Singapore: Would invest in AAA rated paper and use profits to provide monoline insurance to Indian companies accessing the overseas market for infra development in India.
• Wholly owned subsidiary (WOS) in London: Would provide loans to Indian companies raising funds oversees for capital import directly to be used in Infra
Sovereign Wealth Fund (SWF): Japan and China have done this. But India can’t, BOP condition is not that good.
SOR: can be an option.
Asian Development fund: Like IMF.
CRA and Brics development bank.
FeMale
Relation b/w rupee depreciation and export performance
As goods will become cheaper on depreciation exports will go up. FIl also flows in
Depreciation becomes necessary if competing countries suffer depreciation or resort to it deliberately. The forex that RBI holds partly arise out of this need.
But, it will help only up to certain extent Price elasticity need to be considered. Import elasticity of Indian exports is high thus depreciation hurts them
J Curve
It shows relation between rupee depreciation and BOP Initially trade deficit will worsen because foreign imports will be more expensive. Higher prices on foreign imports will be greater than the reduced volume of imports. However slowly export will become competitive, domestic manufacturers will substitute, import will decrease and trade deficit would improve. Opportunities for substitution will exist because domestic manufacturers will make the goods whose imports are expensive.
Convertability of Money
3 dimensions: FeMaLe
Freedom to convert
Convert at market rate
Liberalization: Removal of restrictions on conversion of current and capital accounts
India Acceded to article VIII off IMF in 1994-Current account convertibility
Current account convertibility
Freedom to convert domestic currency into foreign and vice versa for following purposes
Trade
Transfer payments
Factor payments
Capital account convertibility
Means there should be 100% FDI and Fii allowed across all sectors. Similarly, there should be very liberal regime for outflows and inflows. India have liberal policy for inflows i.e. FDI, investment by foreigners etc. but it is quite conservative when it comes to investment by Indians in abroad.
As global financial crisis shows, adoption of fuller convertibility should be calibrated or it can
be quite destabilizing.
Competition may be anti-domestic
Advantages of currency convertibility
Foreign capital for investment. Especially for infrastructure. Indian companies can have more funds which will help them in improving costs and competitiveness. Acquisitions Startups.
Increased liquidity and financial modernization due to FDI. Indian banks can lend at lower rate by borrowing from abroad.
Competition
FDI advantages in tech, invest and trade… TIT
Macro economic discipline
Wider ranges of choices from investment and borrowing
Fears of currency convertibility
As global financial crisis shows, adoption of fuller convertibility should be calibrated or it can be quite destabilizing
Competition may be anti-domestic
Rupee can be subjected to strong volatility
Dutch disease: Discovery of oil in Holland led to sudden upsurge in foreign currency inflow. => Appreciation of Holland currency. Exports suffered. Imports increased. => Loss to domestic manufacturers. Deindustrialization
Tarapore Committee (1997)
Gave a road map for capital account but could not be implemented due to Asian currency crisis,
Tarapore II on fuller rupee convertibility
India should make rupee more freely convertible to realize country’s maximum potential invertibility
In view of huge investment need of country, domestic investments would not be sufficient
But, before FRC India must improve regulatory and supervisory standards across the banking system
