Exchange Rate Management in India

Exchange Rate Management in India
Exchange Rate Management in India

History and Types

Exchange Rate Management in India:- The foreign exchange market is the market in which foreign currencies are bought and sold. Being a member of the IMF till 1971, India followed the ‘Fixed Exchange Rate System’. After the collapse of the Bretton Woods system in 1971, the value of the rupee was determined by the pound for four years, but later this system also died.

At present, India determines the exchange rate according to the market and the International Monetary Fund. The demand and supply of money determines the market based exchange rate. Exchange rate is the value of one currency in relation to another currency. People who buy and sell forex include stock brokers, students, commercial banks, central banks, non-banking financial companies, forex brokers, etc. The major functions of forex exchange include the following:

learn about the Exchange Rate Management in India.

  • moving money from one market to another, where it is needed
  • Facilitating smooth flow of goods and services between countries by providing short-term credit for importers.
  • Stabilizing the foreign exchange rate through spot and futures markets.

 Historical background: –

After independence, a fixed exchange rate system was in force in India, which was later linked to the pound sterling. Market based exchange rate system started running in India from the year 1993.

The development of forex management is discussed below :   

Par Value System – 1947-1971: After attaining independence, India followed IMF’s ‘Par Value System’. In which the external value of rupee was fixed at 4.15 grains of gold.

Fixed exchange arrangements ( Pegged Regime – 1971-1992):

India exchanged its currency with the US dollar from August 1971 to December 1991 and with the UK pound sterling from December 1971 to September 1975 .

Liberalized Exchange Rate Management System : ( Liberalized Exchange Rate Management System ):-

As part of the process of economic reforms, in the budget of 1992-93, the Finance Minister declared partial convertibility of rupee on trade account and Indian rupee became partially convertible from March 1912. From this day liberalized exchange rate management system was implemented.

Under this system, a double exchange rate was fixed, under which 40 percent of the foreign exchange rate was converted into official and the remaining 60 percent at the rate determined by the market.

Types of Forex Market in India :

Spot Market :

This market is the market which is done within two days of the fixed transaction of buying and selling of foreign exchange. Spot buying and selling of foreign exchange forms the spot market. The rate at which foreign currency is bought and sold is called spot exchange rate. For all practical purposes, the spot rate is called the current exchange rate.

Forward Market :

This is the market in which foreign exchange is bought and sold at a future date at a predetermined exchange rate. When both the buyer and seller of foreign currency are involved in a transaction, the transaction is made within 90 days of the transaction. This is called the futures market.

Types of Exchange Rate Management

 A fixed exchange rate

 B flexible exchange rate

 Fixed Exchange Rate : –

The exchange rate between domestic and foreign currencies is decided by the monetary authority of a country. Under this, the exchange rate is not allowed to fluctuate beyond a limit, it is called a fixed exchange rate. Under the IMF system, the monetary authority of its member nation sets a fixed value of its currency relative to a reserve currency, usually the US dollar. This is called the ‘figured’ exchange rate or par value. However, under normal circumstances, there is an upper and lower limit of loudness up to 1 percent.

The basic objective of adopting a fixed exchange rate system is to ensure stability in foreign trade and capital movements. Under the fixed exchange rate system, the responsibility of ensuring the stability of the exchange rate falls on the government. To eliminate it, the government buys and sells foreign currency. When the foreign currency is weak, then the government buys it. And when it is strong then the government sells it. The sale and purchase of foreign exchange in private is kept suspended. Any change in the official exchange rate is made in consultation with the country’s monetary authority and the IMF. However, most countries have adopted a dual system. There is a fixed exchange rate for all government transactions and a market rate for private transactions.

Arguments in favor of Fixed Exchange Rate :

First, it eliminates the risk caused by uncertainty. It provides stability, certainty in the market.

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Second, it creates a system for the smooth flow of foreign capital between nations, as well as assures a certain return in the form of investments.

Third, it removes the possibility of speculative transactions in the foreign exchange market.

Finally, this competitive exchange reduces the chances of depreciation or devaluation of currencies.

B- Flexible Exchange Rate : –

When the exchange rate is determined by the market forces (demand and supply of money), it is called flexible exchange rate.

The proponents of flexible exchange rates also make an equally strong argument in favor of it. It is argued in this regard that flexible exchange rates lead to volatility, uncertainty, risk and speculation. But its proponents refute all these allegations.

Arguments in favor of flexible exchange rate :

First, an autonomy in the form of a flexible exchange rate is a good deal with respect to domestic policies. It is of great importance in the formulation of domestic economic policies.

The flexible exchange rate is self-adjusting and therefore there is no pressure on the government to maintain sufficient foreign exchange reserves to stabilize the exchange rate.

The flexible exchange rate is based on a principle that provides the benefit of predicting the future. Its biggest feature is its ability to auto-adjust.

The flexible exchange rate serves as an indicator of the real purchasing power of a currency in the foreign exchange market.

Finally, some economists argue that the biggest drawback of flexible exchange rates is uncertainty. But he also argues that under a flexible exchange rate system, there is as much uncertainty as possible under a fixed exchange rate.

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