Foreign exchange: the market, determination of the exchange rate, fixed and flexible rates, and exchange control

1. Meaning

Foreign exchange means the currencies of other countries and claims on them (bank deposits, bills, drafts). The rate of exchange is the price of one currency in terms of another: Crowther, “the rate of exchange measures the number of units of one currency which exchange in the foreign exchange market for one unit of another.” It can be quoted directly (Rs. per US dollar, as in India) or indirectly (dollars per rupee). A rise in the rupee price of a dollar is a depreciation of the rupee.

2. The foreign exchange market

The foreign exchange market is the market in which currencies are bought and sold. It is a worldwide network of banks, dealers and brokers linked electronically, not a place.

• Participants: commercial banks (authorised dealers), brokers, exporters and importers, investors, and the central bank, which intervenes to manage the rate.
• Spot market: delivery within two working days at the spot rate.
• Forward market: contracts for delivery at a future date at a rate fixed today; also futures, options and swaps.
• Functions: transfer of purchasing power between countries; credit for foreign trade (bills, letters of credit); and hedging against exchange risk through forward contracts.

3. Determination of the exchange rate

(a) Mint parity theory (under the gold standard)

When both currencies were convertible into gold, the rate was fixed by the ratio of their gold contents (the mint par). It could move only between the gold points, the mint par plus or minus the cost of shipping gold.

(b) Purchasing power parity theory (Gustav Cassel, 1918)

Under inconvertible paper currencies, the rate tends to settle where it equalises the purchasing power of the two currencies. In its relative version, changes in the exchange rate follow changes in relative price levels:

New rate = base rate × (domestic price index / foreign price index)

Example. In the base year US$1 = Rs. 50. Since then the price index in India has risen to 150 and in the US to 120. New rate = 50 × 150/120 = Rs. 62.50 per dollar: the rupee depreciates because Indian prices rose faster.

Criticisms: price indices of different countries cover different goods; many goods and services are not traded; transport costs and tariffs intervene; capital flows and speculation move rates independently of prices; and it ignores demand elasticities.

(c) Balance of payments (demand and supply) theory

In a free market the rate is the price at which the demand for foreign exchange equals its supply.

• Demand for foreign exchange (say dollars) comes from: importers of goods and services, residents investing abroad, repayment of foreign loans and payment of interest and dividends, Indians travelling or studying abroad, and speculators expecting the dollar to rise.
• Supply comes from: exporters, foreign investors (FDI and portfolio), foreign loans and aid, remittances from Indians abroad, foreign tourists, and the central bank selling reserves.

Drawn with the rupee price of the dollar on the vertical axis, the demand curve slopes downwards (a dearer dollar makes imports dearer) and the supply curve upwards (a dearer dollar makes Indian exports cheaper abroad). Equilibrium is where they cross. An increase in imports shifts demand to the right and the rupee depreciates; an increase in capital inflows shifts supply to the right and the rupee appreciates.

4. Fixed and flexible exchange rates

Under a fixed (pegged) system, the government or central bank fixes the rate and maintains it by buying and selling foreign exchange (the gold standard; the Bretton Woods adjustable peg, 1945–1971). Under a flexible (floating) system, the rate is set by demand and supply in the market. Between them is the managed float, in which the market sets the rate but the central bank intervenes to smooth volatility.

Fixed rates: advantages

• Certainty and stability for traders and investors; encourages trade and long-term capital.
• Discourages speculation.
• Imposes discipline on domestic monetary and fiscal policy (inflation cannot be exported easily).
• Suitable for small, open economies dependent on trade; supports currency areas.

Fixed rates: disadvantages

• Requires large reserves to defend the rate.
• Domestic policy is subordinated to the exchange rate: a deficit country must deflate, causing unemployment.
• Disequilibrium can persist and end in a crisis and sudden devaluation.
• Encourages speculative attacks when the peg looks unsustainable (as in 1971 and the Asian crisis of 1997).

Flexible rates: advantages

• Automatic correction of balance of payments disequilibrium.
• Independence of monetary policy: the country can pursue domestic goals.
• No need for large reserves.
• Efficient: the rate reflects real market conditions; insulates the economy from foreign inflation to some extent.

Flexible rates: disadvantages

• Uncertainty and risk discourage trade and long-term investment.
• Destabilising speculation can cause wide swings.
• Inflationary: depreciation raises import prices, which raise costs and wages.
• Unsuitable for developing countries with inelastic exports and thin markets; can lead to competitive depreciations.

India. The rupee was pegged (to sterling, then a basket of currencies) until the 1991 crisis. The Liberalised Exchange Rate Management System (March 1992) introduced a dual rate, and from March 1993 the rate became market-determined, with RBI intervention to contain volatility: a managed float. India accepted current account convertibility under Article VIII of the IMF Articles of Agreement in August 1994.

5. Exchange control

Exchange control is a system under which the government (through the central bank) regulates the purchase and sale of foreign exchange, instead of leaving it to the free market. All foreign exchange earnings must be surrendered, and foreign exchange is released only for approved purposes. Haberler: State regulation that excludes the free play of economic forces from the foreign exchange market.

Objectives

1. Correcting a balance of payments deficit by rationing scarce foreign exchange.
2. Stabilising the exchange rate and preventing wide fluctuations.
3. Checking capital flight and speculative outflows.
4. Maintaining an overvalued currency (to make essential imports and debt servicing cheaper).
5. Protecting home industries by restricting imports.
6. Conserving foreign exchange for development imports and planned priorities.
7. Earning revenue (through multiple rates) and bargaining power in trade negotiations.

Methods

(a) Unilateral (direct) methods

• Intervention (pegging): the central bank buys or sells currency to hold the rate, using an Exchange Equalisation Account (Britain, 1932).
• Exchange restrictions: compulsory surrender of foreign exchange to the central bank and its rationing by licence.
• Blocked accounts: foreigners’ balances cannot be transferred abroad.
• Multiple exchange rates: different rates for different goods or transactions (favourable rates for essential imports, penal rates for luxuries).

(b) Bilateral and multilateral methods

• Clearing agreements: importers pay their own central bank in home currency, which pays its exporters; only the net balance is settled.
• Payments agreements, standstill agreements (freezing short-term foreign debts) and compensation (barter) agreements.

(c) Indirect methods: tariffs, quotas, changes in interest rates to attract or deter capital, and export subsidies.

Demerits: corruption and delay in licensing, black markets in foreign exchange (hawala), inefficiency, retaliation by other countries, and reduction of world trade. India moved from strict control under the Foreign Exchange Regulation Act, 1973 to management under the Foreign Exchange Management Act, 1999 (in force from 1 June 2000), under which current account transactions are free subject to reasonable restrictions and capital account transactions are regulated by the RBI and the Central Government.

How this is examined

For the exchange rate essay, define, explain determination by demand and supply (list the sources of each), and then the advantages and disadvantages of whichever system is asked, with a line on India’s managed float. For exchange control, define, list the objectives and divide the methods into direct, bilateral and indirect. A six-mark “foreign exchange market” note needs section 2 and a line on spot and forward rates.