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Money Matters!

It is rate between two currencies specifying how much one currency is worth in terms of the other. It is the price of a foreign nations currency in terms of the home nations currency. USD $ V/s Rs.

Exchange rate is also known as Foreign exchange rate or Forex rate. The foreign exchange market is one of the largest markets in the world.

By April2009, daily turnover was reported to be over US $ 5.2 trillion.

(1) Spot exchange rate

(2) Forward exchange rate

It refers to the current exchange rate and quoted for immediate delivery of foreign exchange . It refers to an exchange rate that is quoted and traded today but for delivery and payment on a specifc future date. Premium on currency Discount on currency Buying rate Selling rate

(3) Nominal exchange rate the rate at which we can trade the currency of one country for the currency of another (4) Real exchange rate the rate at which we can trade the goods and services of one country with the goods and services of another. (5) Real exchange rate = (nominal exchange rate X domestic price) /(foreign price).

Currency's value is matched to the value of another

single currency or to a basket of other currencies, or to another measure of value, such as gold

It is a rate that the central bank sets and maintains

as the official exchange rate. To maintain exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

If, for example, it is determined that the value of a

single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. the BOP, the central bank eventually runs out of foreign currencies, and will not be able to carry out the interventions

However, if the country persistently runs defcits in

Stabilizes the value of a currency Makes trade and investments between the two

countries easier and predictable

Means to control inflation Helps keep businesses competitive in foreign

markets

Heavy burden on exchange reserve Country must have sufficient reserve Fails to solve the balance of payment disequilibrium It is not a long term solution if the underlying

economy is weak. International disagreement might be created when a country sets its exchange rate on a too low level Fixing the exchange rate is not easy

The rate is determined by the private market through supply and demand. It is in effect since 1973 Clean floating the central bank stands aside completely and allows the exchange rate to be freely determined in the forex market official reserve transactions are zero Managed floating-the central bank intervenes to buy or sell foreign currencies periodically in an attempt to influence the exchange rates

Simple operation, smoother, more fluid

adjustment Brings realism in forex transactions Disequilibrium in balance of payment is auto stabilized No need to maintain large forex reserve

Tends to create uncertainty on the

international markets. Encourages inflation Floating exchange rates are affected by more factors than only demand and supply, such as government intervention Adverse effect of speculation

Devaluation the price of foreign currencies

under a fxed exchange rate regime is increased by official action Revaluation - the price of foreign currencies under a fxed exchange rate regime is decreased by official action Depreciation under a floating rate system, price of foreign currencies increases because of market adjustment Appreciation - under a floating rate system, price of foreign currencies decreases because of market adjustment

Devaluation of Rupee
In September 1949 and June 1966 :-

Historical Perspective
Formative Stage: 1978-1992 The impetus to trading in the foreign exchange market in India came in 1978 when banks in India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and were required to comply with the stipulation of maintaining square or near square position only at the close of business hours each day. The extent of position which could be left uncovered overnight (the open position) as well as the limits up to which dealers could trade during the day were to be decided by the management of banks. The exchange rate of the rupee during this period was ofcially determined by the Reserve Bank in terms of a weighted basket of currencies of Indias major trading partners and the exchange rate regime was characterized by daily announcement by the Reserve Bank of its buying and selling rates to the Authorized Dealers (Ads) for undertaking merchant transactions. Authorized Dealers were also permitted to trade in cross currencies (one convertible foreign currency versus another).

Historical Perspective
Formative Stage: 1978-1992 The foreign exchange market in India till the early 1990s, however, remained highly regulated with restrictions on external transactions, barriers to entry, low liquidity and high transaction costs. The exchange rate during this period was managed mainly for facilitating Indias imports. The strict control on foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets for foreign exchange in the world, i.e., the hawala (unofficial) market. By the late 1980s and the early 1990s, it was recognised that both macroeconomic policy and structural factors had contributed to balance of payments difficulties. Devaluations by Indias competitors had aggravated the situation. Although exports had recorded a higher growth during the second half of the 1980s ( 4.3 per cent of GDP in 1987-88 to about 5.8 per cent of GDP in 1990-91), trade imbalances persisted at around 3 per cent of GDP. This combined with a precipitous fall in invisible receipts in the form of private remittances, travel and tourism earnings in the year 1990-91 led to further widening of current account deficit.

Equilibrium exchange rate depends on :(1)Demand for and supply of currency in forex market. (2) Demand and Supply of foreign exchange arise from debit and credit item in BOP.

Demand and supply for foreign exchange

CHANGES IN EXCHANGE RATE IN FREE MARKET


EXCHANGE RATE (RS. FOR $1)

(1) Balance of trade and investment (2) Politics (3) Other Countries (4) Economic Theory (5) Interest Rate (6) Consumers (7) Housing (8) Inflation (9) Industrial and Economic Indicator (10)Capital Market (11) Economy

(1)BALANCE OF TRADE AND INVESTMENTS :


More import and less export Less Import and more export Balance of investment

(2) POLITICS :
Budget deficit and national debt Presidents popularity Terrorist attacks and war Elections

(3) OTHER COUNTRIES :


Turmoil in other countries A change in foreign reserves Acceptance of commodities in dollars Strong foreign economies

(4) ECONOMIC THEORY


Demand for currency Increase in money supply

(5) INTEREST RATES (6) CONSUMER BEHAVIOR


Savings Spending

(7) HOUSING
Slow housing market Overinflated housing market

(8) INFLATION RATE

(9) INDUSTRY AND ECONOMIC INDICATORS


Growth in Mfg/ Employment Outsourcing Entrepreneurship

(10) CAPITAL MARKET


Bear markets Bull markets Accounting scandals

(11) ECONOMY
Economic growth and stability Economic recession Outperforming other economies

Measures the price of a basket of goods and services available domestically relative to the same basket available abroad purchasing power parity.

Prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs US$4 in the United States and GBP 3 in the United Kingdom, the PPP exchange rate would be 3 for $4.

The central bank of the country--Reserve Bank of India (RBI). Established in April 1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton Young Commission. The share capital was divided into shares of Rs. 100 each fully paid up which was entirely owned by private shareholders in the beginning. The Government held shares of nominal value of Rs. 2,20,000. Reserve Bank of India was nationalized in the year 1949 No of members on central board is 20 (incl. governor and 4 deputy governors)

The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank. The Bank was constituted for the need of following: To regulate the issue of banknotes To maintain reserves with a view to securing monetary stability and To operate the credit and currency system of the country to its advantage.

The Reserve Bank of India Act of 1934 contains all the important functions of a central bank to the Reserve Bank of India. (1) Bank of Issue Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank notes of all denominations. (2) banker to Government The second important function of the reserve bank of India is to act as government banker, agent and adviser. RBI carries out banking operations (e.g. to receive and make payments, carry cash reserves) for all governments except J&Kacts as advisor to govt on all monetary and banking matters. (3) Bankers' Bank and Lender of the Last Resort The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible securities or get financial accommodation in times of need or stringency. Banks have been asked to keep cash reserves equal to 3 percent of their aggregate deposit liabilities.
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(4) Controller of Credit The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume of credit created by banks in India. It can do so through changing the Bank rate or through open market operations. (5) Controller of money market The Reserve Bank of India is armed with many more powers to control the Indian money market (6) Custodian of foreign exchange reserves Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act as the custodian of India's reserve of international currencies.

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A macroeconomic policy tool used to influence interest rates, inflation, and credit availability through changes in the supply of money available in the economy. In India it is also called the Reserve Bank of Indias Credit Policy as the stress is primarily on directing credit.

Bank Rate
Bank Rate is the rate at which RBI allows finance to commercial banks. Bank Rate is a tool, which RBI uses for short-term purposes. Any revision in Bank Rate by RBI is a signal to banks to revise deposit rates as well as Prime Lending Rate. Role of bank rate is limited in India because The structure of interest rates is administered by RBI Commercial banks enjoy specific refinance facilities.

CRR
All scheduled commercial banks are required to maintain a fortnightly minimum average daily cash reserve equivalent with RBI .The apex bank is empowered to vary this ratio between 3 and 15 per cent. RBI uses CRR either to impound the excess liquidity or to release funds needed for the economy from time to time.
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SLR Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold etc, in addition to cash reserve requirements. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). Present SLR is 24%.

Repos and Reverse Repo RBI is empowered to enter a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on which party initiated the transaction.
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Key Figures :
Reverse Repo 4% Repo Rate 4.25% Bank Rate 6% CRR Unchanged 5.5% Inflation 5.07%

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The Bretton Woods Agreement of 1944 fxed the conversion rate for one troy ounce of gold at $35. August 1971 - United States President Richard Nixon takes the dollar off the 'gold standard March 1973 - Most major countries adopt floating exchange rate system. US devalues dollar to $42.2 per ounce. January 1980 - Gold hits record high at $850 per ounce. High inflation because of strong oil prices, Soviet intervention in Afghanistan and the impact of the Iranian revolution, prompts investors to move into the metal. August 1999 - Gold falls to a low at $251.70 on worries about central banks reducing reserves of gold bullion and mining companies selling gold in forward markets to protect against falling prices.

Feb 20, 2009 - US gold futures rise back above $1,000 an ounce to a peak of $1,005.40 as investors turn to gold as major economies face recession and equity markets tumble. Oct 6 - Gold hits a record high of $1,035.95 an ounce in Europe, with buying fuelled by dollar weakness. Oct 8 - Spot gold tops $1,050 per ounce, as the dollar's continued struggle makes the precious metal more attractive to investors. Nov 4 - Gold surges to 1,097.25 an ounce, a record for a second straight day, as the dollar drops broadly after the Federal Reserve says it intends to keep interest rates low for some time .

THIS YEAR

In 1991, India pawned 67 tons of gold to tide over a balance of payments crisis. 18 years later, the Reserve Bank of India has bought thrice that amount of gold from the IMF to diversify its assets. In other words, it is a hedge against a falling dollar. The exchange rate of the dollar against the rupee will decline as many countries are following suit.

(A) The Dubai Meltdown (B) SDR

Dubai world a holding frm had taken loans to build real estate tourism ventures etc. They are not able to repay the interest. For the frst time in almost 10 years is a country defaulting. Since Dirham is pegged to the dollar foreign investments are affected. This will result in the dollar becoming weaker, gold rising further and the Rupee becoming stronger.

SDRs (Special Drawing Rights) are defned in terms of a basket of major currencies used in international trade and fnance. SDRs were originally created to replace Gold and Silver in large international transactions. So called Paper Gold, eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts. The Dollar, Euro and Pound are contained in the SDRthese currencies have been losing value to secondary reserve currencies. The SDR does not contain the Yuan, Rupee, Australian Dollar and Canadian Dollar which are important secondary reserve currencies. A big question mark on whether the SDR would be used as an alternative reserve currency in the future in place of the Dollar.

Dec 02 2009 Dec 01 2009 Nov 30 2009 Euro Pound Dollar Yuan Rupee 0.93600900 1.03476000 0.62028400 0.09091490 0.01336220 0.93560700 1.02809000 0.62028400 0.09096670 0.01336160 0.93300000 1.02305000 0.62104800 0.09134420 0.01332190

Nov 29 2009 0.93028300 1.02108000 0.62359800 0.09089980 0.01341160

The International Monetary Fund allocated about $4.78 billion as its share from Special Drawing Rights (SDR) fund to India for providing liquidity to the recession hit global economic system. Out of IMFs 186 member countries, emerging markets and developing countries would get over $18 billion out of the $100 billion allocated.

The recent G20 summit in London raised a few questions about the SDR. Russia and China suggested that the Dollar be replaced with SDR as the new reserve currency. The countries under this proposal could convert their reserves from dollars to SDRs without any erosion in their value.

Dr. Manmohan Singh :As far as I can see right now, there is no substitute for the dollar. China holds about $2.5 trillion of reserve assets and have not disposed of even a fraction of them. This shows their confdence in the US dollar.

The dollar continues to dominate global currency reserves nearly 64 per cent, against 27 per cent held in Euros. OPEC countries prefer to price all petroleum products only in the US dollar. Many of the worlds currencies are pegged against the dollar. Some countries have dispensed with their own currencies and adopted the US dollar as their currency

FCA 241,426 GOLD Physical stock has remained unchanged at approximately 357 tonnes. Forex Reserves 981 251,985

Current Account Convertibility: Convertibility required in the case of transactions relating to exchange of goods and services, money transfers, income and current transfers and all those transactions are classifed as Current Account Convertibility E.g.: If an Indian citizen needs foreign exchange of smaller amounts, say $1,000, for going abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer. This is a current account transaction

Capital Account convertibility: A capital account refers to capital transfers and acquisition or disposal of non-produced, non-fnancial assets E.g.: Suppose, one wants to import plant and machinery or invest abroad, and needs a large amount of foreign exchange, say $2 million, the importer will have to frst obtain the permission of the Reserve Bank of India (RBI). If approved, this becomes a capital account transaction

Capital Account Convertibility (CAC) was frst coined as a theory by the Reserve Bank of India in 1997 by the Tarapore Committee. Objective: to fnd a fscal and economic policy that would enable developing Third World countries transition to globalized market economies.

Capital Account Convertibility (CAC) means the freedom to convert local fnancial assets into foreign fnancial assets and vice versa at market determined rates of exchange. Capital Account Convertibility allows anyone to freely move from local currency into foreign currency and back. It refers to the removal of restraints on international flows on a country's capital account, enabling full currency convertibility and opening of the fnancial system.

Ensure total fnancial mobility in the country Efficient appropriation or distribution of international capital in India and also helps in attracting foreign investment Enables foreign investors to re-convert local currency into foreign currency anytime they want to and take their money away. Helps domestic companies to tap foreign markets. Greater access for resident companies to foreign capital and debt markets reduce cost of capital

One has to operate within the limits specifed by the reserve bank of India and obtain permission from RBI for anything concerning foreign currency With the advent of capital account convertibility, one would be able to look forward to more and better goods and services Help NRIs remove all shackles on movement of their funds

1.

CAC has 5 basic statements designed as points of action: All types of liquid capital assets must be able to be exchanged freely, between any two nations, with standardized exchange rates. The amounts must be a signifcant amount (in excess of $500,000). Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. Institutional investors should not use CAC to manipulate fscal policy or exchange rates. Excessive inflows and outflows should be buffered by national banks to provide collateral.

2. 3. 4. 5.

It allows domestic residents to invest abroad and have a globally diversifed investment portfolio, this reduces risk and stabilizes the economy.. Our NRI Diaspora will beneft tremendously if and when CAC becomes a reality. The reason is on account of current restrictions imposed on movement of their funds. As the remittances made by NRIs are subject to numerous restrictions which will be eased considerably once CAC is incorporated. It also opens the gate for international savings to be invested in India. It is good for India if foreigners invest in Indian assets this makes more capital available for Indias development.

Huge amounts of capital are moving across the border anyway. It is better for India if these transactions happen in white money. Convertibility would reduce the size of the black economy, and improve law and order, tax compliance and corporate governance. Most importantly convertibility induces competition against Indian fnance. Currently, fnance is a monopoly in mobilizing the savings of Indian households for the investment plans of Indian frms. No matter how inefficient Indian fnance is, households and frms do not have an alternative, thanks to capital controls. As trade liberalization has consequently led to lower prices and superior quality of goods produced in India, capital account liberalization will improve the quality and drop the price of fnancial intermediation in India.

Good economy leads to huge inflows of foreign capital, but bad economy will lead to an enormous outflow of capital under herd behavior . For example, the South East Asian crisis. Possibility of misallocation of capital inflows. E.g. capital inflows may fund low-quality domestic investments, like investments in the stock markets or real estates, and desist from investing in building up industries and factories, which leads to more capacity creation and utilization, and increased level of employment. An open capital account can lead to the export of domestic savings (the rich can convert their savings into dollars or pounds in foreign banks or even assets in foreign countries), which for capital scarce developing countries would curb domestic investment. Moreover, under the threat of a crisis, the domestic savings too might leave the country along with the foreign investments, thereby rendering the government helpless to counter the threat.

International fnance capital today is highly volatile, i.e. it shifts from country to country in search of higher speculative returns. In this process, it has led to economic crisis in numerous developing countries. Such fnance capital is referred to as hot money in todays context. Full capital account convertibility exposes an economy to extreme volatility on account of hot money flows.

The Indian economy has the competence of bearing the strains of free capital mobility given its fantastic growth rate and investor confdence. The FOREX reserves provide enough buffer to bear the immediate flight of capital which although seems unlikely given the macroeconomic variables of the economy alongside the confdence that international investors have leveraged on India.

However it must not be forgotten that CAC is a big step and integrates the economy with the global economy completely thereby subjecting it to international fluctuations and business cycles. Thus due caution must be incorporated while taking this decision in order to avoid any situation that results in economic downfall instead of rise in the economy.

There are restrictions on either residents or foreigners converting currency for transactions but no ban on at least one side resorting to such conversion. there are ceilings on the amount of foreign exchange that can be purchased by residents or frms registered in the country for acquisition of assets abroad. Rupee is not convertible for all transactions on capital account or inflows and outflows of capital. Also known as external convertibility.

In March 1992, under dual exchange rate system, 60% of all the receipts foreign exchange were exchanged at the market rate, remaining 40% of the receipts were converted at the official rate of exchange. It is available for some transactions like for goods, services, capital movements, some selected items of goods, services and capital. Restrictions on the amounts of the currencies that can be exchanged. It is applicable for the transactions on capital account.

Controls Reduces

on capital movements include prohibitions the uncertainty of outflow of foreign funds with short term maturity .

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