Currency Mechanism

Question 1

Exchange Rate

Answer 1

An exchange rate is the price at which one currency is converted into or exchanged for another currency

Question 2

Floating Rate

Answer 2

Role of monetary authority is nil. Except through indirect ways like OMO, interest rate etc.

Demand and supply determines the exchange rate.

Question 3

Dirty Float

Answer 3

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

Question 4

Fixed exchange rate

Answer 4

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

Question 5

Pegged System

Answer 5

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.

Question 6

Crawl Peg

Answer 6

Currency will crawl up or down by certain rate.

Question 7

India’s History in currency mechanism

Answer 7

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

Question 8

Depreciation

Answer 8

In foreign exchange market, it is a situation when domestic currency loses its value in front of a foreign currency which is market-driven

Question 9

Devaluation

Answer 9

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.

Question 10

Appreciation

Answer 10

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

Question 11

Revaluation

Answer 11

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

Question 12

NEER

Answer 12

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.

Question 13

REER

Answer 13

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

Question 14

Foreign Reserve

Answer 14

RBI holds foreign exchange reserves which are made up of foreign currency, bank deposits, government securities, gold reserves, special drawing rights of IMF.

Question 15

How much forex is neccessary

Answer 15

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

Question 16

Whether forex is adequate, depends upon

Answer 16

Composition of our flows

Debt composition

Food Position

Question 17

Sufficiency of Forex

Answer 17

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

Question 18

Problem with huge forex

Answer 18

Cost of acquisition is high
Sterilization cost is high
Returns are miniscule
Forex in dollar or US security is risky

Question 19

How can foreign reserve be used?

Answer 19

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

Question 20

Relation b/w rupee depreciation and export performance

Answer 20

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

Question 21

J Curve

Answer 21

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.

Question 22

Convertability of Money

Answer 22

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

Question 23

Current account convertibility

Answer 23

Freedom to convert domestic currency into foreign and vice versa for following purposes

Trade

Transfer payments

Factor payments

Question 24

Capital account convertibility

Answer 24

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

Question 25

Advantages of currency convertibility

Answer 25

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

Question 26

Fears of currency convertibility

Answer 26

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

Question 27

Tarapore Committee (1997)

Answer 27

Gave a road map for capital account but could not be implemented due to Asian currency crisis,

Question 28

Tarapore II on fuller rupee convertibility

Answer 28

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