EXCHANGE RATE-AJAY MASSAND

What is Exchange Rate ? Exchange Rate is a rate at which one currency

can be exchanged into another currency. In other words it is value of one currency in terms of other.

say:

US $ 1 = Rs.66.30

This rate is the conversion rate of every US $ 1 to Rs. 66.30

Methods of Quotation

Method – I

One Orange = Rs 2

One Apple = Rs 2.50

Method – II

Rs. 10 = 5 Oranges

Rs. 10 = 4 Apples

Price under both the methods is the same though expressed differently

Method - IDIRECT(FC fixed)USD 1 = Rs 62.60GBP 1 = Rs.100.64EUR 1 = Rs 84.65

Method - IIINDIRECT( HC fixed)Rs 100 = USD 1.5974Rs 100 = GBP 0.9936Rs 100 = EUR 1.1813

With Effect from 07.11.2013, all exchanges are quoted in Direct Method

In other world, the rate of exchange expresses the external purchasing power of a home currency.

According to Crowther, the rate of exchange “measures the number of units of one currency which will exchange in the foreign exchange market for another”.

Anatol Murad “The ratio at which one country’s currency can be exchanged for another is the rate of exchange between these two currencies”.

According to Sayers “the prices of currencies in terms of each other are called foreign exchange rate”.

Determination of Exchange Rate Rate of exchange is the price of one currency

in terms of another currency. Therefore, like other prices, the rate of

exchange is also determined in accordance with the general theory of value i.e., interaction of demand & supply forces. Supply of foreign exchange Demand for foreign exchange

1. Supply of foreign exchange

1. The domestic exporters who receive payments of foreign currency.

2. The foreigners who invest & lend in the home country.

3. Domestic residents who repatriate capital funds previously send abroad.

4. The domestic residents who receive gifts from abroad.

2. Demand for foreign exchange

1. The domestic residents to import goods & services from abroad.

2. The domestic residents investing & lending abroad

3. The foreign residents to repatriate funds previously invested in the home country.

4. Sending gifts to foreign countries.

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Excess supply

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Equilibrium of Exchange rate Equilibrium rate of exchange is determined at the

point where demand for foreign exchange becomes equal to the supply of foreign exchange.

The demand schedule for pounds, i.e., D £ (S$) intersects the supply schedule for pounds i.e., S £ (D$) at point E.

The equilibrium rate of exchange is OR & at this rate OM amounts of pounds are demanded as well as supplied.

Any rate of exchange above or below OR will represents disequilibrium position & will be unstable.

For example, At OR1 rate, there exist excess supply for foreign exchange i.e., the supply of rupees exceeds the demand for rupees (R1S1 > R1D1).

This will lead to a fall in the rupees rate of exchange & bring it down to the equilibrium level OR.

Similarly, OR2 rate represents a situation of excess demand i.e., the demand for pound exceeds the supply of pounds (R2D2 > R2S2).

This will push up the pound exchange rate to the equilibrium level OR.

Factors Determining Exchange Rates(a). Fundamental Reasons:

- Balance of Payment – surplus leads to stronger currency.- Economic Growth Rates –High/Low growth rate.- Fiscal / Monetary Policy- deficit financing leads to depreciation of currency.- Interest Rates –currency with higher interest will depreciate in the short term.- Political Issues –Political stability leads to stable rates

(b). Technical Reasons- Government Control can lead to unrealistic value. - Free flow of Capital from lower interest rate to higher

interest rates.(c). Speculation – higher the speculation higher the volatility in rates

12Determination of Exchange

Rates

EXCHANGE RATE

1. Spot Rate

2. Forward Rate

3. Long Rate

4. Fixed Rate

5. Flexible Rate

6. Multiple Rate

7. Two Tier Rate System

1. Spot Rate Spot rate of exchange is the rate at which foreign

exchange is made available on the spot. It is also known as cable rate or telegraphic transfer rate.

Spot rate is the day to day rate of exchange. The spot rate is quoted differently for buyers & sellers. For example $ 1 = Rs. 66.50 for buyers & $1 = Rs.

66.30 for the seller. This difference is due to the transport charges,

insurance charges, dealer’s commission etc – these costs are to be bears by the buyers.

2. Forward Rate Forward rate of exchange is the rate at which the future

contract for currency is made. The forward exchange rate is settled now but the

actual sale & purchase of foreign exchange occurs in future.

3. Long Rate The long rate of exchange is calculated by adding

premium to the spot rate of exchange in the case of credit purchase of foreign exchange & deducting premium from the spot rate in the case of credit sale.

5. Flexible Rate Flexible or floating of exchange rate refers to the

system in which the rate of exchange is determined by the forces of demand & supply in the foreign exchange market.

It is free to fluctuate according to the changes in the demand & supply of foreign currency.

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6. Multiple Rate Multiple rates refer to a system in which a country

adopts more than one rate of exchange for its currency. Different exchange rates are fixed for imports, exports

& for different countries.

7. Two - tier Rate System Two tier exchange rate system is a form of multiple

exchange rate system in which a country maintains two rates.

Higher exchange rate for commercial transaction & a lower rate for capital transaction.

EXCHANGE CONTROL Exchange Control is one of the device to control

international trade & payments. It aims at equilibrium of foreign receipts & payments. The chief function of most systems of exchange control is

to prevent or redress an adverse balance of payments Exchange control is also being used as protective device

in modern time – to ensure equilibrium of foreign receipts & payments.

Restrictions on conversion of a country's currency for another, imposed by its government in an attempt to improve its balance of payments position

However, the main objective of exchange control is to maintain the stability of the fixed exchange rate of a currency – BOP

Exchange rate determined by govt by fixing official exchange rate but not by determination of demand & supply forces.

Exchange control may be complete or partial, if exchange control is complete when the govt has full control over the exchange market.

Infact under complete exchange control, full control is possible to govt on exchange market & no disequilibrium in the BOP.

The exchange control applies to all types of international transactions & the govt restricts the sale & purchase of all currencies.

Govt control partially controls the exchange market – specified banks & financial institutions.

Definition of Exchange Controls Haberlar – exchange control refers to state regulation

excluding the free play of economic forces in the foreign exchange market.

P.T. Ellsworth – exchange control dealing with BOP difficulties, disregards market forces & substitutes for them the arbitrary decision of govt officials.

G.D.H. Cole – “The essence of exchange control is that the possessor of the controlled currency has no right, without special leave to convert it into foreign currency”.

Features of exchange control1. Exchange control has full control over the foreign

exchange market.2. Only specified banks & licensed dealers can deal in

foreign exchange.3. All foreign currencies are required to be surrendered

to the central bank.4. The central bank sanctions & allocates all foreign

payments in respect of different currencies.5. The central bank fixes the Official Exchange Rate

by the govt – not by market demand & supply forces.6. There is regulation on imports.

Objectives of exchange control

1. Over valuation

2. Under valuation

3. Stabilization of exchange rates

4. Prevention of capital flight

5. Protection to domestic industries

6. Checking non – essential imports

7. Help to the planning process

8. Remedying unfavorable BOP

9. Earning Revenues

1. Overvaluation Some countries resort to exchange control to keep their

currencies overvalued. Under this, the foreign exchange value of the

currency is fixed at a higher level than the free market rate – overvaluation

It is also known as pegging up – increases values of home currency to foreigners – reduces the prices of imports & raises the prices of exports.

The currency is overvalued for three reasons –1. At time of war – many countries leads large quantities of imports.

2. In the development process needs – raw material & capital equipment form abroad.

3. The repayment of large foreign debt.

2. Under valuation Undervaluation refers to the fixing of the value of a

currency at a rate lower than the free market rate. It is also known as ‘pegging down’. Reduced export

price & increases prices of imports. This is done to stimulate exports & reduce imports &

to raise the general price level of the country. But such a policy can succeed only in the case of a

small country whose participation in world trade is insignificant.

But if a large county were to adopt this policy, it will lead other countries to retaliate & follow this policy – highly dangerous.

3. Stabilization of exchange rates Foreign control is adopted to stabilise the rates of

exchange. Fluctuating exchange rates harms commerce &

industry. The govt, therefore, adopts exchange control measures

to stabilise the exchange rates by fixation of official exchange rate.

4. To check Flight of Capital Exchange control may be adopted to prevent the flight

of capital from the country. Flight of capital refers to the action of the citizens of

a country to convert their cash holding into foreign currencies.

Flight of capital may be the result of speculative activities, economic fluctuations and political uncertainty.

Flight of capital exhausts the country’s limited reserves of foreign exchange & de-stabilize the economy.

Through exchange control, the govt imposes restrictions on the sale of foreign currencies & there by checks the flight of capital.

5. Protection to domestic industries Exchange control may be restored to protect the home

industry from foreign competition. For this purpose, the govt restricts the imports through

foreign exchange controls & thus provides opportunity to the domestic industries to develop without any fear of international competition.6. Checking non-essential imports

Exchange control also aims at checking imports of non-essential commodities.

The non-essential, luxury, harmful & socially undesirable commodities through foreign exchange control.

Licenses are issued for imports of essential commodities.

8. To correct adverse BOP Exchange control is introduced to correct adverse BOPs. This is achieved by checking & regulating imports of

foreign exchange. With reduction in imports & control of foreign exchange

visible & invisible imports are reduced. Consequently, adverse BOP are corrected.9. Sources of Income

Exchange control is also used to earn revenue by the govt.

Under the multiple exchange rate system, the govt fixes the selling rates higher than the buying rates and earns income equal to the difference between the two rates.

10. To practices discrimination in trade Exchange control helps a country to follow a policy of

discrimination in international trade. The govt fixes favourable rates of exchange for the

countries with which it wants to strengthen its trade relation.

11. To check enemy nations Exchange control is also used by some countries to

prevent the enemy countries from using their foreign assets.

Regulations are adopted to freeze the assets held by the residents of the enemy country & they are not allowed to use transfer these assets.

Methods of Exchange Control According to Prof. Paul Einzig there are 41 methods of exchange control.

But in reality only two methods of control adopted by various countries of the world.

Generally speaking, the methods of exchange control are classified under two head.

1. Direct Methods of exchange control – unilateral methods.

2. Indirect methods of exchange control – bilateral or multilateral methods.

Direct Methods Indirect Methods

Methods of Exchange Control

1. Intervention or exchange Pegging

2. Rationing of foreign exchange

3. Blocked Accounts

4. Multiple Exchange Rates

5. Exchange Clearing Agreements

6. Payment Agreement

7. Gold Policy

1. Changes in interest rates

2. Quantitative Restrictions

3. Export Bounties/subsidies

Direct methods of exchange control1. Intervention or exchange Pegging

Interventions means govt may intervene in the foreign exchange market and fixing exchange rate either above or below the normal market rate, this is know as exchange pegging.

When the govt fixes the rate of exchange above the normal rate it is known as ‘Pegging up”.

On the contrary, if the govt fixes the exchange rate below the normal market rate it is known as ‘Pegging Down”.

Obviously, these ups & down of Pegging adopted by less developed countries (LDCs) to overcome pressure of BOP disequilibrium.

2. Rationing of foreign exchange Under this method of exchange control the

govt keeps the exchange value of its currency fixed by rationing the ability of its residents to acquire foreign exchange for spending abroad.

The govt imposes restrictions on the use, sale & purchase of foreign exchange.

All foreign exchange business is centralized either with the govt or with its agents.

3. Blocked Accounts – convertibility of accounts

Blocked accounts imply restrictions on the transfer of foreign capital to home countries or transfer of funds by foreigners to their home countries.

The central bank not allowed to convert foreign account into home account.

Under this methods, the foreigners are not allowed to convert their deposits, securities & other assets into their currency.

4. Multiple exchange rates When a country, instead of single exchange

rate, fixes different exchange rates for the import & exports of different goods – it is known as multiple exchange rates.

Even, different countries or different types of imports & exports – different exchange rates.

This types of multiple exchange rates fixed on different goods & services, different countries & different types of imports & exports.

Earning substantial foreign exchange.

5. Exchange Clearing Agreements Clearing agreements refers to a system under which

agreement is made between two countries for settling their international trade account through their respective central bank.

Kent in his words “Clearing Agreement is an agreement between the govt of the two countries for payments & receipts of import & exports.

Under this system, the importers instead of making payment for the imported goods in foreign currency pay in home currency to their central bank.

Similarly, the exporters, instead of receiving payment for goods exported in foreign currency receive it through the central bank in the home currency.

6. Payment Agreement The system of payment agreement solves two

major problems experienced under the system of clearing agreement i.e.,

1. The centralisation of payment

2. The problem of waiting for exporters The payment includes the trade transaction

such as shipping charges, debt services, tourism etc which are reflected in the BOP

7. Gold Policy Exchange control can also be affected by manipulating

the buying & selling price of gold. Such a policy affects exchange rates through its effect

on the gold points. For example, the Tripartite Agreement of 1936 between

U.K., France & USA sought to control exchange rates by fixing the purchase & sale prices of gold at a level at which these parties proposed to fix up the exchange rates.

Indirect Methods of exchange control1. Changes in interest rates

The govt can influence the rate of exchange indirectly through changes in the rate of interest.

The exchange rates can be reduced by lowering the interest rate & can be increased by rising the interest rates.2. Quantitative restriction

Another indirect method of exchange control is to restrict the imports of the country through measures like tariff, import quotas & other such quantitative restrictions.

Import duties reduces imports & with it rises the value of home currency relative to foreign currency.

Similarly, export duty restricts exports as a result, the value of home currency falls relative to foreign currencies.

In short, when import duties & quotas are imposed, the rate of exchange tends to go up in favour of the controlling country.3. Export Bounties

Export bounties or subsidies increases to exports. Export bounties refer to the financial assistance to

industries producing exportable goods. Export subsides increase exports as a consequence, the

demand for home currency in the foreign exchange market increase, thus raising the rate of home currency in terms of foreign currencies.