FOREIGN EXCHANGE MANAGEMENT IN INDIA

8.1 INTRODUCTION

The Foreign Exchange Management Act, 1999 (FEMA) provides the Central government the powers to execute the act, and provides the Reserve Bank of India the powers to make regulations for executing the provisions for the act in terms of sec. 46 and Sec. 47 respectively. Section 41 provides that the central government may direct or instruct the reserve bank of India who shall comply with such directions or instructions. The reserve bank of India has the sole authority as well as the responsibility to administer the foreign exchange business in the country.

AUTHORIZED PERSONS:

Although the RBI has the sole authority to administer the foreign exchange business in India, it does not deal with individuals or other private entities and therefore cannot undertake the business itself. Foreign exchange is required by a large number of individuals, exporters and importers in the country spread over the vast geographical area of the country. It is not possible for the bank to deal with them individually. Section 10 of the acts permits the bank to delegate this activity. The bank provides license to three categories of persons called authorized dealers, Money changers and Offshore banking units (OBU) to transact with the public at different levels. All such transactions are governed by the exchange control Regulations provided by RBI.

Authorized persons are mandatorily required to comply with the directions and orders of RBI in all the foreign exchange dealings undertaken by them. Before undertaking any transaction in foreign exchange, necessary declarations and information should be obtained by the customer so as to ensure that provisions of the act are not violated.

AUTHORIZED DEALERS

The bulk of foreign exchange transactions undertaken in the country involve end-users and banks. Banks and select entities licensed by the RBI to undertake these transactions are called “Authorized Dealers” (AD). They are permitted to undertake all type of transactions pertaining to both the current and capital accounts of the balance of payments.

An authorized dealer is required to comply with the directions and instructions of the RBI. Such instructions are collectively called as ‘Exchange Control Regulations’ and are contained in the ‘Exchange Control Manual’. All amendments to the exchange control manual are intimated to the authorized dealers by the RBI in the form of its AD (MA series) circulars. Further directions pertaining to general procedures are given in the form of its AD (GP series) circulars.

With regard to the operational aspects of foreign exchange transactions such as charging of commission, methods of quotation of rates etc., the authorized dealers is required to comply with the rules of The Foreign exchange Dealers Association of India (FEDAI).

AUTHORIZED MONEY CHANGERS:

Money changers are licensed entities to provide facilities for establishment of foreign currency denominated travel related instruments such as foreign currency notes and travelers cheques. Licenses to operate as money changers are normally provided to hotels, travel agencies etc. Authorized money changers are further classified as full fledged money changer and restricted money changer. A full fledged money changer is permitted to take both purchase and sales transactions with public eg: Travel agencies. A restricted money changer is permitted only to purchase foreign currency notes and travelers cheques eg: 5 star hotels. All collections need to be surrendered to the authorized dealer in foreign exchange through a back to back arrangement.

OFFSHORE BANKING UNITS:

Branches of banks in India established in Special Economic Zones (SEZ) are accorded the status of Offshore Banking Units (OBU). The OBU are allowed to undertake banking operations only in designated foreign currencies essentially with non-residents. Each such OBU has a minimum startup capital of USD 100 million and its balance sheet is prepared in designated foreign currencies.

8.2 MANAGEMENT OF FOREIGN EXCHANGE IN INDIA

Foreign exchange is a scarce commodity and was subject to strict control in almost all countries till 1970s. In India, in keeping with the policy of liberalization the focus has changed to exchange management and not exchange control. The term ‘Exchange Control’ can be described as the quantitative control by the government or a centralized agency of transaction involving foreign currencies. Effectively any directive or regulation which restricts the free play of demand – supply forces in the foreign exchange market can be termed as exchange control.

HISTORY OF EXCHANGE CONTROL IN INDIA:

Exchange control was introduced in India on September 3, 1939 with the start of world war II in accordance with the emergency powers derived under the financial provision of the defence of India rules. The intention was mainly to conserve the foreign currency resources and utilize them for essential purpose.

The Foreign Exchange Regulation Act of 1947 was enacted after independence to provide a statutory base for conserving foreign currency resources and to put them to optimum use.

The Foreign Exchange Regulation Act, 1973 replaced the previous act. The purpose was to consolidate and amend the law pertaining to permissible transaction affecting foreign exchange resource resources, ensure the conservation of foreign exchange resources of the country and

their appropriate utilization in the interest of the economic development of the country.

The act was reviewed in 1993 and necessary amendments were enacted with conformity of the ongoing process of economic liberalization relating to foreign investments and foreign trade for closer integration with the world economy.

The foreign exchange Management Act 1999 (FEMA) is focused towards consolidating and amending the law related to the Foreign exchange utilization with the objective of facilitating external trade and payments. It also promotes orderly development and maintenance of foreign exchange market in India. The important features in the new act as compared to previous act are:

1. The classification of current and capital accounts transactions are clearly defined in the act.

2. The new enactment is positive i.e all current account transactions not specifically restricted can be carried out freely.

3. The FERA provided for criminal proceedings against violations whereas the FEMA provides for only civil liabilities against violations.

4. The definition of residents and non-residents now takes into account the duration of their stay in India as in the case of income tax act.

5. The FERA dealt with ‘Demand side’ management whereas the FEMA dealt with the ‘Supply side’ management of foreign currency resources of the economy.

8.3 THE FOREIGN EXCHANGE MARKET IN INDIA

The foreign exchange market in India may be broadly classified as ‘Retail Market’ and ‘Wholesale Market’

RETAIL MARKET:

1. In this segment end numbers of foreign currencies which include individuals who receive and make remittance, exporters and importers who buy and sell foreign currency requirements from commercial banks and travelers and tourists who exchange one currency with other in the

form of currency notes and foreign currency traveler’s cheques approach Ads for their requirements.

2. ADs provide committed rates for such transactions. Therefore this is the segments where exchange rates are used. These rates are called ‘Merchant Rates’.

3. Total turnover and individual transaction size is very small. Transactions are customized in terms of maturity to meet the requirements of individual customers.

4. All transactions taking place in this segment are governed by the Exchange Control Regulation of RBI. ADs also need to maintain tariffs and commission as per FEDAI guidelines.

5. Brokers and other intermediaries are not allowed in this segment.

WHOLESALE MARKET:

1. The wholesale market is also referred to as inter-bank market. It includes transaction between ADs as also operation between ADs and RBI.

2. Transactions in this segment are conducted in standard market lots and the average transaction size is large.

3. Transactions are conducted at ‘Inter-Bank’ rates. This is the segment in which exchange rates are determined. The external value of the domestic currency as a function of market demand-supply gets established in this segment.

4. A large proportion of inter-bank transaction are conducted through approved / authorized exchange brokers.

5. All transactions are conducted in accordance with the code of conduct established by RBI and FEDAI in this regard.

PARTICIPANTS IN THE INDIAN FOREIGN EXCHANGE MARKET:

END USERS:

They are represented by individuals, business house, international investors and multinational corporations operate in the market to meet their genuine trade or investment requirements. They also buy or sell currencies to speculate or trade in currencies to the extent permitted by the exchange Control regulation. They operate by placing orders in the commercial banks. The deal between the bank and their clients represents the retail segment of foreign exchange market. Speculative and arbitrage transactions constitute a major proportion of the market turnover.

COMMERCIAL BANKS:

They are the major players in the market. They buy and sell currencies for their clients. They may also operate on their own account. This is called ‘Proprietary trading’. When a bank undertakes transaction to adjust sale or purchase position in the foreign currency arising from its deal with its customers, such deals are called cover operations. Such transactions constitute only 15% of total transaction done by a trading bank. A major portion of the volume is accounted by proprietary trading in currencies to gain from exchange rate movements. All foreign exchange transactions are conducted through banking system and thus banks are ideally situated to establish the demand supply equilibrium. Thus banks actively participate in establishing the exchange rates between currencies. Banks may directly deal with themselves or use the service of exchange rate brokers. Foreign exchange trading profits are very important source of revenue for major international banks.

FOREIGN ECURRENCY BROKERS:

They function as intermediaries between authorized dealers transacting in the wholesale interbank market. Banks place orders with the brokers indicating the amount and rate at which they would be interested at buying or selling of currencies. These orders enable the brokers to create very fine combination quotes. When market makers or users approach them the brokers are able to provide ready quotes and match their requirements. The details of counterparties are conveyed to complete the transaction.

Brokers in India are not permitted to maintain ‘Open Position’ or trade on proprietary account. They only act as a deal facilitators. The rates of brokerage and general operations are governed by the guidelines by FEDAI.

Foreign exchange Brokers in India require license From the RBI to operate. This license is renewed based on the periodic review undertaken by FEDAI which makes the necessary recommendations to RBI. All such entities are required to maintain specified security deposit with FEDAI.

CENTRAL BANK (RESERVE BANK OF INDIA)

The central bank may intervene in the market to influence the exchange rates or to reduce volatility. The basic intention in such action is to redefine demand-supply equilibrium. The central bank may transact in the market on its own for the above purpose or on behalf of the govt, when undertaking transactions which may involve foreign currency payments and receipts. Under the flexible exchange rate system currently in operation, Central banks are under no obligation to defend any particular exchange rate but still intervene to change market sentiment.

The role of RBI in the exchange market is as follows:

1. Monitoring and management of exchange without a predetermined target rate or range with intermittent intervention as and when necessary has been the basis of the Managed Float System followed in India.

2. A policy to build a higher level of foreign exchange reserves. Which takes into account not only anticipated current account deficit but also liquidity requirements arising from unanticipated capital outflows.

3. A judicious policy for management of capital account transactions, with progressive liberalization of such transactions.

4. Balancing the external economy represented by the exchange rate and the internal economy represented by interest rates, inflation, money supply etc.

DISTINCTION BETWEEN THE RETAIL NAD WHOLESALE FOREIGN EXCHNAGE MARKET:

No

Retail Segment Wholesale Segment

1. This segment covers transaction between authorized dealers/ money changers and customers.

This segment covers transaction between authorized dealers as also between authorized dealers and central bank.

2. Rates quoted in this segment are called ‘Merchant Rates’.

Rates quoted in this segment are called ‘Interbank Rates’.

3. No brokers are permitted in this component of market.

Authorized brokers operate between Authorized dealers.

4. Transactions are governed by the exchange control regulation.

Dealing operations are conducted according to the code of conduct issued by FEDAI and RBI.

5. This segment ‘uses’ exchange rates.

This segment ‘determines’ exchange rates.

Transactions are customized. Transactions are standardized.

DEFECIENCIES OF THE INDIAN FOREIGN EXCHANGE MARKET:

1. It is dominated by merchant traders.

2. The forward rate is influenced by the demand and supply conditions, and do not exactly reflect the interest rate differentials.

3. It is not integrated with money markets, thereby creating opportunities for arbitrage.

4. There are few market makers due to which market lacks depth.

5. The cross currency market has not developed.

6. There are limitations to the use of hedging products like swaps, forward rate agreements, and currency futures. Exchange traded currency options are not available.

8.4 CONVERTBILITY OF INDIAN RUPEE (INR)

BACKGROUND:

When the Bretton woods system ended in august 1971, the INR was pegged against the British Sterling pound (GBP) by the way of a hard peg which means the GBP/INR rate remained constant whereas cross rates were calculated on a daily basis using this fixed relationship as a vehicle currency quotation.

Due to certain deficiencies in the above system it was discontinued in September 1975 and the INR was pegged to the basket of 16 currencies. This represented a soft peg which means that the value of INR was calculated afresh daily but represented by way of GBP/INR ‘fixing’. Cross rates were calculated using the fixing quotation. Effectively GBP continued to function as vehicle currency and also as the intervention currency.

Effective from August 1 1991 USD was made the vehicle currency. Therefore the USD/ INR rate functioned as the vehicle currency quotation for calculating cross rates. The factors which usually contribute to the choice of vehicle currency are:

1. Composition of the foreign currency reserve of the country.2. Usage of the currency in invoicing of exports and imports.3. Acceptability of the currency in the international markets.4. Availability of cross currency rates for calculating cross rates.

In March 1992 India adopted a dual exchange rate system called ‘LERMS’ (Liberalized Exchange Rate Management System). In this system exporters were required to sell 40% of all exports proceeds to the RBI at a fixed price. The balance component of 60% was permitted to be sold at market driven price through the domestic foreign exchange market. LERMS represents partial float of INR. This system was introduced because the country’s foreign exchange had depleted substantially. The component of 40% sold to RBI ensured a corpus of foreign currency at a fixed cost which

guaranteed availability of foreign currency resources for purchase of essential imports like petro-products, defence equipments, agro-products etc. As the foreign exchange reserves position gradually improved the system was discontinued from March 1993. From this period onwards the Indian rupees has always been valued on market related basis. This is known as ‘The Unified Exchange rate System’. It represented floating of the INR which means that the government and the RBI was no longer participants in the currency valuation process. Market demand-supply forces established the external value of INR. This was the first step towards introduction of currency convertibility in India.

Floating of a currency is a pre-requisite to convertibility of a currency. While floating deals with the method used to establish the value of currency, convertibility deals with the operational ease with which domestic currency is allowed to be converted into foreign currency. Convertibility therefore represents procedural simplification of foreign exchange transactions for personal dealings in the currency.

In August 1994, the INR was made convertible for current account transactions. This means that all impediments such as licensing, etc were removed in so far as foreign exchange transactions involved purchase/ sale of foreign currency for permitted import and export of goods and services. Limits were placed on conversion allowed foe several categories of activities. Eg: Currently each resident individual is permitted to purchase foreign currencies upto USD 10000 per calendar year for international tourism described as basic travel quota.

CAPITAL ACCOUNT CONVERTIBILITY (CAC)

In 1997 a committee headed by Mr. S.S Tarapore, the deputy governor of RBI, was constituted to recommend stepwise implementation of CAC. The recommendations of this committee could not be implemented because of international developments such as the South East Asian crisis, Currency failures in Brazil and Russia and events such as 11th September, 2001 in America.

While there is no formal definition of CAC, the committee under the chairmanship of Mr. Tarapore defined CAC as the freedom to convert local financial assets into foreign financial assets and vice versa at a market determined rates of exchange. It is associated with changes of ownership in foreign/ local financial assets and liabilities in the form of receivables and payables and involves the creation and liquidation of claims on or by non- resident entities.

A second committee to suggest a road map for achieving fuller CAC was constituted. The recommendation of this committee was received in 2006, will be implemented by RBI in phased manner so as to achieve the desired level of CAC by 2011-2012.

In the interim period, the RBI has progressively allowed greater freedom in capital transactions some of these relaxations are:

1. Individual residents are permitted to invest up-to USD 100,000 in international securities.

2. Individual residents are permitted to establish non-interest bearing accounts in specified currencies with banks in India.

3. In a gradual manner, the RBI has allowed Indian corporate entities to raise resources and invest overseas in higher manner.

4. Branches of Indian banks located in SEZ are permitted to conduct banking operations such accepting deposits and giving loans in non-resident currencies.

The current status of INR is that it is fully convertible for foreign account transactions and partially convertible for capital account transactions. The limitations in capital account transaction apply only to residents and not non-residents which means that for non-resident entities the INR is for all practical purpose, fully convertible, subject to quantitative sector –wise limits for investments.

Following are the prerequisites for CAC:

1. Maintenance of domestic stability.2. Adequate foreign exchange reserves.

3. Restrictions on inessential imports.4. Comfortable current account position.5. An appropriate industrial policy and a friendly investment climate.

8.5 MANAGEMENT OF RESERVES

Foreign Currency Reserves Management can be described as the process that ensures that adequate foreign assets are readily available to the authorities for meeting identified liabilities and a defined range of objectives for a country. These objectives include:

1. Exchange rates management represented by the capacity to intervene in the support of domestic currency.

2. Maintaining adequate foreign currency liquidity to absorb shocks during the crisis or when access to borrowing is curtailed thereby reducing vulnerability of the economy too external forces.

3. Providing confidence to the international community that the country can meet its external obligations/ liabilities.

4. Ensuring that the domestic currency is largely backed by external assets.

5. Managing foreign currency line of credit for promoting high value exports.

Adequate Foreign Currency Reserves makes the economy resilient to demand pressures as also unanticipated fund requirements. The South East Asian crisis in 1997 highlighted the fact that a financial crisis gets amplified when the monetary authorities do not hold sufficient reserves to meet unexpected demands.

Similarly appropriate Portfolio management policies concerning the currency composition, choice of investment instruments and acceptable duration of the reserve portfolio, commensurate with the country unique needs, ensures that assets are protected and readily available to ensure market confidence.

Sound reserve management policies and practices can support but cannot substitute sound macroeconomics management. Inappropriate

economic policies create serious limitations to efficient reserves management.

ROLE OF IIMF:

The International Monetary Fund (IMF) has provided detail guidelines to member countries on this subject. These guidelines assist government in strengthening their policy framework for reserve management so as to increase their resilience to shocks that may originate from global financial markets or domestic financial system. The aim is to help the authorities to introduce appropriate objectives and principles for reserve management and built adequate institutional and operational support system for effective reserve management practices. There is no unique set of reserve management practices or institutional arrangements that would suit all countries or situations, which means that there cannot be standardized set of regulations. Each member therefore has to structure an independent structure for managing reserves. Guidelines of the IMF are therefore not mandatory.

The common elements of all such models are:

1. Adequate foreign exchange reserves should be available for meeting a defined range of objectives.

2. Liquidity, market and credit risks should be adequately controlled, and3. Liquidity and other risks constraints should be appropriately balanced to

ensure that reserves generate reasonable returns.

LEVEL OF RESERVES:

Reserve management forms a part of official economic policies, and specific circumstances will impact decisions concerning both reserve adequacy and reserve management objectives. In order to ensure timely availability of reserves, the reserve manager needs to have assessments of what constitutes adequate level of reserves. There are no universally

applicable measures foe assessing the adequacy of reserves and the determination of reserve adequacy falls beyond the scope of IMF guidelines. The factors influencing such decisions are:

1. The monetary and exchange rate policies of the country.2. The size nature and variability of its balance of payments deficit or

surplus.3. The external debt position, and4. The volatility of its capital flows.

DETERMINANTS:

Reserves should be available when they are needed most which means they should be liquid. Liquidity can be described as the ability to convert quickly reserve assets into foreign exchange. Liquidity however carries a cost which involves accepting investments, providing lower yield.

Reserve management involves control of risks to ensure that assets value are protected. Market and credit risks can cause sudden losses and impair liquidity.

Finally earnings on investments of reserves are an important element of the management of reserve assets. For some countries, they offset the cost associated with other central bank policies and other domestic monetary operations, which actually fund the acquisition of reserves. In cases where reserves are created by borrowing in foreign markets, earnings play an important role in minimizing the carrying cost of reserve assets. Thus achieving an acceptable level of earnings involves a balance between clearly defined liquidity and risk factors.

EXCAHNGE RATE REGIMES:

Under a free float there is no commitment by the authorities to participate in the foreign exchange market through intervention. This provides the reserve management authority greater flexibility in structuring the duration and liquidity of portfolio. However in reality the monetary

authority would prefer to maintain a capacity to ensure orderly market during the time of very sharp adjustments of the exchange rate or market pressures and be able to counter unforeseen internal or external shocks.

In countries with fixed exchange rate including those which operate currency boards the authorities need to intermittently participate in the foreign exchange market, and will therefore need reserves that can be readily converted into foreign exchange. Especially in these cases reserves are needed to provide confidence in the currency peg and deter speculation. For these purposes reserves ten to be invested in the form that facilitates their ready availability.

RISK IN RESERVE MANAGEMENT:

1. Liquidity risk : The probability risk of not having sufficient assets in liquid form to meet immediate liability.

2. Credit risk : The probability of counterparty default. This is the probability that the issuer of the assets may default.

3. Currency risk : The probability of loss due to fall in values of currencies forming the reserves is described as currency risk. Some elements of exchange rate risk is unavoidable with reserve assets portfolios.

4. Interest rate risk : The probability of loss due to changes in interest rate. Yield value of debt instruments is inversely proportional to the interest rates.

5. Control system failure risk : Losses arising due to frauds, money laundering and theft of reserves assets due to inadequate control procedures inadequate skills poor separation of duties and collusion among reserves management staff members are describes as system risk.

6. Financial error risk : Off balance sheet foreign currency dominated asset and liabilities are often ignored when establishing the exposure in different currencies. Losses due to such errors are financial errors.

7. Loss of potential income : Failure to re-invest funds accumulating in ‘Nostro’ accounts with foreign banks in a timely manner gives rise to loss

of potential revenue. Such losses arise due to inadequate procedures for monitoring and managing settlements and reconciling accounts.

8.6 FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA (FEDAI)

The FEDAU was set up in 1958 as an association of banks dealing in foreign exchange in India (called Authorized Dealers-ADs). It is a self regulatory body and incorporated under section 25 of The Companies Act 1956. The major activities includes framing of rules governing the conduct of foreign exchange business between banks and the public and liaison with RBI for reforms and development of the foreign exchange market.

Presently their main functions are as follows:

1. Frame guidelines and rules for foreign exchange business.2. Training of bank personnel in the areas of foreign exchange business.3. Accreditation of foreign exchange brokers and periodic review of their

operations. They also advise RBI regarding licensing of new brokers.4. Advising/ Assisting member banks in setting issues/ matters in their

dealings. They provide a standardized dispute settlement process for all market participants.

5. Represent member banks in discussion with government/ RBI/ other bodies and provide a common platform for ADs to interact with government and RBI.

6. Announcement of daily and periodical rates to member banks. At the end of each calendar month they provide a schedule of forward rates to be used by ADs for revaluing the foreign currency denominated assets and liabilities.

7. Announcement of ‘spot date’ at the start of each trading day to ensure uniformity in settlement between different market participants.

8. Circulate guidelines for quotation of rates, charging of commissions, etc. by ADs to their customers and by brokers for interbank transactions.

Due to continuing integration of global financial markets and increased speed of de-regulation, the role of self-regulatory organizations like FEDAI has also changed. In such an environment, FEDAI plays a catalytic role for smooth functioning of the market through closer co-ordination with RBI, organizations like FIMMDA (Fixed Income Money Market and Derivatives Association), the Forex association of India and various market participants. FEDAI also helps to maximize the benefits derived from synergies of member banks by way of innovation in the areas like new customized products, bench marking against international standards on accounting, market prices, risk management system etc.

8.7 RESERVES ACCOUNT IN BALANCE OF PAYMENTS

It comprises of balance with IMF, allocated SDRs, monetary gold reserves and foreign currency assets held by the monetary authority of the country i.e. the RBI. The SDR’s monetary gold reserves and foreign currency assets collectively represents the external performance of the economy over a given period. This is because the net imbalance in the inflows and outflows of foreign currency on account of all autonomous transactions gets reflected as a change in one of these elements of the reserve account on daily basis.

The issue department of the RBI is responsible for creation of physical money in the country and maintain its equality against an asset basket controlled by the RBI. This asset basket in addition to the above three elements includes government securities. Effectively the quantum of government securities as a proportion of the asset basket represents the balancing element between the actual level of money supply and the money supply backed by the external trade performance of the country. Adjustments in the money supply created against government securities is done through open market operations whereas adjustments required on account of money created against foreign currency assets is done through the use of market stabilization scheme.

The issue department of RBI is also responsible for maintaining the desired proportionality between the different elements of assets basket. This assets basket is subject to a ‘Minimum Reserve System’ which means a minimum proportion of each individual asset has to be maintained. This is to ensure that there is no concentration of holding in any particular category. It therefore reduces the risk of incurring loss due to fall in the value of the asset of any particular category.

The monetary policy of RBI which is mow declared twice in each quarter is a process involving a review of the economic performance of the country and provides for variation in various tools of monetary management such as Cash Reserve Ratio, Statutory Liquidity Ratio, Bank Rate, Repo and Reverse Rate, etc so as to achieve an optimum balance between economic growth, interest rate, inflation rate, and the exchange rate of the domestic currency.