Exchange Rate System - Vaibhav Barick(International Finance)

8/3/2019 Exchange Rate System - Vaibhav Barick(International Finance)

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International Finance -

Exchange Rate System


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Group members

Vaibhav Barick

Lalit Chawhan

Paras Furia

Mamta Pawar

Rohan Nilesh


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Contents

Introduction to Exchange Rate system

Types of Exchange Rate system

Gold Standard Bretton Woods System

Nixon Shock

Foreign Exchange Governing Body Exchange rate system in India


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Introduction to Exchange rate system

Exchange Rate is a rate at which one currency can be exchanged into anothercurrency.

In other words it is value of one currency in terms of other

The exchange rate system is the way a country manages its currency inrelation to other currencies and the foreign exchange market

It is closely related to monetary policy and the two are generally dependent onmany of the same factors

For e.g. If you are travelling to Egypt and the exchange rate for U.S. dollars 1:5.5Egyptian pounds, this means that for every U.S. dollar, you can buy five and ahalf Egyptian pounds


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Types of exchange rate system

Float

A floating exchange rate or fluctuating exchange rate is a typeof exchange rate regime wherein a currency's value is allowed to fluctuate

according to the foreign exchange market. A currency that uses a floatingexchange rate is known as a floating currency

Floating rates are the most common exchange rate regime today.

For example, the Dollar, Euro, Yen, and British pound all are floating

currencies


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Float

However, since central banks frequently intervene to avoid excessiveappreciation or depreciation, these regimes are often called managed

float or a dirty float Take a look at this simplified model: if demand for a currency is low, its

value will decrease, thus making imported goods more expensive andstimulating demand for local goods and services. This in turn will generatemore jobs, causing an auto-correction in the market. A floating exchangerate is constantly changing


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Peggedfloat

Pegged floating currencies are pegged to some band or value, either fixedor periodically adjusted. Pegged floats are:

Crawling bands: the rate is allowed to fluctuate in a band around a centralvalue, which is adjusted periodically. This is done at a preannounced rate orin a controlled way following economic indicators

Crawling pegs: Here, the rate itself is fixed, and adjusted as above

Pegged with horizontal bands: The currency is allowed to fluctuate in afixed band (bigger than 1%) around a central rate

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Fixed

A fixed or pegged rate is a rate the government (central bank) sets andmaintains as the official exchange rate

A set price will be determined against a major world currency (usually theU.S. dollar, but also other major currencies such as the euro, the yen or abasket of currencies)

In order to maintain the local exchange rate, the central bank buys andsells its own currency on the foreign exchange market in return for thecurrency to which it is pegged

A pegged currency with very small bands (< 1%) also fall under thiscategory

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Dollarization

Euroizing or Dollarization occurs when the inhabitants of a country useforeign currency in parallel to or instead of the domestic currency.

The term is not only applied to usage of the US dollars but generally to theuse of any foreign currency as the national currency.

For e.g.

Zimbabwe

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World Wide Scenario

Managed float regime

Free float regime

Different types of currency peg

Usage of foreign currency


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Gold standard

The gold standard is a monetary system in which thestandard economic unit of account is a fixed mass of gold.

The Gold Standard is described in a variety of reference materials as aeconomic system in which the unit of foreign currency used is a fixedamount or weight of gold. In this technique, each forms of money,together with notes and bank deposits, are freely transformed into gold

on the fixed cost.


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There are distinct kinds of gold standard

First, the gold specie standard is a system in which the, the unit ofcurrency is related to gold coins which have been in circulation. More

specifically, the economic unit is related with the unit of price of a uniquegold coin in distribution together with that relating to some secondarycoinage (coins made from metal that's priced lower than gold).

In a version called Gold Specie Standard, the actual currency incirculation consists of gold coins with a fixed gold content.

Similarly, the gold exchange standard typically involves the circulation ofonly coins made of silver or other metals, but where the authoritiesguarantee a fixed exchange rate with another country that is on the goldstandard.

Gold standard

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Gold standard

Finally, the gold bullion standard is a system in which gold coins do notcirculate, but in which the authorities have agreed to sell gold bullion ondemand at a fixed price in exchange for the circulating currency.

Gold certificates were used as paper

currency in the United States from 1882 to

1933. These certificates were freely

convertible into gold coins.

Under a gold standard,paper notes are

convertible intopre-set,fixed quantities of

gold.

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Gold standard

Some Facts

The gold exchange standard (18701914)

Impact of World WarI (191425)

Governments faced with the need to fund high levels of expenditure, but

with limited sources of tax revenue, suspended convertibility of currencyinto gold on a number of occasions in the 19th century The real test, however, came in the form of World War I, a test "it failed

utterly" according to economist Richard Lipsey. In order to finance the costs of war, most belligerent countries went off

the gold standard during the war, and suffered significant inflation.Because inflation levels varied between states, when they returned to thestandard after the war at price determined by themselves (some, forexample, chose to enter at pre-war prices), some countries' goods wereundervalued and some overvalued.

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Gold standard

The gold bullion standard and the decline of the gold standard (192531) The gold specie standard ended in the United Kingdom and the rest of the

British Empire at the outbreak of World War I. Treasury notes replaced thecirculation of the gold sovereigns and gold half sovereigns. However,

legally, the gold specie standard was not repealed.

Depression and World WarII (193246) - Prolongation of the Great

Depression

Some economic historians, such asA

merican professor Barry Eichengreen,blame the gold standard of the 1920s for prolonging the Great Depression.

The gold standard limited the flexibility of Central Banks' Monetary Policy bylimiting their ability to expand the money supply, and thus their ability tolower interest rates.

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Post-war international gold-dollar standard (19461971)

After the Second World War, a system similar to a Gold Standard andsometimes described as a "gold exchange standard" was established by the

Bretton WoodsA

greements.

Gold standard

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Advantages ofGold standard

Long-term price stability has been described as the great virtue of the goldstandard.

Under the gold standard, high levels of inflation are rare.

Hyperinflation is nearly impossible as the money supply can only grow at the

rate that the gold supply increases. The gold standard limits the power of governments to inflate prices through

excessive issuance of paper currency.

It provides fixed international exchange rates between those countries that

have adopted it, and thus reduces uncertainty in international trade. A central bank could not create unlimited quantities of money at will, as there is

a limited supply of gold.

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Disadvantages ofGold standard

The total amount of gold that has ever been mined has been estimated ataround 142,000 metric tons. This is less than the value of circulating money inthe U.S. alone, where more than $8.3 trillion is in circulation or in deposit.

Mainstream economists believe that economic recessions can be largelymitigated by increasing money supply during economic downturns. Following agold standard would mean that the amount of money would be determined bythe supply of gold, and hence monetary policy could no longer be used tostabilize the economy in times of economic recession.

Monetary policy would essentially be determined by the rate of gold

production. Fluctuations in the amount of gold that is mined could causeinflation if there is an increase, or deflation if there is a decrease

Although the gold standard gives long-run price stability, it does in the shortrun bring high price volatility.

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Bretton Woods System

The United Nations Monetary and Financial Conference, commonly known asthe Bretton Woods conference, was a gathering of 730 delegates from all44 Allied nations at the Mount Washington Hotel, situated in Bretton Woods, NewHampshire, to regulate the international monetary and financial order after theconclusion of World War II

The conference was held from 1-22 July 1944, when the agreements weresigned to set up the International Bank for Reconstruction andDevelopment (IBRD), the General Agreement on Tariffs and Trade (GATT), and

the International Monetary Fund (IMF)


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As a result of the conference, the Bretton Woodssystem of exchange rate management was set up, which remainedin place until the early 1970s

The Bretton Woods Conference took place in July 1944, but did notbecome operative until 1959, when all the European currenciesbecame convertible.

Under this system, the IMF and the IBRD were established.

The IBRD was created to speed up post-war reconstruction, to aidpolitical stability, and to foster peace.

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The planners at Bretton Woods established the International MonetaryFund (IMF) and the International Bank for Reconstruction andDevelopment (IBRD), which today is part of the World Bank Group.

These organizations became operational in 1945 after a sufficient numberof countries had ratified the agreement

The chief features of the Bretton Woods system were

An obligation for each country to adopt a monetary policy that

maintained the exchange rate by tying its currency to the U.S. dollarand

The ability of the IMF to bridge temporary imbalances of payments.

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Nixon Shock

The Nixon Shock was a series of economic measures taken by U.S.President Richard Nixon in 1971 including unilaterally cancelling the directconvertibility of the United States dollar to gold that essentially ended theexisting Bretton Woods system of international financial exchange.

By the early 1970s, as the costs of the Vietnam War and increased domesticspending accelerated inflation, the U.S. was running a balance-of-payments deficit and a trade deficit, the first in the 20th century.

By 1971, the money supply had increased by 10%. In the first six months of 1971,

$22 billion in assets left the U.S. In May 1971, inflation-wary West Germany wasthe first member country to unilaterally leave the Bretton Woods system unwilling to devalue the Deutsche Mark in order to prop up the dollar.


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Nixon Shock

In the next three months, West Germany's move strengthened their economy.Simultaneously, the dollar dropped 7.5% against the Deutsche Mark.

Due to the excess printed dollars, and the negative U.S. trade balance, othernations began demanding fulfillment of America's "promise to pay" that is, the

redemption of their dollars for gold To stabilize the economy and combat the 1970 inflation rate of 5.84%, on August

15, 1971, President Nixon imposed a 90-day wage and price freeze, a 10 percentimport surcharge, and, most importantly, "closed the gold window", endingconvertibility between US dollars and gold.

By March 1976, the worlds major currencies were floating in other words,the currency exchange rates no longer were governments' principal means ofadministering monetary policy.

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Foreign Exchange Governing Body

The Foreign Exchange Regulation Act, 1973 (FERA)

There has been a substantial increase in the Foreign Exchange Reserves ofIndia.

Since the year 1993, Foreign trade has grown up. Development has taken place such as current account convertibility,

liberalization in investments abroad, increased access to external commercialborrowings by Indian Companies and participation by foreign institutionalinvestors in securities markets in India.

Keeping in view these changes the Central Government of India has introducedthe FOREIGN EXCHANGE MANAGEMENTBILL 1998 (FEMA)to repeal FERA.


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The main change between FERA and FEMA is in the approach.

FERA seeks to regulate almost all the transactions involving foreign exchangeand inbound/outbound investments.

In FERA every provision is restrictive and starts with a negative propositionstating that nothing can be done without RBI's permission.

In comparison to this existing negative piece of legislation, the provisions of theproposed Bill has a positive approach.

This can be found from the provisions of FEMA dealing with capital account

transactions which are to be regulated.


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Unlike FERA which provides that these transactions cannot be entered intowithout prior permission of RBI, FEMA provides that any person may sell ordraw foreign exchange for such transactions and then specifies the powers ofthe RBI to regulate the class or limits of such capital account transactions.

FEMA classifies foreign exchange transactions into capital account transactionsand current account transactions and amongst the two regulates the formermore closely.

The provisions of the FEMABill aims at consolidating and amending the law

relating to foreign exchange with the object of facilitating external trade andpayments and for promoting the orderly payment and amendments in foreignexchange markets in India.


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The FEMA Bill empowers the RBI to authorize persons to deal in foreignsecurities specifying the conditions for the same.

It also provides for a person resident in India in holding, owning, transferring or

investing in foreign security and for a person resident out side India in holding,owning, transferring or investing in Indian Securities.


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Foreign Exchange Dealer's Association ofIndia (FEDAI) was set up in 1958 as anAssociation of banks dealing in foreign exchange in India (typically calledAuthorised Dealers - ADs) as a self regulatory body and is incorporated underSection 25 of The Companies Act, 1956.

It's major activities include framing of rules governing the conduct of inter-bank

foreign exchange business among banks vis--vis public and liaison with RBI forreforms and development of forex market. Presently some of the functions are as follows:

Guidelines and Rules for Forex Business. Training of Bank Personnel in the areas of Foreign Exchange Business. A

ccreditation of Forex Brokers Advising/Assisting member banks in settling issues/matters in their dealings. Represent member banks on Government/Reserve Bank of India/Other

Bodies. Announcement of daily and periodical rates to member banks.


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Due to continuing integration of the global financial markets and increased paceof de-regulation, the role of self-regulatory organizations like FEDAI has alsotransformed

In such an environment, FEDA

I plays a catalytic role for smooth functioning ofthe markets through closer co-ordination with the RBI

FEDAI also maximizes the benefits derived from synergies of member banksthrough innovation in areas like new customized products, bench markingagainst international standards on accounting, market practices, risk

management systems, etc.


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On March 1, 1992 Reserve Bank of India announced a new system of exchangerates known as Liberalized Exchange Rate Management System. Under LERMS,the rupee become convertible for all approved external transactions.

The exporters of goods and services and those who received remittances fromabroad were allowed to sell bulk of their forex receipts.

Similarly, those who need foreign exchange to import and travel abroad were tobuy foreign exchange from market-determined rate.

From March 1 1993 modified LERMS under which the all forex transactions,under current and capital account, are being put through by Authorized Dealersat market determined exchange rate.


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Exchange rate system in India

The rupee was historically linked i.e. pegged to the pound sterling. Earlier,during British regime and till late sixties, most of Indias trade transactionswere dominated to pound sterling

Under Bretton Woods system, as a member of IMF Indian declared its par valueof rupee in terms of gold

The corresponding rupee sterling rate was fixed 1 GBP = RS 18

When Bretton Woods system bore down in August 1971, the rupee was de-linkedfrom US $ and the exchange rate was fixed at 1 US $ = Rs 7.50. Reserve bank ofIndia, however, remained pound sterling as the currency of intervention


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The US $ and rupee pegging was used to arrive at rupee-sterling parity.

After Smithsonian Agreement in December 1971, the rupee was de-linked fromUS $ and again linked to pound sterling.

This parity was maintained with a band of 2.25%. Due to poor fundamentalpound got depreciated by 20%, which cause rupee to depreciate.

To be not dependent on the single currency, pound sterling on September 25,1975 rupee was de-linked from pound sterling and was linked to basket ofcurrencies, the currencies includes as well as their relative weights were keptsecret so that speculators dont get a wind of the direction of the movement ofexchange rate of rupee.


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From January 1, 1984 the sterling rate schedule was abolished.

The interest element, which was hitherto in built the exchange rate, was alsode-linked. The interest was to be recovered from the customers separately.

This not only allowed transparency in the exchange rate quotations but alsowas in tune with international practice in this regard. FEDAI issued guidelinesfor calculation of merchant rates.

The liquidity crunch in 1990 and 1991 on forex front only hastened the process.On March 1, 1992 Reserve Bank of India announced a new system of exchange

rates known as Liberalized Exchange Rate Management System. LERMS was to make balance of payment sustainable on ongoing basis allowing

market force to play a greater role in determining exchange rate of rupee.


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Exchange Rate System - Vaibhav Barick(International Finance)

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