Economy: Foreign Exchange and India

1) Foreign sector and foreign exchange: -

All those economic activities of an economy which take place in foreign exchange, come under the definition of foreign sector. Examples of Foreign Sector: Exports, Imports, Foreign Investment, Foreign Debt, Current Account, Capital Account, Balance of Payments, etc. Thus “foreign currency” means any currency other than Indian currency.There are 180 different types of official currencies in the world. Most international forex trading and payments are generally done in currencies called the US dollar, British pound, Japanese yen and euro.

2) Foreign Exchange Reserves:

Foreign exchange reserves are funds or other assets held by the central bank of any country so that it can pay its liabilities when needed. Foreign exchange reserves are held in one or more currencies. Most of the dollar and to a lesser extent the euro comprise foreign exchange reserves. According to the Economic Survey 2021-22, India is now the fourth largest foreign exchange reserve country in the world. India’s foreign exchange reserves include: –
a) Foreign Currency Assets;
b) Gold Reserves;
c) Special Drawing Rights (SDR);
d) Reserve Trench with The International Monetary Fund (IMF)

3) With the recent record fall in the rupee,

the country’s foreign exchange reserves have gone below $ 600 billion, which has fallen significantly from the all-time high of $ 642 billion on September 3, 2021, due to which there have been reasons like Fed’s interest rate hike. reduction, effect of the Russo-Ukraine War, etc. The role of foreign exchange reserves to cover imports is of utmost importance. A ratio called ‘foreign exchange cover’ refers to a country’s ability to pay off its foreign debts.

4) Methods of regulating exchange rates:

a) Fixed Exchange Rate System: It is a method of regulating the exchange rates of global currencies brought in by the International Monetary Fund. In this system the exchange rate of a particular currency was fixed by the International Monetary Fund. The exchange rates of currencies were revised from time to time by the International Monetary Fund.

b) Floating Exchange Rate System: The floating exchange rate system is another method of regulating the exchange rates of global currencies. It is based on the market mechanism (i.e., demand and supply of domestic and foreign currencies). In the floating exchange rate system, one domestic currency is left free to flow and determine its value in line with many other foreign currencies in the foreign exchange market.

c) Managed Float Exchange Rate System: A managed float exchange rate system is a hybrid or mixture of fixed and floating exchange rate systems. In this system, the government attempts to influence the exchange rate for the economy in two ways, either directly by buying and selling foreign currencies from the market, or indirectly, through monetary policy (i.e., foreign exchange rates). Lowering or raising interest rates on bank accounts, affecting foreign investment, etc.). Today, most of the world’s economies operate on the managed float exchange rate system.

5) Foreign Exchange Market:

The market in which various currencies can be bought and sold is called foreign exchange market. This market does not work with a fixed currency system. It provides an institutional framework for the exchange of one national currency for another currency or currencies.

6) Exchange rate in India:

The Indian currency, the ‘rupee’, was historically linked to the British pound sterling until 1948. After the arrival of the IMF on December 27, 1945, India became the currency of the rupee in terms of gold or the US ($dollar). Moved to fixed currency system to maintain foreign value (ie exchange rate).

a) In 1948 ₹3.30 was fixed equal to US$1. In September 1975, India separated the rupee’s regulation linkage from the British pound, and the RBI began to determine the rupee’s exchange rate based on exchange rate fluctuations of the basket of world currencies.

b) India announced ‘Liberalized Exchange Rate Mechanism (LERMS)’ in the Union Budget of 1992-93 and it was operationalized in March 1993 and adopted its own method which is also known as ‘Dual Exchange Rate’ One is the ‘official rate’ and the other is the ‘market rate’. RBI can intervene in the foreign exchange market through demand and supply of rupee or foreign currencies as it is a highly volatile speculative market.

c) NEER (Nominal Effective Exchange Rate): -This rate is the weighted average of the bilateral exchange rates of the domestic currency with respect to foreign currencies.

d) REER (Real Effective Exchange Rate): – This rate is the weighted average of the domestic currency relative to other major currencies, adjusted for the effects of inflation.