The foreign exchange rate is the price of one country’s currency expressed in terms of another country’s currency. It is an important determinant of the price of imports and exports, international investment, capital flows and India’s Balance of Payments (BoP).
In a market-oriented system, the exchange rate is driven primarily by demand and supply of foreign currency. However, various countries adopt different exchange rate regimes from rigidly fixed to floating with managed float in between.
India has gradually moved from a fixed- and pegged-exchange rate regime to a market-determined exchange rate system.
What Is the Foreign Exchange Rate?
The foreign exchange rate refers to the amount of domestic currency needed to purchase one unit of foreign currency.
For example, if a foreign exchange rate is:
US$1 = ₹100
it implies that ₹100 is needed to purchase one US dollar.
The Purchasing Power Parity (PPP) approach explains the foreign exchange rate in terms of the relative purchasing power of the currencies.
For instance, if an identical product costs $20 in the US and ₹100 in India, the implied exchange rate would be:
₹100 ÷ $20 = ₹5 per US$
However, actual exchange rates in foreign exchange markets are influenced by a variety of economic and financial factors in addition to the purchasing power.
How Is the Foreign Exchange Rate Determined?
Foreign exchange essentially reflects the price of one currency in terms of another. The value of foreign exchange, similar to other goods and assets, is determined by demand and supply.
The demand for and the supply of foreign currencies are the result of buying and selling by the residents of different countries.
| Demand for Foreign Exchange | Supply of Foreign Exchange |
| Imports of goods and services | Exports of goods and services |
| Investment in foreign assets, shares and bonds | Foreign investment in Indian assets, shares and bonds |
| Payments and transfers to people abroad | Remittances received from abroad |
| Deposits or funds held by Indians in overseas banks | Foreign funds held in Indian banks and financial assets |
| Indians travelling abroad | Foreigners travelling to India |
Equilibrium Exchange Rate
The exchange rate is determined where demand for and the supply of foreign exchange are equal.
For instance, if the equilibrium exchange rate is US$1 = ₹5, the demand for and the supply of dollars would be equal at that rate.
1. Excess Supply of Foreign Currency
If there is excess supply of foreign currency, there will be downward pressure on the price of the foreign currency and upwards pressure on the domestic currency.
2. Excess Demand for Foreign Currency
In contrast, if there is excess demand for the foreign currency, it will tend to depreciate the domestic currency.
Thus, favourable external developments such as a BoP surplus may create an appreciation pressure while an adverse external position implies depreciation pressure.
Types of Exchange Rate Regimes
Broadly, the exchange rate regimes could be classified into three:
- Fixed exchange rate
- Floating exchange rate
- Managed exchange float
Fixed Exchange Rate System
In a fixed exchange rate system the government or the central bank maintains the currency at a predetermined rate against another currency, a basket of currency or occasionally a commodity such as gold.
If the market forces push the exchange rate away from the desired level, the exchange rate is adjusted by the central bank in the foreign exchange market.
Advantages of Fixed Exchange Rate
1. Exchange Rate Stability
Provides greater stability and predictability in international trade and investment.
2. Lower Currency Risk
Helps reduce the economic risk and uncertainties for businesses and investors.
3. Trade Facilitation
Stable exchange rates make international transactions easier to plan and execute.
Limitations of Fixed Exchange Rate
1. High Reserve Requirements
May require the central bank to hold substantial foreign exchange to guard against attacks on the exchange rate target.
2. Reduction in Policy Autonomy
Fixed exchange rate regime limits the freedom of monetary policy.
3. Speculative Pressures
If the markets speculate that the fixed rate may not last, it could result in attacks on the currency.
4. Adjustments
Failure to adjust to changing economic conditions and respond to external shocks.
Floating Exchange Rate System
The floating exchange rate system refers to the situation where the value of a currency is primarily determined by the demand and supply of foreign exchange.
Thus, the foreign exchange rate is allowed to appreciate or depreciate based on the economic and financial conditions.
Advantages of Floating Exchange Rate
1. Determined by the Markets
In contrast to a fixed foreign exchange rate, it reflects the changing market conditions.
2. Greater Policy Autonomy
The central bank has the freedom to implement monetary policy measures according to domestic economic conditions.
3. Adjustment Mechanism
Helps adjust to external disequilibrium resulting from the changing Balance of Payments (BoP) position.
4. Reduced Need for Peg
The central bank does not have to continuously intervene in the foreign exchange market.
5. Shock Absorption
It helps absorb external economic shocks.
Limitations of Floating Exchange Rate
1. Exchange Rate Volatility
May experience large swings in values resulting in greater uncertainty for businesses and investors.
2. Imported Inflation
Persistent depreciation could lead to increased cost for imported goods and inputs.
3. Investment Uncertainties
The frequent and unpredictable swings in the foreign exchange rate could affect the expected returns from foreign investment.
4. Trade Uncertainties
Fixed vs Floating Exchange Rate
| Basis | Fixed Exchange Rate | Floating Exchange Rate |
| Determination | Maintained at a predetermined level | Mainly determined by demand and supply |
| Government intervention | High | Generally limited |
| Exchange rate stability | Relatively high | Relatively volatile |
| Monetary policy autonomy | More constrained | Greater |
| Foreign exchange reserves | Greater requirement | Lower requirement for defending a specific rate |
| Adjustment mechanism | Requires policy intervention | Currency adjusts through market forces |
| Speculative attack | Higher vulnerability to attacks on the peg | No fixed peg to defend |
| External shock absorption | Relatively limited | Relatively greater |
Exchange Rate Management in India
India’s exchange system has undergone major structural changes since Independence. The country had moved from a fixed exchange rate regime to a pegged system and then finally to a market-determined system.
Evolution of India’s Exchange Rate Regime
1. Par Value System
In the immediate post-Independence period, the rupee’s external value was maintained on a par value basis, pegged to gold and sterling.
Consequently, it was devalued in 1966.
2. Pegged Exchange Rate
Later, it was moved to a pegged system wherein the rupee’s value was linked to major currencies, and subsequently, to a basket of currencies representing India’s trading partners.
3. BOP Crisis of 1991
India’s severe Balance of Payments (BoP) crisis necessitated deep external sector reforms and change towards a market-driven exchange rate system.
4. LERMS, 1992–93
The Liberalised Exchange Rate Management System (LERMS) introduced partial convertibility and followed a dual foreign exchange rate system.
5. Market-Based Exchange Rate, 1993 onwards
India subsequently moved towards a market-driven exchange rate system and gave greater role to market forces in determining the rate of the rupee.
What Was LERMS?
LERSM or the Liberalised Exchange Rate Management System was a transitional framework introduced in India as the country moved towards a market-determined foreign exchange rate.
Under LERMS:
- 40% of foreign exchange earnings were converted at the official exchange rate.
- The remaining 60% were at the market-determined exchange rate.
This system was subsequently replaced by a unified market-based exchange rate system completing India’s transition to a market-based exchange system.
Why Does the Exchange Rate Matter for India?
A change in the rupee’s value affects a variety of Indian economic variables and outcomes.
1. Imports
Rupee depreciation leads to an increase in the price of foreign goods and services in terms of rupees.
2. Exports
Depreciation would generally improve price competitiveness of exports in the foreign market, but the actual impact would depend on the nature of the demand and the import content of exports.
3. Inflation
It leads to an increase in imported crude oil, commodities, machinery and other inputs, raising the probability of imported inflation.
4. Foreign Investment
Exchange rate uncertainty impacts the return and risks associated with FDI and portfolio investment.
5. Balance of Payments
The value of rupee influences India’s trade balance, services and capital flows and, hence, the external position of the economy.
Key Takeaway
The foreign exchange rate is determined by market, economic fundamentals and policy intervention. While the fixed exchange rates provide stability, floating regimes offer greater flexibility. A managed float tries to balance the two.
India’s experience demonstrates gradual move from a fixed and pegged-exchange-rate system to a market-determined system largely due to a series of changes and reforms initiated after a Balance of Payments (BoP) crisis in 1991.
Conclusion
There are various reasons why the foreign exchange rates matter. The exchange rate is one of the key variables linking the domestic economy to the global economy. Exchange rate influences a variety of economic activities like imports and exports, foreign investment, capital flows, and a country’s Balance of Payments (BoP).
India’s system of exchange rate has moved from a relatively fixed to market-determined system, with the authorities maintaining a potential ability to intervene when necessary. This shift offered greater flexibility and responded to the changing external environment. However, the primary function was left to market forces in determining the value of the rupee.
FAQs
What is a foreign exchange rate?
A foreign exchange rate is the amount of domestic currency required to purchase one unit of a foreign currency.
How is the exchange rate determined?
In a market-based system, the foreign exchange rate is primarily determined by the demand and supply for foreign currency.
What causes demand for foreign exchanged?
Demand arises out of purchases of goods and services, overseas investment, foreign travel by domestic residents and payments and transfers to other countries.
What creates the supply of foreign exchange?
The supply of foreign exchange arises out of exports of goods and services, foreign investments on Indian assets, shares and bonds, remittances and foreign travel spending by foreigners in the domestic economy.
What happens when demand for foreign currency exceeds supply?
Demand for greater than the supply for foreign currency would generally create depreciation pressure on the domestic currency.
What is a fixed exchange rate?
A system where the authorities maintain the currency at a predetermined exchange rate.
What is a floating exchange rate?
An exchange rate that is primarily determined by market forces of demand and supply.
What is a managed floating exchange rate?
It is a system wherein, the exchange rate is largely market-determined, but occasional intervention by the central bank is undertaken to moderate excessive volatility or disorderly market conditions.
What is LERMS?
LERMS or the Liberalised Exchange Rate System was introduced in India in the year 1992-93 as a step towards a market-based foreign exchange rate system.
When did India move towards a market-determined exchange rate?
India moved towards the process following the Balance of Payments (BoP) crisis in 1991, introducing LERMS in 1992-93 and moving further towards a unified market-based foreign exchange rate system in 1993.
How does rupee depreciation affect imports?
Depreciation of the rupee generally makes imported goods or inputs which are priced in terms of foreign currency more expensive or higher in value in terms of the domestic currency or rupee.
How does rupee depreciation affect exports?
It makes Indian exports relatively cheaper for the buyer in the foreign country depending on the demand conditions for Indian exports.
Why is exchange rate management important for India?
The movement in the value of the rupee affects inflation, trade, investment, capital flows and overall balance of payment and foreign exchange reserves.
Ravi Raaz
Hassan Khan
Shadab Ali