Introduction to Indian Foreign Exchange Market
5.1: Forex Market in India:
Traditionally Indian forex market has been a highly regulated one. Till
about 1992-93, government exercised absolute control on the exchange rate,
export-import policy, FDI ( Foreign Direct Investment) policy. The Foreign Exchange
Regulation Act(FERA) enacted in 1973, strictly controlled any
activities in any remote way related to foreign exchange. FERA was introduced
during 1973, when foreign exchange was a scarce commodity. Post independence,
union government’s socialistic way of managing business and the license raj
made the Indian companies noncompetitive in the international market, leading
to decline in export. Simultaneously India import bill because of capital
goods, crude oil & petrol products increased the forex outgo leading to
sever scarcity of foreign exchange. FERA was enacted so that all forex earnings
by companies and residents have to reported and surrendered (immediately after
receiving) to RBI (Reserve Bank of India) at a rate which was mandated by RBI.
FERA was given the real power by making “any violation of FERA was a criminal
offense liable
to imprisonment”. It a professed a
policy of
“a person is
guilty of forex violations unless he proves that he has not violated any norms
of FERA”. To sum up, FERA prescribed a
policy – “nothing (forex
transactions) is permitted unless specifically
mentioned in the act”.
Post liberalization, the Government of India, felt the necessity to
liberalize the foreign exchange policy. Hence, Foreign Exchange Management Act (FEMA) 2000
was introduced. FEMA expanded the list of activities in which a person/company
can undertake forex transactions. Through FEMA, government liberalized the
export-import policy, limits of FDI (Foreign Direct Investment) & FII
(Foreign Institutional Investors) investments and repatriations, cross-border
M&A and fund raising activities.
Prior to 1992, Government of India strictly controlled the exchange
rate. After 1992, Government of India slowly started relaxing the control and
exchange rate became more and more market determined. Foreign Exchange Dealer’s association of India
(FEDAI), set up in 1958, helped the government of India in framing
rules and regulation to conduct
forex exchange trading and
developing forex market In India.
A major step in development of Indian forex market happened in 2008,
when currency futures (Indian Rupee and US Dollar) started trading at National
Stock Exchange (NSE). Since the introduction, the turnover in futures has
increased leaps and bound. Though banks and authorized dealers were undertaking
forex derivatives contracts, but the introduction of exchange traded currency
futures marked a new beginning as the retail investors were able to participate
in forex derivatives trading.
RBI document titled” Foreign Exchange Market” available at http://rbidocs.rbi.org.in/rdocs/publicationreport/pdfs/77577.pdf is an informative document on
historical development of Foreign exchange market in India. The next section,
Section 5.2, the important milestone of “Historical Development in Forex Market
in India” is given. The readers are advised to supplement this section with the
document available at the above link.
5.2: Foreign Exchange Market in India: Historical Perspective:
Indian forex market since
independence can be grouped in three distinct phases.
1947 to1977: During 1947 to 1971, India exchange rate system followed the
par value system. RBI fixed
rupee’s external par value at 4.15 grains of fine gold. 15.432grains of gold is
equivalent to 1 gram of gold. RBI allowed the par value to fluctuate within the
permitted margin of ±1 percent. With the breakdown of the Bretton Woods System
in 1971 and the floatation of major currencies, the rupee was linked with
Pound-Sterling. Since Pound-Sterling was fixed in terms of US dollar under the
Smithsonian Agreement of 1971, the rupee also remained stable against dollar.
1978-1992: During this period, exchange rate of the rupee was
officially determined in terms of a weighted
basket of currencies of India’s major trading partners. During this period, RBI
set the rate by daily announcing the buying and selling rates to authorized
dealers. In other words, RBI instructed authorized dealers to buy and sell
foreign currency at the rate given by the RBI on daily basis. Hence exchange
rate fluctuated but within a certain range. RBI managed the exchange rate in
such a manner so that it primarily facilitates imports to India. As mentioned
in Section 5.1, the FERA Act was part of the exchange rate regulation practices
followed by RBI.
India’s perennial trade deficit widened during this period. By the
beginning of 1991, Indian foreign exchange reserve had dwindled down to such a
level that it could barely be sufficient for three-week’s worth of imports.
During June 1991, India airlifted 67 tonnes of gold, pledged these with Union
Bank of Switzerland and Bank of England, and raised US$ 605 millions to shore
up its precarious forex reserve. At the height of the crisis, between 2nd and 4th June 1991, rupee was officially devalued
by 19.5% from 20.5 to 24.5 to 1 US$. This crisis paved the path to the famed “liberalization
program” of government of India to make rules and regulations pertaining to
foreign trade, investment, public finance and exchange rate encompassing a
broad gamut of economic activities more market oriented.
1992 onwards: 1992 marked a watershed in India’s economic condition.
During this period, it was felt
that India needs to have an integrated policy combining various aspects of
trade, industry, foreign investment, exchange rate, public finance and the
financial sector to create a market-oriented environment. Many policy changes
were brought in covering different aspects of import-export, FDI, Foreign
Portfolio Investment etc.
One important policy changes pertinent to India’s forex exchange system
was brought in -- rupees was made convertible in current account. This paved to
the path of foreign exchange payments/receipts to be converted at
market-determined exchange rate. However, it is worthwhile to mention here that
changes brought in by government of India to make the exchange rate market
oriented have not happened in one big bang. This process has been gradual.
Convertibility in
current account means that
individuals and companies have the freedom to buy or
sell foreign currency on specific activities like foreign travel, medical
expenses, college fees, as well as for payment/receipt related to
export-import, interest payment/receipt, investment in foreign securities,
business expenses etc. An related concept to this is the “convertibility in
capital account”. Convertibility in capital account indicates that Indian
people and business houses can freely convert rupee to any other currency to any extent and can invest in foreign
assets like shares, real estate in foreign countries. Most importantly Indian
banks can accept deposit in any currency.
Even though the exchange rate has been market determined, from time to
time RBI intervenes in spot and forward market, if it feels exchange rate has
deviated too much.
Table 5.1: RBI Intervention in Indian Forex Market
5.3 Forex Exchange Turnover
According to the RBI report (September 2009) by Goyal, Nair & Samataray
titled “Monetary Policy, Forex Markets, and Feedback under
Uncertainty in an Opening Economy”,
The extract from the report
highlights the foreign exchange turnover in India
“ Indian FX market has
grown many times over the last several years. The average daily turnover, which
was in the vicinity of US $ 3.0 billion in 1998-99 grew to US $ 18 billion
during 2005-06. The turnover rose considerably to US $ 48 billion during
2007-08 with the monthly turnover crossing US $ 65 billion in February 2007.
The inter-bank to
merchant turnover ratio halved from 5.2 during 1997-98 to 2.3 during 2007-08
reflecting the growing participation in the merchant segment of the foreign
exchange market.
The spot market
remains the most important FX market segment accounting for 51 per cent of the
total turnover. Its share has declined marginally in recent years due to a pick
up in the turnover in derivative segment. Even so, Indian derivative
trading remains a small fraction of that in other developing
countries such as Mexico or South Korea. Short-term instruments with maturities
of less than one year dominate, and activity is concentrated among a few banks
(IMF 2008)”.
5.1: Interesting facts about Indian Rupee
India has been one of the earliest issuers of coins
in the world (6th Century BC). The origin of the word "rupee" is
found in the word rup or rupa, which means "silver" in many
Indo-Aryan languages such as Hindi. The Sanskrit word rupyakam means coin of
silver. The derivative word Rupaya was used to denote the coin introduced by
Sher Shah Suri during his reign from 1540 to 1545 CE. The original Rupaya was a
silver coin weighing 175 grains troy (about 11.34 grams) . The coin has been
used since then, even during the times of British India. Formerly the rupee was
divided into 16 annas, 64 paise, or 192 pies. In India decimalization occurred
India in 1957.
5.4: Pre-Liberalization exchange rate regime in
India and Hawala Market
At this juncture, it is pertinent to discuss “Hawala market”
operating in India before liberalization. Before 1992, RBI was strictly
controlling the exchange rate. This created a parallel foreign exchange market –
a black market in foreign exchange popularly known as “Hawala Market”.
Hawala market is nothing but illegal foreign
exchange market where forex trading happen at rates different than the rate mandated
by the RBI. When the official rate “overvalues” the home currency, Hawala
market starts operating.
Example of a Hawala Transaction: a NRI working in USA wants to send 20,000 US$ to his family member. If he send this money through bank, he
receives rupees at prevailing exchange rate of INR 35/US$. But in the black
market, the exchange rate is INR 40/US$.
In other words, RBI puts a value of INR.35 per US$
, when it should have been Rs.40/US$. Hence INR is overvalued at the official
rate.
The NRI contacts a hawala operator in USA and gives $20,000 to him. The
USA hawala operators counterparty in India, pays Rs. 40/US$ to the family
members of NRI here in India. The transaction between hawala dealer in USA and
his counterparty India are done through smugglers.
During the heyday of hawala transactions in 1990’s, it was a common
knowledge that exporters under invoice their export earnings and importers
over invoice
their imports goods ( so as to increase the cost of import denominated in
foreign currency) and the differences are kept abroad and later repatriated
back through Hawala route.
Even after 17 years of liberalization and even though exchange rate is
market determined by supply & demand forces, Hawala market still operates,
though at a smaller scale. According to a news report in Hindu ( March 2005),
many people working in the Gulf countries opt for the `pipe' or ‘Hawala’
transactions for obvious reasons of convenience and speedy transactions. No
bank can beat these operators in delivering the money so fast, and that too at
the receiver's doorstep!
The
ramifications of Hawala market operations are manifold. In fact, through Hawala
market, the money laundering is undertaken. A very informative article on
Hawala Transactions are available at Interpol website
It
is probably one of the most comprehensive pieces of document on Hawala market
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