Foreign exchange control and rates

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Foreign Exchange Control: Definition, Objectives, Types and Conditions
1. Definition of Foreign exchange control
2. Objectives of Foreign Exchange Control
3. Types of Foreign Exchange Control
4. Conditions Necessitating Foreign Exchange Control.
Definition of Foreign Exchange Control:
In modern times various devices have been adopted to control international trade and
regulate international indebtedness arising out of international workings and dealings.
The spirit of economic nationalism induces every country to look primarily to its own
economic interests. Foreign Exchange control is one of the devices adopted for the
purpose.
Foreign Exchange control is a system in which the government of the country
intervenes not only to maintain a rate of exchange which is quite different from what
would have prevailed without such control and to require the home buyers and sellers
of foreign currencies to dispose of their foreign funds in particular ways.
Definition:
(1) “Foreign Exchange Control” is a method of state intervention in the imports and
exports of the country, so that the adverse balance of payments may be corrected”.
Here the government restricts the free play of inflow and outflow of capital and the
exchange rate of currencies.
2. According to Crowther:
“When the Government of a country intervenes directly or indirectly in international
payments and undertakes the authority of purchase and sale of foreign currencies it
is called Foreign Exchange Control”.
3. According to Haberler:
“Foreign Exchange Control in the state regulation excluding the free play of economic
forces for the Foreign Exchange Market”. The Government regulates the Foreign
Exchange dealings by Consideration of national needs.
To be more clear, “Foreign Exchange Control means the monopoly of the government
in the purchase and sale of foreign currencies in order to restore the balance of
payments equilibrium and disregard the market forces in the decision of monetary
authority”. When tariffs and quotas do not help in correcting the adverse balance of
trade and balance of payments the system of Foreign Exchange Control is restored to
by Governments.
Objectives of Foreign Exchange Control:
Important objectives of Exchange Control are as follows:
1. Correcting Balance of Payments:

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The main purpose of exchange control is to restore the balance of payments
equilibrium, by allowing the imports only when they are necessary in the interest of the
country and thus limiting the demands for foreign exchange up to the available
resources. Sometimes the country devalues its currency so that it may export more to
get more foreign currency.
2. To Protect Domestic Industries:
The Government in order to protect the domestic trade and industries from foreign
competitions, resort to exchange control. It induces the domestic industries to produce
and export more with a view to restrict imports of goods.
3. To Maintain an Overvalued Rate of Exchange:
This is the principal object of exchange control. When the Government feels that the
rate of exchange is not at a particular level, it intervenes in maintaining the rate of
exchange at that level. For this purpose the Government maintains a fund, may be
called Exchange Equalization Fund to peg the rate of exchange when the rate of
particular currency goes up, the Government start selling that particular currency in
the open market and thus the rate of that currency falls because of increased supply.
On the other hand, the Government may overvalue or undervalue its currency on the
basis of economic forces. In over valuing, the Government increases the rate of its
currency in the value of other currencies and in under-valuing; the rate of its over-
currency is fixed at a lower level.
4. To Prevent Flight of Capital:
When the domestic capital starts flying out of the country, the Government may check
its exports through exchange control.
5. Policy of Differentiation:
The Government may adopt the policy of differentiation by exercising exchange
control. If the Government may allow international trade with some countries by
releasing the required foreign currency the Government may restrict the trade import
and exports with some other countries by not releasing the foreign currency.
6. Other Objectives:
Apart from the above there may be certain other objectives of exchange control.
They are:
(i) To earn revenue in the form of difference between selling and purchasing rates of
foreign exchange;
(ii) To stabilise the exchange rates;
(iii) To make imports of preferable goods possible by making the necessary foreign
exchange available; and
(iv) To pay off foreign liabilities with the help of available foreign exchange resources.

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Types of Foreign Exchange Control:
There may be five types of Exchange Control:
1. Mild System of Exchange Control:
Under mild system of exchange control, also known as exchange pegging, the
Government intervenes in maintaining the rate of exchange at a particular level. Under
this system, the Government maintains on ‘Exchange Equalization Fund’ in foreign
currencies.
The British Exchange Equalization Account and U.S. Exchange Stabilisation Fund
were two examples of mild control. In case the demand for dollar goes up and as a
result the value of pound falls, the U.K. Government would sell dollars for pounds and
thus restrict the fall in the value of pound by increasing the supply of dollars.
2. Full Fledged System of Exchange Control:
Under this system, the Government does not only Peg the Rate of Exchange but have
complete control over the entire foreign exchange transactions. All receipts from
exports and other transactions are surrendered to the control authority i.e., Reserve
Bank of India. The available supply of foreign exchange is then allocated to different
buyers of foreign exchanges on the basis of certain pre-determined criteria. In this way
the Government is the sole dealer in foreign exchange.
3. Compensating Arrangement:
A compensating arrangement per-takes of the character of the old-fashioned barter
deal. An example would be the sale by India of cotton goods of a particular value to
Pakistan, the latter agreeing to supply raw cotton of the same value to India at a
mutually agreed exchange rate. Imports thus compensate for exports, leaving no
balance requiring settlement in foreign exchange.
4. Clearing Agreement:
A clearing agreement consists of an understanding by two or more countries to buy
and sell goods and services to each other, at mutually agreed exchange rates against
payments made by buyers entirely in their own currency.
The balance of outstanding claims are settled as between the central banks at the end
of stipulated periods either by transfers of gold or of an acceptable third currency, or
the balance might be allowed to accumulate for another period, pending an
arrangement whereby the creditor country works of the balance by extra purchases
from the other country.
5. Payments Arrangements:
In a payments arrangement the usual procedure of making foreign payments through
the exchange market is left intact. But each country agrees to establish a method of
control whereby its citizens are forced to purchase goods and services from the other
country in amounts equal to the latter’s purchase from the first country. Another type
of payments agreement is one designed to collect past debts.
Conditions Necessitating Foreign Exchange Control:

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The exchange control device is not effective in all cases. Only in selective cases, this
measure of curbing imports is effective.
The following are conditions where exchange control can be resorted:
1. The exchange control is necessary and should be adopted to check the flight of
capital. This is especially important when a country’s currency is under speculative
pressure. In such cases tariffs and quotas would not be effective. Exchange control
being direct method would successfully present the flight of capital of hot money.
2. Exchange control is effective only when the balance of payment is disturbed due to
some temporary reasons such as fear of war, failure of crops or some other reasons.
But if there are some other underlying reasons, exchange control device would not be
fruitful.
3. Exchange Control is necessary when the country wants to discriminate between
various sources of supply. Country may allow foreign exchange liberally for imports
from soft currency area and imports from hard currency areas will be subject to light
import control. This practice was adopted after Second World War due to acute dollar
shortage.
Even in India, many import licenses were given for use in rupee currency areas only,
i.e., countries with which India had rupee-trade arrangements. Thus in above cases,
the exchange control is adopted. In such cases quotas and tariffs do not help in
restoring balance of payment equilibrium.

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Foreign Exchange Rate: Meaning and Exchange Rate Determination
1. Meaning:
If a Kashmiri shawl maker sells his goods to a buyer in Kanyakumari, he will re-ceive
in terms of Indian rupee.
This suggests that domestic trade is conducted in terms of domestic currency. But if
the Indian shawl- maker decides to go abroad, he must exchange Indian rupee into
franc or dollar or pound or euro.
To facilitate this exchange form, bank-ing institutions appear. Indian shawlmaker will
then go to a bank for foreign currencies. The bank will then quote the day’s exchange
rate—the rate at which Indian rupee will be exchanged for foreign currencies. Thus,
for-eign currencies are required in the conduct of international trade.
In a foreign exchange mar-ket comprising commercial banks, foreign ex-change
brokers and authorised dealers and the monetary authority (i.e., the RBI), one
cur-rency is converted into another currency.
A (foreign) exchange rate is the rate at which one currency is exchanged for another.
Thus, an exchange rate can be regarded as the price of one currency in terms of
another. An exchange rate is a ratio between two monies. If 5 UK pounds or 5 US
dollars buy Indian goods worth Rs. 400 and Rs. 250 then pound- rupee or dollar-rupee
exchange rate becomes Rs. 80 = £1 or Rs. 50 = $1, respectively. Ex-change rate is
usually quoted in terms of ru-pees per unit of foreign currencies. Thus, an exchange
rate indicates external purchasing power of money.
A fall in the external pur-chasing power or external value of rupee (i.e., a fall in
exchange rate, say from Rs. 80 = £1 to Rs. 90 = £1) amounts to depreciation of the
Indian rupee. Consequently, an appreciation of the Indian rupee occurs when there
occurs an increase in the exchange rate from the existing level to Rs. 78 = £1.
In other words, external value of the rupee rises. This indicates strengthening of the
Indian rupee. Conversely, the weakening of the Indian rupee occurs if external value
of rupee in terms of pound falls. Remember that each currency has a rate of exchange
with every other currency.
Not all exchange rates but about 150 currencies are quoted, since no significant
foreign exchange market exists for all currencies. That is why exchange rate of these
national currencies are quoted usually in terms of US dollars and euros.
2. Exchange Rate Determination:
Now two pertinent questions that usually arise in the foreign exchange market are to
be an-swered now. Firstly, how is equilibrium ex-change rate determined and,
secondly, why exchange rate moves up and down?
There are two methods of foreign exchange rate determination. One method falls
under the classical gold standard mechanism and another method falls under the
classical pa-per currency system. Today, gold standard mechanism does not operate
since no stand-ard monetary unit is now exchanged for gold.

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All countries now have paper currencies not convertible to gold. Under inconvertible
pa-per currency system, there are two methods of exchange rate determination. The
first is known as the purchasing power parity theory and the second is known as the
demand-sup-ply theory or balance of payments theory. Since today there is no
believer of purchasing power parity theory, we consider only demand-supply approach
to foreign exchange rate determination.
A. Demand-Supply Approach of Foreign Exchange, Or BOP Theory of
For-eign Exchange:
Since the foreign exchange rate is a price, economists apply supply-demand
conditions of price theory in the foreign exchange mar-ket. A simple explanation is that
the rate of foreign exchange equals its supply. For sim-plicity, we assume that there
are two coun-tries: India and the USA. Let the domestic cur-rency be rupee. US dollar
stands for foreign exchange and the value of rupee in terms of dollar (or conversely
value of dollar in terms of rupee) stands for foreign exchange rate. Now the value of
one currency in terms of another currency depends upon demand for and supply of
foreign exchange.
(a) Demand for foreign exchange:
When Indian people and business firms want to make payments to the US nationals
for buy-ing US goods and services or to make gifts to the US citizens or to buy assets
there, the de-mand for foreign exchange (here dollar) is gen-erated. In other words,
Indians demand or buy dollars by paying rupee in the foreign ex-change market.
A country releases its foreign currency for buying imports. Thus, what ap-pears in the
debit side of the BOP account is the sources of demand for foreign exchange. The
larger the volume of imports the greater is the demand for foreign exchange.
The demand curve for foreign exchange is negative sloping. A fall in the price of foreign
exchange or a fall in the price of dollar in terms of rupee (i.e., dollar depreciates) means
that foreign goods are now cheaper.
Thus, an Indian could buy more American goods at a low price. Consequently, imports
from the USA would increase resulting in an increase in the demand for foreign
exchange, i.e., dol-lar. Conversely, if the price of foreign exchange or price of dollar
rises (i.e., dollar appreciates) then foreign goods will be expensive leading to a fall in
import demand and, hence, fall in the demand for foreign exchange.
Since price of foreign exchange and demand for foreign exchange move in opposite
direction, the im­porting country’s demand curve for foreign exchange is downward
sloping from left to right.
In Fig. 5.4, DD1 is the demand curve for foreign exchange. In this figure, we measure
exchange rate expressed in terms of domestic currency that costs 1 unit of foreign
currency (i.e., dollar per rupee) on the vertical axis. This makes demand curve for
foreign exchange negative sloping.

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If exchange rate is expressed in terms of foreign currency that could be pur-chased
with 1 unit of domestic currency (i.e., dollar per rupee), the demand curve would then
exhibit positive slope. Here we have chosen the former one.
(b) Supply of foreign exchange:
In a simi-lar fashion, we can determine supply of for-eign exchange. Supply of foreign
currency comes from its receipts for its exports. If the foreign nationals and firms intend
to purchase Indian goods or buy Indian assets or give grants to the Government of
India, the sup-ply of foreign exchange is generated.
In other words, what the Indian exports (both goods and invisibles) to the rest of the
world is the source of foreign exchange. To be more spe-cific, all the transactions that
appear on the credit side of the BOP account are the sources of supply of foreign
exchange.
A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to
for-eigners in terms of dollars. This will induce India to export more. Foreigners will
also find that investment is now more profitable. Thus, a high price or exchange rate
ensures larger supply of foreign exchange. Conversely, a low exchange rate causes
exchange rate to fall. Thus, the supply curve of foreign exchange, SS1, is positive
sloping.
Now we can bring both demand and sup-ply curves together to determine foreign
ex-change rate. The equilibrium exchange rate is determined at that point where
demand for foreign exchange equals supply of foreign ex-change. In Fig. 5.4, DD1
and SS1 curves inter-sect at point E. The foreign exchange rate thus determined is
OP. At this rate, quantities of foreign exchange demanded (OM) equals quantity
supplied (OM). The market is cleared and there is no incentive on the part of the
players to change the rate determined.

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Suppose that at the rate OP, Rs. 50 = $1, demand for foreign exchange is matched
by the supply of foreign exchange. If the current exchange rate OP1 exceeds the
equilibrium rate of exchange (OP) there occurs an excess supply of dollar by the
amount ‘ab’. Now the bank and other institutions dealing with for­eign exchange—
wishing to make money by exchanging currency—would lower the ex-change rate to
reduce excess supply.
Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand
for for­eign exchange by the amount ‘cd’ arises if the exchange rate falls below OP,
i.e., OP2. Thus, banks would experience a shortage of dollars to meet the demand.
Rate of foreign exchange will rise till demand equals supply.
The exchange rate that we have deter-mined is called a floating or flexible exchange
rate. (Under this exchange rate system, the government does not intervene in the
foreign exchange market.) A floating exchange rate, by definition, results in an
equilibrium rate of exchange that will move up and down accord-ing to a change in
demand and supply forces. The process by which currencies float up and down
following a change in demand or change in supply forces is, thus, illustrated in Fig.
5.5.
Let us assume that national income rises. This results in an increase in the demand
for imports of goods and services and, hence, de-mand for dollar rises. This results in
a shift in the demand curve from DD1 to DD2. Conse-quently, exchange rate rises as
from OP1 to OP2 determined by the intersection of new demand curve and supply
curve. Note that dollar appreciates from Rs. 50 = $1 to Rs. 53 = $1, while rupee
depreciates from $1 = Rs. 50 to $1 = Rs. 53.
Similarly, if supply curve shifts from SS1 to SS2, as shown in Fig. 5.6, new exchange
rate thus determined would be OP2. If Indian goods are exported more, following an
in-crease in national income of the USA, the sup-ply curve would then shift rightward.
Con-sequently, dollar depreciates and rupee appre-ciates. New exchange rate is

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settled at that point where the new supply curve (SS2) inter-sects the demand curve
at E2.
This is the balance of payments theory of exchange rate determination. Wherever
government does not intervene in the market, a floating or a flexible exchange rate
prevails. Such system may not necessarily be ideal since frequent changes in demand
and supply forces cause frequent as well as violent changes in exchange rate.
Consequently, an air of uncertainty in trade and business would prevail.
Such uncertainty may be damaging for the smooth flow of trade. To prevent this
situation, government intervenes in the for-eign exchange rate. It may keep the
exchange rate fixed. This exchange rate is called a fixed exchange rate system where
both demand and supply forces are manipulated or calibrated by the central bank in
such a way that the ex-change rate is kept pegged at the old level.
Often managed exchange rate is suggested. Under this system, exchange rate, as
usual, is determined by demand for and supply of for-eign exchange. But the central
bank intervenes in the foreign exchange market when the situ-ation demands to
stabilise or influence the rate of foreign exchange. If rupee depreciates in terms of
dollar, the RBI would then sell dol-lars and buy rupee in order to reduce the downward
pressure in the exchange rate.

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Foreign Exchange Rate and Foreign Exchange Market in India
The article provides an explanation of foreign exchange rate and foreign exchange
market in India.
Introduction:
It may be noted that the foreign exchange is the name given to any foreign currency.
Thus US dollars or British pounds are foreign exchange for India. Further, the
exchange rate is the price of a country’s currency in terms of another country’s
currency. Thus, at present (Aug. 30, 2013) one US dollar is exchanged for about 65.70
rupees of India (the spot exchange rate). Thus 65.70 Indian rupees for one US at
present dollar is the exchange rate of a dollar in terms of rupees.
In the above table we give the exchange rates of Indian rupee in terms of currencies
of some important countries of the world. It will be seen from the above table that there
has been a lot of volatility in the exchange rate of rupee. There had been 15 per cent
appreciation of Indian rupee vis-a-vis US Dollar between Oct. 2006 and Dec. 2007.
Beyond Jan.2008, rupee started depreciating under pressure of capital outflows by
FIIs and it fell to Rs.49.44 to a US dollar on Nov. 27, 2008.
From later half of2009-10 to Aug. 2011, as a result of return of capital flows to India,
rupee started appreciating and its value rose to around Rs. 45 to a US dollar at end-
Aug. 2011. However, again from Sept. 2011 due to Eurozone sovereign debt crisis
there had been large capital outflows by FIIs from India (and other emerging
economies) resulting in drastic depreciation of Indian rupee which fell to even Rs. 54
to a US dollar on Dec. 15, 2011.
But due to intervention of RBI by way of selling dollars in the foreign exchange market
from its foreign exchange reserves, the value of rupee fluctuated within range of Rs
52 to Rs.53 to a US dollar between December 16, 2011 and January 13, 2012. It will

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be seen that Indian rupee depreciated against currencies of all countries in March 5,
2013 except Japan. On March 5, 2013, value of rupee was 54.9 rupees per US dollar.
However, a very large depreciation of rupee has occurred since May 22, 2013. In the
month of June 2013, the rupee fell from to around Rs. 56 to a US dollar in the first
week of June 2013 to Rs. 60 to a dollar in the end of June 2013 and hit very level of
Rs.61.21 to a dollar on July 8, 2013. The RBI intervened by selling US dollars from its
foreign exchange reserves and took steps to discourage the import of gold so as to
reduce the demand for dollars.
The Finance Minister also raised the duty on gold, first from 6% to 8% and then to
10% to restrict the imports of gold to check further deprecia-tion of rupee. However,
despite these measures, depreciation of rupee continued and the value of rupee hit a
record of Rs. 68.83 to a US dollar on Aug. 28, 2013. Then with aggressive intervention
by the RBI through sale of dollars from its foreign exchange reserves and as a result
the value of rupee rose to Rs.65.70 to a dollar on Aug. 30, 2013. That is, about 18%
fall in the value of rupee from early June 2013.
Both domestic and external factors are responsible for this sharp depreciation of rupee
since May 2013. The domestic factor responsible for this steep slide of rupee has been
the emergence of large current account deficit (CAD) which was estimated at $ 88
billion in 2012-13 (4.8% of GDP of the year) due to sluggish exports and rise in imports
causing a net increase in demand for US dollars over their supply.
The external factor which triggered the sharp depreciation of rupee was the
an-nouncement by the governor of the US Reserve System in May 2013 that since the
US economy had recovered, he would start the unwinding of the policy of quantitative
easing (QE) under which it was purchasing bonds worth $ 85 billion per month from
the market to revive the US economy. This triggered capital outflows by FIIs from the
emerging economies including India. These capital out-flows on a large scale from
India contributed to the sharp slide in the exchange rate of rupee.
Floating (Flexible) and Fixed Exchange Rate System:
Since exchange rate is a price, its determination can be explained through demand
for and supply of currencies. Suppose we consider the transactions between two
countries, India and USA. In this case therefore the demand for and supply of dollar is
the demand for and supply of foreign exchange from the Indian perspective and the
price of a US dollar in terms of Indian rupees or a number of dollars per Indian rupee
is the exchange rate.
The system of exchange rate in which the value of a currency is allowed to adjust
freely or to float as determined by demand for and supply of foreign exchange is called
a flexible exchange system which is also known as floating exchange system.
On the other hand, if the exchange rate instead of being determined by demand for
and supply of foreign exchange is fixed by the Government, it is called the fixed
exchange rate system which prevailed in the world under an agreement reached at
Bretton Woods in New Hampshire in July 1944. It may be noted that under the fixed
exchange rate system, exchange rate is not determined by demand for and supply of
foreign exchange but is pegged at a certain rate.

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At the fixed exchange rate, if there is disequilibrium in the balance of payments giving
rise to either excess demand or excess supply of foreign exchange, the Central Bank
of the country has to buy and sell the required quantities of foreign exchange to
eliminate the excess demand or supply.
In 1977 USA decided to float its dollar and switched over to the flexible exchange
system resulting in the collapse of Bretton Woods System of fixed exchange rate. Both
the floating (flex-ible) and fixed exchange rate system have their merits and demerits.
Appreciation and Depreciation of Currencies:
It is important to explain the meanings of the terms, appreciation and depreciation, of
curren-cies which are often mentioned in the discussion of foreign exchange rate. Let
us consider the exchange rate of rupee for dollar. Appreciation of a currency is the
increase in its value in terms of another foreign currency.
Thus, if the value of a rupee in terms of U S dollar increases from Rs. 45.50 to Rs. 44
to a dollar, Indian rupee is said to appreciate. This indicates strengthening of the Indian
rupee. Note that when Indian rupee in dollar terms appreciates, the dollar would
depreciate.
On the other hand, if the value of Indian rupee in terms of US dollars falls, say from
Rs. 45.5 to Rs. 46 to a dollar, the Indian rupee is said to depreciate which shows the
weakening of Indian rupee. Thus, under a flexible exchange system, the exchange
value of a currency frequently appreciates or depre-ciates depending upon the
demand for and supply of a currency.
In a fixed exchange rate system the government has to buy or sell foreign exchange
in order to maintain the rate at the controlled level. However, even under the fixed
exchange rate system, the value of one’s currency can be changed only occasionally.
For instance, in June 1966, the value of rupee in terms of US dollar and U.K’s, pound
sterling was lowered. Again in July 1991 India re-duced its value of rupee in terms of
dollar by about 20 per cent.
Such a one-time lowering of value of its currency in terms of foreign exchange
occasionally by a country is called devaluation as distinguished from depreciation
which can often take place under the influence of changes in de-mand for and supply
of a currency.
On the other hand, with a fixed rate exchange system if a country raises the value of
its currency in terms of foreign currency, it is called revaluation. It should be noted that
since March 1993 India has also now made its rupee convertible into a foreign
currency and allowed its value to adjust freely depending upon demand and supply
forces.

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Foreign Exchange Rate in India
This article provides an essay on foreign exchange rate in India.
Introduction:
Related to the problem of balance of payments is the macro issue of foreign exchange
rate.
The balance of payments is influenced by the foreign exchange rate. Exchange rate
is the value of national currency in terms of a foreign currency. Thus, currently
(September 20,2013) one US dollar is exchanged for around Rs. 62.
Thus Rs. 62 to a dollar is the foreign exchange rate of rupee in terms of US dollars.
Changes in foreign exchange rate affect the prices of exports and imports which in
turn determine their volume and thereby determine balance of payments of a country.
Since exchange rate is a price, its determination can be explained through demand
for and supply of foreign exchange.
However, in the long run the foreign exchange rate between the two currencies is
determined by the purchasing powers of the two currencies in the domestic
economies. In the short run, the demand for imports and exports of goods and services
(that is, both visible and invisible items), magnitude of capital flows between the
countries affects demand for and supply of foreign exchange and thereby determine
the exchange rate between the currencies.
The system of exchange rate in which the value of a currency is allowed to adjust
freely or to float as determined by demand for and supply of foreign exchange is called
a flexible exchange rate system. The flexible exchange rate system is also called
floating exchange system. At present, in most of the countries of the world (including
India), the flexible exchange rate system prevails.
On the other hand, if foreign exchange rate, instead of being determined by demand
for and supply of foreign exchange, is fixed by the government, it is called the fixed
exchange rate system which prevailed in the world under an agreement reached at
Bretton Woods in New Hampshire in July 1944. Therefore, fixed exchange rate is also
often called Bretton Woods System.
Under the Bretton Woods fixed exchange rate system, exchange rate is not
determined by demand for and supply of foreign exchange but is pegged at a certain
rate. At the fixed exchange rate, if there is disequilibrium in the balance of payments
giving rise to either excess demand or excess supply of foreign exchange, the Central
Bank of the country has to buy or sell the required quantifies of foreign exchange to
eliminate the excess demand or supply. But in the mid seventies Bretton Woods
system of fixed exchange rate system in which US dollar played a key role collapsed
as the USA could not keep constant the price of US dollar in terms of gold.
In a fixed exchange rate system the government has to buy or sell foreign exchange
in order to maintain the rate at the controlled level. However, under the fixed exchange
rate system, the value of one’s currency can be changed occasionally. For instance,

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in June 1966, the value of rupee in terms of US dollar and U.K’s pound sterling was
lowered.
Again in July 1991 India reduced its value of rupee in terms of US dollar by about 20
per cent. Such a one-time lowering of value of its currency in terms of foreign exchange
occasionally by a country is called devaluation as distinguished from depreciation
which under flexible exchange rate system can often take place under the influence of
changes in demand for and supply of a currency.
On the other hand, with a fixed rate exchange system if a country raises the value of
its currency in terms of foreign currency, it is called revaluation. It should be noted that
since March 1993 India has adopted flexible exchange rate system and has also now
made its rupee convertible into a foreign currency.
In fact, at present the Indian rupee can appreciate or depreciate every day depending
on the demand for and supply of US dollar and other foreign currencies and demand
for and supply of the Indian rupee.
Foreign Exchange Rate, Balance of Payments and Capital Inflows and Outflows:
Changes in foreign exchange rate have an important effect on the balance of
payments of a country. When there is depreciation or devaluation in the currency of a
country, its exports become cheaper and imports costlier than before.
This causes exports to increase and imports to decrease causing reduction in deficit
in balance of payments. Thus in order to check increase in deficit in balance of
payment and to restore equilibrium in it, devaluation or depreciation of the domestic
currency against foreign currencies is often undertaken.
Besides, the foreign exchange inflows in various forms such as those resulting from
rising exports, portfolio investment by FIIs (Foreign Institutional Investors), foreign
direct investment (FDI) not only causes appreciation of exchange rate of the domestic
currency but also leads to the increase in money supply in the economy and therefore
inflationary situation in the country.
Thus higher appreciation in the value of rupee against US dollar in 2007-08 in India
was the direct result of large capital inflows in India. The price of Indian rupee against
US dollar rose from around Rs. 45 in January 2007 to 39.5 in Sept. 2007, that is, over
11 per cent appreciation in the year 2007 alone.
This appreciation of rupee was driven by foreign exchange inflows partly by rising
software exports but more importantly inflows by FIIs coming in large quantity to take
advantage of the stock market boom in India. Besides, foreign exchange inflows
through NRI deposits lured by higher interest rates in India than those prevailing in
their country of residence took place. Further, large capital inflows through foreign
direct investment (FDI) in India also increased in 2006-07 and 2007-08.
These large inflows of foreign exchange in India through its effect on the supply of
dollars in foreign exchange market would have caused a very high appreciation of
rupee vis-a-vis US dollar but RBI did buy some dollars from market from time to time

15. Page 15 of 16
to prevent it and built up reserves of foreign exchange. But RBI could not buy dollars
as fast as the large inflows came in. This resulted in appreciation of rupee in 2007-08.
RBI could not ensure foreign exchange rate stability in situation of large capital inflows
by buying sufficient amount of dollars from the market.
Again in Sept. 2011 there had been large capital outflows from the Indian economy
resulting in increase in demand for US dollars and therefore depreciation of Indian
rupee. The value of Indian rupee which was Rs. 43 to a US dollar in July 2011 declined
to around Rs. 53 to a US dollar in the second week of December 2011. To prevent
excessive depreciation of the Indian rupee RBI intervened and sold US dollars from
its foreign exchange reserves.
Further from May 2013 FIIs started withdrawing capital from debt market and capital
markets as a result of which demand for US dollars rose for sending it for investment
in the US. This was triggered by the statement of the governor Ben Bernanke of the
US Federal Reserve that as the US economy had revived; it would start unwinding the
quantitative easing (QE) which was adopted to give stimulus to the US economy.
This led to capital outflows from the emerging economies including India to the US.
Besides, India’s large current account deficit which was estimated at a very high level
of 4.8 per cent of GDP in 2012-13 was caused by rapid growth of imports, especially
of gold and crude oil on the one hand and stagnant exports on the other also lead to
the net increase in demand for US dollars. In the months of May and June 2013 about
9 billion US dollars were withdrawn from India and contributed to capital outflows from
India.
Thus large capital outflows by FIIs and large current account deficit (CAD) led to the
sharp depreciation of the value of Indian rupee which was around Rs. 56 to a US dollar
in the first week of June 2013 fell to 61.21 to a US dollar on July 8, 2013 and further
hit a record low level Rs. 68.83 to a US dollar on August 28, 2013. This prompted
Reserve Bank of India to take steps to squeeze liquidity in the Indian banking system
whose funds were being used for speculative activities in the foreign exchange market.
Though depreciation of a currency is considered to be desirable as it boosts exports
and reduces imports. But a sharp depreciationof rupee in the present macro-economic
situation has a serious consequence. Not only will it make imports costlier and fuel
another round of inflation, it will also restrain the RBI from pushing through the cuts in
repo rate and cash reserve ratio urgently needed for kick-starting investments and
boosting growth Breaking out of this policy logjam requires that the government should
curtail current account deficit (CAD) by taking steps to boost exports by increasing its
competitiveness and undertaking its diversification and also cut imports by imposing
high tariffs on luxury imports, as it has already raised imports duty on gold from 6% to
10%. Besides, it should make reforms in foreign direct investment policy so that stable
capital inflows are attracted to the Indian economy.
It follows from above that portfolio capital flows result in a lot of instability in foreign
exchange rate of rupee which adversely affects our real economy through its effects
on our exports and imports. Dr. Manmohan Singh who is considered as votary of
globalisation in its address to the United Nations General Assembly in Sept. 2011

16. Page 16 of 16
called the attention of world leaders to its risks. He said, “Today we are being called
upon to cope with negative dimension of globalisation and global inter-dependence”.
He further said that US, Europe and Japan faced with economic slowdown are
affecting confidence in world financial and capital markets creating a lot of economic
instability which has a negative impact on emerging economies like India. He added
that world had taken for granted the benefits of globalisation and it is time that UN asks
its development agencies (World Bank, IMF) to ensure inclusive and sustainable
development for vast sections of humanity.
He rightly warned against protectionist measures as a response to the global
economic crisis, which he said has “deepened even further since 2008, in many
respects.” Calling for better coordination of macroeconomic policies of major
economies, Singh said: “We should not allow the global economic slowdown to
become a trigger for building walls around ourselves through protectionism or erecting
barriers to movement of people, services and capital.”
Another conclusion which follows from above is that there is a clash between foreign
exchange rate stability and domestic price stability and RBI has been attempting to
strike a balance between foreign exchange rate stability and domestic price stability.
If in order to ensure foreign exchange rate stability RBI mops up sufficient dollars, it
will result in pumping large sum of Indian rupees into the economy which will lead to
the large increase in money supply causing a high rate of inflation.
If to check inflation and ensure price stability, it does not mop up dollars from the
market and let dollar inflows, this will result in appreciation of rupee. Thus it has to
strike a balance in buying dollars from the market so as to check inflation one the hand
and to prevent too much appreciation of rupee. It is important to note that appreciation
of rupee adversely affects India’s exports and leads to loss of jobs.
Appreciation of rupee also makes imports cheaper causing increase in them. Fall in
exports and rise in imports adversely affects balance of payments on current account.
However, more imports brought in through appreciation of rupee adds to aggregate
supply of output and help in controlling inflation. On the other hand, too much
depreciation of rupee is also bad because it makes imports costlier, especially of fuel
oil. Higher value of imports also adversely affects balance payments.