Meaning of the Term “Foreign Exchange”, Exchange Market, Statutory basis of Foreign Exchange, Evolution of Exchange Control, Outline of Exchange Rate and Types, Import Export India’s Forex Scenario: BOP crisis of 1990, LOERMS, Convertibility. Introduction to International Monetary Developments: Gold standard, Bretton Woods’s system, Fixed Flexible Exchange Rate Systems, Euro market.

1. The Currency Market:
Where money denominated in one currency is bought And sold with money
denominated in another currency.
“Foreign Exchange”
 "Foreign Exchange" means includes any instrument drawn, accepted, made or
issued under clause (8) of section 17 of the Banking Regulation Act, 1956, all
deposits, credits and balance payable in any foreign currency, and any drafts,
traveller's cheques, letters of credit and bills of exchange, expressed or drawn in
Indian currency but payable in any foreign currency
 Foreign exchange is the mechanism by which the currency of one country gets
converted into the currency of another country.
 The conversion of currency is done by the banks who deal in foreign exchange.
 These banks maintain stocks of one currencies in the form of balances with
banks
 It also refers to the stock of foreign currencies and other foreign assets.
 The foreign exchange management ACT 1999 defines
 “Foreign exchange means foreign currency and includes
o Deposits credits and balances payable in any foreign currency.
o Draft traveler’s cheques, letter or credit or bills of exchange expressed or
drawn in Indian currency but payable in any foreign currency.
o Drafts traveller’s cheques, letter of credit or bills of exchange drawn by
banks, institution or persons outside India, but payable in Indian currency
Nature of foreign exchange
 Volatile, affected by hedger, speculator etc..
 Affected by demand and supply.
 Affected by rate of interest.
 Affected by balance of payment surplus and deficit.
 Affected inflation rate.
 Spot and forward rates are different.
 Affected by the economic stability of the country.
 Affected by the fiscal policy of the government.
 Affected by the political condition of the country.
 It can be quoted directly or indirectly
Foreign Exchange Markets
 The market where the commodity traded is Currencies.

2.  Price of each currency is determined in term of other currencies.
What is an Exchange Rate ?
 Exchange Rate is the price of one country's currency expressed in another
country's currency.
 In other words, the rate at which one currency can be exchanged for another.
 e.g. Rs. 70.80 per one USD
Fixed Exchange Rate System
 Fixed rates provide greater certainty for exporters and importers.
Flexible Exchange Rate System
 Flexible exchange rate or floating exchange rates change freely and are
determined by trading in the forex market.
A Foreign Exchange Transaction
 Any financial transaction that involves more than one currency is a foreign
exchange transaction.
 Most important characteristic of a foreign exchange transaction is that it involves
Foreign Exchange Risk.
Foreign Exchange Reserves
 Foreign exchange reserves are the foreign currencies held by a country's central bank.
 They are also called foreign currency reserves or foreign reserves.
 There are many reasons why banks hold reserves.
 The most important reason is to manage their currencies' values.
PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET
 All Scheduled Commercial Banks (Authorized Dealers only).
 Reserve Bank of India (RBI).
 Corporate Treasuries.
 Public Sector/Government.
 Inter Bank Brokerage Houses.
 Resident Indians
 Non Residents
 Exchange Companies

3. Operation of foreign exchange market:
Spot Market:
Current Market) Spot market for foreign exchange is that market which handles only spot
transaction or current transactions.
Principle characteristics:-
 Spot Market is of daily nature. It does not trade in future deliveries.
 Spot rate of exchange is that rate which happens to prevail at the time when
transactions are incurred.
Forward Market:
Forward Market for foreign exchange is that market which handles such transaction of
foreign exchange as are meant for future delivery.
Principles Characteristics:-
 It only caters to forward transaction.
 It determines forward exchange rate at which forward transaction are to be
honoured.
Functions of Foreign Exchange Market
1. Transfer Function:
 The basic and the most visible function of foreign exchange market
 The transfer of funds (foreign currency) from one country to another for the
settlement of payments.
 It basically includes the conversion of one currency to another,
 Wherein the role of FOREX is to transfer the purchasing power from one country to
another.
2. Credit Function
 It provides credit for foreign trade.
 Useful for import and export
 Bills of exchange, with maturity period of three months, are generally used for
international payments.
 Credit is required for this period in order to enable the importer to take possession of
goods, sell them and obtain money to pay off the bill.
3. Hedging Function

4.  To hedge foreign exchange risks.
 Hedging means the avoidance of a foreign exchange risk.
 In a free exchange market when exchange rate, i.e., the price of one currency in terms
of another currency, change, there may be a gain or loss to the party concerned.
 Under this condition, a person or a firm undertakes a great exchange risk if there are
huge amounts of net claims or net liabilities which are to be met in foreign money.
 Exchange risk as such should be avoided or reduced.
 For this the exchange market provides facilities for hedging anticipated or actual
claims or liabilities through forward contracts in exchange.
 A forward contract which is normally for three months is a contract to buy or sell
foreign exchange against another currency at some fixed date in the future at a price
agreed upon now.
 No money passes at the time of the contract.
 But the contract makes it possible to ignore any likely changes in exchange rate.
 The existence of a forward market thus makes it possible to hedge an exchange
position.
 Foreign bills of exchange, telegraphic transfer, bank draft, letter of credit, etc., are the
important foreign exchange instruments used in the foreign exchange market to carry
out its functions
4. Minimizing Foreign Exchange Risk:
The foreign exchange market provides "hedging" facilities for transferring foreign
exchange risk to someone else.
Statutory Basis for Exchange Control
The Foreign Exchange Regulation Act, 1973 (FERA 1973), as amended by the Foreign
Exchange Regulation (Amendment) Act, 1993, forms the statutory basis for Exchange
Control in India
History
 Foreign Exchange control was first introduced in September, 1939 under Defence of
India Rules.
 ‘The Foreign Exchange Regulation Act (FERA), 1973.
 FERA was very strict and even has a provision for imprisonment.
 FERA was not suitable in the new and liberal economy, thus it was replaced by
Foreign Exchange Management Act (FEMA) 1999, which came into effect from 1st
June 2000.
 RBI plays a key role in the management of foreign exchange

5. Foreign Exchange Regulation Act (FERA)
Introduction
 It was a legislation passed by the Indian Parliament in 1973 and came into force
with effect from January 1, 1974.
 FERA emphasized strict exchange control over everything that was specified,
relating to foreign exchange.
 Law violators were treated as criminal offenders.
 Aimed at minimizing dealings in foreign exchange and foreign securities.
Objectives
 To regulate certain payments.
 To regulate dealings in foreign exchange and securities.
 To regulate transactions, indirectly affecting foreign exchange.
 To regulate the import and export of currency.
 To conserve precious foreign exchange.
 The proper utilization of foreign exchange so as to promote the economic
development of the country
Reasons
 Low foreign exchange (Forex) reserves
 Forex is a scarce commodity.
 FERA therefore proceeded on the presumption that all foreign exchange earned by
Indian residents rightfully belonged to the Government of India and had to be
collected and surrendered to the Reserve bank of India (RBI).
 FERA primarily prohibited all transactions, except one’s permitted by RBI.
Coca –Cola Example:
 Coca-Cola was India's leading soft drink until 1977 when it left India after a new
government ordered the company to turn over its secret formula for Coca-Cola and
dilute its stake in its Indian unit as required by the Foreign Exchange Regulation Act
(FERA).
 In 1993, the company (along with PepsiCo) returned after the introduction of India's
Liberalization policy

6. Foreign Exchange Management Act (1999)
FEMA stands for Foreign Exchange Management Act. It is a soft, liberal & simplified
law that aims at boosting foreign trade and investment more in tune with Country’s new
economic environment of globalization of Indian economy
 Statutory Basis for Exchange Control.
o The Foreign Exchange Regulation Act, 1973 (FERA 1973), as amended by
the Foreign Exchange Management (Amendment) Act, 1999. from the
statutory basis for Exchange Control in India.
 FEMA has been introduced as a replacement of FERA.
 FEMA facilitating external trade & payments.
 Consolidate & amend the law relating to foreign exchange.
 Promoting the orderly development & maintenance of foreign exchange market in
India.
 49 Section in the Act.
Introduction
 The FEMA was an act passed in the winter session of Parliament in 1999 which replaced
FERA
 FERA did not succeed in restricting activities.
 The act would become FEMA to relax the control on foreign exchange in India.
 The deals in Foreign Exchange were to be ‘managed’ instead of ‘regulated’
 The switch to FEMA shows the change on the part of the government in terms of the foreign
capital.
 FEMA gives the central government the power to impose the restrictions.
 The transactions should be made only through an authorized person.
 Deals in foreign exchange under the current account by an authorized person can be
restricted by the Central Government, based on public interest.
 The RBI is empowered by this Act to subject the capital account transactions to a number of
restrictions.
Objective of the Act:
• The main objectives of FEMA is to utilize foreign exchange resource of the country
effectively.
• It is facilitates external trade and payment
• For promoting orderly development & maintenance of foreign exchange in India.
• It Is applicable to all parts of India.

7. • To maintain a good relation with other countries.
• It is also applicable to all branches, offices & agencies outside India owned or controlled
by a person who is a resident of India.
FEMA Act : (applicable to)
o To the whole of India.
o Any Branch, office & agency, which is situated outside India, but is owned or
controlled by a person resident in India.
 Broadly speaking FEMA, covers three different types of categories are:
o Person.
o Person Resident in India.
o Person Resident outside India
 Export:
o Goods & services from India to outside.
 Foreign Currency:
o Other than Indian Currency.
 Foreign Exchange:
o Means exchange of foreign currency.
 Foreign Security:
o Security expressed in foreign currency.
 Import:
o Goods & services from outside to India.
 Security:
o Share, Stock etc. as defined in the Public Debt Act of 1994.
 Service:
o Banking, Financing, Insurance etc..
 Transfer:
o sale, Purchase, Exchange etc..
 Non-Resident Indian (NRI):
o Citizen of India residing outside.
 Overseas Corporate Body (OCB):
o A company, firm, etc… Owned at least 60% by NRIs.
FERA v/s FEMA
• The objective of FERA was to conserve forex and prevent its misuse. The objective of
FEMA is to facilitate external trade and payments and maintenance of foreign exchange
in India.

8. • Violation of FERA was considered a criminal offence. Whereas violation of FEMA was
considered a civil offence.
• Under FERA citizenship was a criteria while determining a person as resident of India
whereas under FEMA stay of more than 182 days is a criteria to determine residential
status of a person.
Few Definitions in FEMA
 "Authorized person" means an authorized dealer, money changer, off-shore banking unit
or any other person for the time being authorized under sub-section (1) of section 10 to
deal in foreign exchange or foreign securities;
 "capital account transaction" means a transaction which alters the assets or liabilities,
including contingent liabilities, outside india of persons resident in india or assets or
liabilities in india of persons resident outside india, and includes transactions referred to
in sub-section (3) of section 6;
 "currency" includes all currency notes, postal notes, postal orders, money orders,
cheques, drafts, travellers cheques, letters of credit, bills of exchange and promissory
notes, credit cards or such other similar instruments, as may be notified by the reserve
bank;
 "currency notes" means and includes cash in the form of coins and bank notes;
 "current account transaction" means a transaction other than a capital account transaction
and without prejudice to the generality of the foregoing.
 "foreign exchange" means foreign currency and includes,-
 Deposits, credits and balances payable in any foreign currency,
 Drafts, travellers cheques, letters of credit or bills of exchange, expressed or drawn in
indian currency but payable in any foreign currency,
 Drafts, travellers cheques, letters of credit or bills of exchange drawn by banks,
institutions or persons outside india, but payable in indian currency;
 "Person" includes – an individual, a hindu undivided family, a company, a firm, an
association of persons or a body of individuals, whether incorporated or not, every
artificial juridical person, not falling within any of the preceding sub-clauses
 "person resident in india" means- a person residing in india for more than one hundred
and eighty-two days during the course of the preceding financial year
 "person resident outside india" means a person who is not resident in india;

9. Exchange Control
What is Exchange Control?
• It is one of the devices adopted for the purpose of control international trade and regulate
international indebtedness arising out of international workings and dealings.
• Foreign exchange controls are various forms of controls imposed by a government on the
purchase/sale of foreign currencies by residents or on the purchase / sale of local currency
by non-residents.
Definition
• “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.
• 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”.
• 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
 Means the monopoly of the government
 In the purchase and sale of foreign currencies
 To restore the balance of payments and avoid the market forces in the decision of
monetary authority
 When tariffs and quotas do not help in correcting the balance of payments the system
of Foreign Exchange Control is restored to by Governments
Objectives of Foreign Exchange Control
1. Correcting Balance of Payments
 Main purpose - restore the balance of payments equilibrium
 By allowing the imports only when its necessary
 Limiting the demands for foreign exchange up to the available resources.

10. 2. To Protect Domestic Industries
 To protect the domestic trade and industries from foreign competitions
 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 Govt. feels that the rate of exchange is not at a particular level, Govt.
involve in maintaining the rate of exchange at that level.
 For this purpose the Government maintains a fund
 May be called Exchange Equalization Fund to limit the rate of exchange when the
rate of particular currency goes up,
 Govt. 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
 Govt. may overvalue or undervalue its currency on the basis of economic forces.
 In over valuing, the Govt. increases the rate of its currency in the value of other
currencies
 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:
 Govt. policy of differentiation by exercising exchange control.
 Govt. may allow international trade with some countries by releasing the required
foreign currency
 Govt. may restrict the trade import and exports with some other countries by not
releasing the foreign currency.
6. Other Objectives
 To earn revenue (selling and purchasing)
 To stabilise the exchange rates
 To make imports of preferable goods possible by making the necessary foreign
exchange available
 To pay off foreign liabilities with the help of available foreign exchange resources.

11. Methods of Exchange Controls
1. Direct Methods 2. Indirect Methods
1. Direct Methods
• Adopted by the central bank
• Aimed to restricting the use and the quantity of foreign exchange.
• These include
I. Intervention
II. Exchange restriction
III. Exchange clearing agreements
IV. Payments agreements
I. Intervention
 By Central bank or Central Govt.
 Related to pegging
 To fix or change the exchange rate
 Sale and purchase of currency
 Central bank or government may intervene in the foreign exchange market with a view to
raise or lower the exchange value of home currency relative to foreign currency through
the sale or purchase of the former
 It is termed as pegging
 The sale of home currency in the foreign exchange market is made to peg the rate of
exchange at a lower than the free market rate of exchange. The buying of the home
currency, on the other hand, permits the pegging of rate of exchange at a level higher than
the free market rate.
 It means the central banking or government intervention in the foreign exchange market
through sale of home currency takes place, when the excess demand for the home
currency is likely to cause its significant appreciation. In the event of excess demand
pressures for the foreign currency, when the depreciation of home currency is likely to
occur, the intervention will take the form of purchase of home currency in the foreign
exchange market. So intervention can ensure stability of exchange rate at the officially
fixed level.
 As regards the effectiveness of intervention, it has certain limitations. Firstly, the
intervention through the sale of foreign currency can be successful only, if a country has
sufficiently large reserves of foreign currencies.

12.  Secondly, it is easier for a country to sell the home currency and buy the excess amount
of foreign exchange through the use of home currency. It is greatly constrained in the sale
of foreign currency.
 Thirdly, the intervention in the foreign exchange market or the pegging operations should
be employed as a temporary expedient and cannot be a permanent remedy of exchange
instability. In this context, Crowther said, “But it is nevertheless an expensive and
hazardous proceeding for any country that adopts it more than a temporary expedient. We
may conclude that intervention is temporarily, rather than permanently, possible.”
II. Exchange Restrictions
 Strict form of exchange control
 Policies or measures as are directed to restrict or reduce compulsorily the flow of
domestic currency in the foreign exchange market.
 Compulsory reduction of the supply of its currency into the market.
 The essence of this type of control is the acquisition by the government or the central
bank of all foreign exchange earnings and receipts and their exchange for domestic
currency.
 The importers and other categories of people can purchase foreign exchange only from
the government or central banking authorities.
The Exchange Restriction
• The exchange restriction is a more severe form of exchange control.
• The exchange restrictions include such policies or measures as are directed to restrict or
reduce compulsorily the flow of domestic currency in the foreign exchange market.
 The policy of exchange restriction, according to G. Crowther, is a compulsory reduction
by the government of the supply of its currency into the market. The essence of this type
of control is the acquisition by the government or the central bank of all foreign exchange
earnings and receipts and their exchange for domestic currency.
 The importers and other categories of people can purchase foreign exchange only from
the government or central banking authorities.
 The exchange restrictions assume following inter-linked forms
• Compulsory surrender of all foreign exchange earnings or receipts to the central
bank or government.
• Preventions for the exchange without prior permission of Govt.
• Prescription of all foreign exchange transactions through the central agency
• Enactment of laws providing for punishment in the event of non-compliance of
foreign exchange regulations.

13. The prominent variants of exchange restrictions are as follows
i.. Blocked Accounts
ii. Multiple Exchange Rates
iii. Allocation of Exchange According to Priorities
i. Blocked Accounts
• Central bank of an importing country maintains the foreign exchange accounts of the
foreign exporters.
• The central bank does not permit the creditors to use their currency holdings in their
accounts for a specified period.
• Under the system of blocked accounts, the central bank of an importing country
maintains the foreign exchange accounts of the foreign exporters. The central bank
does not permit the creditors to use their currency holdings in their accounts for a
specified period.
• That is why these accounts are referred as blocked accounts. The balances held in
these accounts, no doubt, can be utilised by the creditors in the country where the
accounts are blocked. This provides some time during which a debtor or deficit
country can adopt appropriate corrective actions.
Example
• Germany adopted this practice in 1931.
• England exercised it during 1939-45 period when large Sterling balances, payable to
India, got accumulated on account of large scale imports of goods from the latter
during war period.
• The payment remained blocked till the termination of war.
• Only after 1945, the payments were released in instalments at the convenience of
England.
ii. Multiple Exchange Rates
 An elaborate structure of exchange rates applicable to different categories of imports,
exports and capital transfers.
 Low exchange rates are maintained in exportable goods for improve their export.
 In case of imports,
o Low exchange rates for necessaries
o High exchange rates for luxury goods or harmful products
 Under this system, a country has an elaborate structure of exchange rates applicable to
different categories of imports, exports and capital transfers. Low exchange rates are
maintained in the case of exportable goods for stimulating their export. In case of

14. imports, low exchange rates are established in the case of necessaries but prohibitive
(or high) exchange rates are set in the case of luxury goods or harmful products
Example
 South Africa from 1985 to 1995,
 China (1981 to 1985) during a period of Chinese economic reform
iii. Allocation of Exchange According to Priorities
 The foreign exchange is allocated for the import of different categories of goods and
for other purposes according to a specific order of priorities.
 Essential items (food, raw materials, intermediate products, defence materials,
machinery, and technology) - higher priority
 luxury imports – less priority
 The exchange restrictions may be practiced by the central bank of a country, when the
foreign exchange is allocated for the import of different categories of goods and for
other purposes according to a specific order of priorities.
 For instance, the import of essential items like food, raw materials, intermediate
products, defence materials, machinery, and technology may be accorded a higher
priority compared with luxury imports.
 This method of exchange restriction remained in use in England and several others
advanced as well as LDC’s. There are certain pitfalls in this method.
 The exchange restrictions may be practiced by the central bank of a country, when the
foreign exchange is allocated for the import of different categories of goods and for
other purposes according to a specific order of priorities.
 For instance, the import of essential items like food, raw materials, intermediate
products, defence materials, machinery, and technology may be accorded a higher
priority compared with luxury imports.
 This method of exchange restriction remained in use in England and several others
advanced as well as LDC’s. There are certain pitfalls in this method.

15. III. Exchange Clearing Agreements
Definition of clearing agreement
 An agreement between nations as to the method of settlement of commercial accounts
that is usually designed to avoid transfer of foreign exchange
 Two or more trading countries establish accounts in their respective countries.
 The importers of a given country make payments into that central account in the domestic
currencies.
 These amounts are paid out to the exporters for the goods exported
 Any surplus or deficit after the clearing operations is settled either in terms of gold or a
convertible currency acceptable to the trading partners.
 The claims and counter-claims upon foreign exchange related to different countries are
adjusted through appropriate book entries.
 This method greatly simplifies the payment mechanism.
 This method is convenient for those countries which do not have sufficient foreign
exchange reserves.
In other words
 Clearing Agreement Normally, importers have to make payments in foreign currency and
while exporters are paid in foreign currency.
 Under the clearing agreement, importers make payments in domestic currency to the and
exporters obtain payments in domestic currency from the clearing fund.
 Thus, under the clearing agreement, the importer does not directly pay the exporter and
hence, the need for foreign exchange does not arise, except for settling the net. balance
between the two countries.
IV. Payments Agreements
 To overcome the difficulties of delay involved in settling international payments
 For the centralisation of payments observed in clearing agreements
 A creditor is paid as soon as information is received by the central bank of the debtor
country from the creditor country’s central bank that its debtor has discharged his
obligation and vice versa.
 Payment agreements have the advantage that direct relation between the exporters and
importers is maintained.

16. 2. Indirect Methods
(i) Tariff and Non-Tariff Restrictions
(ii) Export Subsidies
(iii) Increase in Interest Rates
(ii) Export Subsidies
 When the government follows the policy of subsidizing exports
 The home exporters to enlarge exports.
 This measure, on the one hand,
o Can bring about an improvement in the BOP deficit and,
o On the other, can raise the external value of home currency.
(iii) Increase in Interest Rates
 The increase in the structure of interest rates in the home country leads to an inflow of
capital from abroad and the prevention of capital outflow.
 These changes effect improvement in the BOP situation in addition to making the foreign
exchange rate more favourable.

17. GOLD STANDARD, BRETTON WOODS’S AND EXCHANGE RATE
Gold Standard
 The gold standard is a monetary system where a country's currency or paper money has a
value directly linked to gold.
 With the gold standard, countries agreed to convert paper money into a fixed amount of
gold
The Gold Standard (1876 – 1913)
 A system of setting currency values whereby the participating countries commit to fix the
prices of their domestic currencies in terms of a specified amount of gold.
 The gold standard as an international monetary system gained acceptance in Western
Europe in the 1870s.
 The United States was something of a latecomer to the system, not officially adopting the
standard until 1879.
 The gold standard is a monetary system where a country's currency or paper money has a
value directly linked to gold.
 With the gold standard, countries agreed to convert paper money into a fixed amount of
gold
Advantages of Gold Standard
 It is an objective system and is not subject to the changing policies of the government or
the whims of the currency authority
 Gold standard enables the country to maintain the purchasing power of its currency over
long periods. This is so because the currency and credit structure is ultimately based on
gold in possession of the currency authority.
 Another important advantage claimed for gold standard is that it preserves and maintains
the external value of the currency (rate of exchange) within narrow limits. As a matter of
fact, within the gold standard system, it provides fixed exchanges, which is a great boon
to traders and investors. International division of labour is greatly facilitated
Bretton Woods’s (1944)
 In 1994 – 730 delegates from 44 allied powers met at Bretton Woods, New
Hampshire
 To create a new post-war international monetary system
 The Bretton Woods Agreement, implemented in 1946
 Each member government pledged to maintain a fixed, or pegged, exchange rate for
its currency vis-à-vis the dollar or gold.
 Established a US Dollar - based international monetary system

18.  Also established two new institutions