Exchange Rate - An Indian Perspective

By

Aman Singla
PGDM (2006-08 Batch)
Alliance Business School
Bangalore
 

Introduction-

Exchange rate is a key determinant in international finance and turning of world into a global village has just made this variable all the more important. Forex markets have undergone many changes from setting up of Bretton Woods System in 1944 according to which each country had to fix its currency exchange rate plus or minus 1 percent to its abandonment in 1984 due to increased Balance of Trade deficit of U.S. Then it has witnessed East Asian crisis of 1997 when majority of the currencies of East Asian countries depreciated.

Now most of the countries follow a free floating exchange rate system. India's approach can be characterized as intermediate since it follows a system between a freely floating and fully managed system. This type of system is known as managed float system .Exchange rates are allowed to float freely, but RBI intervenes when it feels necessary in the way it considers suitable. For e.g. in order to curb appreciation of INR it may buy USD from the market or it may increase the interest rates.

Price determination-

The Forex market like any other market is essentially governed by the law of supply and demand. According to the law of supply, as prices rise for a given commodity (in this case currency), the quantity of the item that is supplied will increase; conversely, as the price falls, the quantity provided will fall. The law of demand states that as the price for an item rises, the quantity demanded will fall. As the price for an item falls, the quantity demanded will rise.

In the case of currency, it is the demand and supply of both domestic and foreign currency that is considered. It is the interaction of these basic forces that results in the movement of currency prices in the Forex market.

Factors affecting the demand and supply-

There are various factors in a macro-economic environment which affect the demand and supply of a currency and in return affect the exchange rate.

• Interest Rates- If there are higher interest rates in home country then it will attract investments from abroad in the form of FII, FDI and increased borrowings. This will lead to increased supply of foreign currency. On the other hand, if the interest rates are higher in the other country, investments will flow out leading to decreased supply of foreign currency.
• Rate of Inflation -If inflation rates are high then the central bank will have to reduce the supply of domestic currency in order to curb it. This would ultimately lead to strong currency and vice versa.
• Political or Military Unrest - All exchange rates are susceptible to political instability and anticipations about the new government. All the market players get worried about the policies and may start unwinding their positions thereby affecting the demand and supply.
• Domestic Financial Market – Strong domestic financial markets will also lead to the strengthening of domestic currency as investors will be less worried about their investments and vice versa.
• Strong Domestic Economy- If the domestic economy is strong then there will be lots of investments from abroad which will lead to increased supply of foreign currency, ultimately leading to strengthening of domestic currency. And if there is weaker domestic economy it would lead to outflow of funds from a country.
• Business Environment- Positive indications (in terms of government policy, competitive advantages, market size, etc.) increase the demand for currency, as more and more enterprises want to invest there. Any positive indications abroad will lead to strengthening of foreign currency.
• Stock Markets - The major stock indices also have a correlation with currency rates as investors link the growth in markets to the economic growth of a country. 
• Economic data: Economic data such as labor reports (payrolls, unemployment rate and average hourly earnings), Consumer Price Indices (CPI), Gross Domestic Product (GDP), International Trade, Productivity, Industrial Production, Consumer Confidence etc, also affect fluctuations in currency exchange rates.
• Balance of trade- If the exports to other countries are more than the exchange rate will be stronger as there will be inflow of foreign currency.  More one relies on imports, weaker will be the exchange rate because there will be outflow of domestic currency. A large, consistent government deficit will lead to outflow of domestic borrowing.
• Government budget deficits/surpluses- If a government runs into deficit, it has to borrow money (by selling bonds). If it can't borrow from its own citizens, it must borrow from foreign investors. That means selling more of its currency, increasing the supply and thus driving the prices down.
• Rumors – Any rumor in the markets also leads to fluctuation in the values. Any favourable news will lead to strengthening of domestic currency and any negative rumor will lead to weakening of the currency.

During the year 2004, the exchange value for a USD touched a high of Rs 46.46 and a low of Rs 43.39. In all there was an appreciation of 4.40% during the year. In the year 2005, it touched a high of Rs 46.63 and a low of Rs 43.33 and in all there was a depreciation of 3.34%. In the year 2006, it touched a high of Rs 46.95 and a low of Rs 44.07 and in all there was an appreciation of Rs 1.83%.

This appreciation is mainly on account of huge capital inflows and due to other steps taken by the Government to control the inflation.

First of all, RBI increased the Cash Reserve Ratio by 50 BPS in order to reduce the disbursal of loans by banks and thereby reducing the money supply. Moreover it also refrained from buying dollars from the market which led to decrease in demand of the dollar. It also issued Market Stabilization Bonds in order to remove liquidity form the market.

Secondly, there has been a massive capital inflow in the form of ECBs, FIIs and FDI this year. ECBs in the first six months were 5.5 billion USD which is almost the double of what was borrowed in the whole of 2006. Similarly in case of FIIs, they have already invested USD 8.45 billion in first six months this year as compared to USD 7.99 billion last year. FDI in India has also increased many folds. In the first four months itself, there has been an investment of USD 8007 million and if we look at the same period of four months last year it was just USD 2500 million recording an increase of over 200%.

Impact on Oil

Oil is an important commodity. India's oil import growth is at a 5 year low of 5.33% in the first four months of the year 2007-08 as compared to massive growth rate of 43.23% last year. India's Oil imports during the period were valued at US$ 19.878 billion as compared to 18.87 billion last year. We can't say that oil consumption has decreased as economy is doing well so consumption is bound to increase. On the other hand the price per barrel has increased sharply. So we can attribute this slowdown in growth to appreciation of INR because this would have reduced the bills of the oil companies.

Appreciating currency –  A Boon or Bane

 The question arises whether an appreciation of a currency is good or bad for a country. We can say that it has its own advantages and disadvantages.

Advantages-

• The importers have benefited as they have to pay less of domestic currency in order to pay their bills in foreign currency. The foreign products have become cheaper for the domestic consumer which helps in keeping the inflation down.
• Consumers benefit when they travel abroad as the domestic currency will be able to fetch more of foreign currency while exchanging.
• Investors can buy foreign stocks and bonds at lower prices.

• It has reduced the competitiveness of the exporters in the international markets as their goods have become expensive.
• Many exporters have incurred huge losses on account of INR appreciation.
• It has also put pressure on the domestic suppliers as there will be inflow of foreign goods and that to at lower prices.
• Foreign tourists will find it more expensive to visit the country.

Hedging

Peter Drucker once said, "Not to Hedge is to Speculate".

"Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business unit to profit from a business activity." Every business is exposed to a certain risks like banks are exposed to asset liability mismatches or oil companies are exposed to increase or decrease in the prices of oil.

Similarly, a company faces certain risks when it is dealing with the foreign exchange which must be properly hedged. It faces mainly three types of risks i.e. transactional risk, translation risk, and economic exposure risk which it needs to hedge because the investors invest in a firm's ability to profit from its line of business and not from its ability to speculate in the currency markets. The hedging cost must be made part of cost of the product.

Although, while hedging the risk the company is saved from any possible loss arising on account of fluctuation in currency value, on the other hand it also mitigates the possibility of making the profit on account of any favourable change.

For e.g. XYZ ltd is an exporter. It enters into a contract for supplying 1 lakh auto components to ABC Ltd in U.S @ of $5 per piece. Its cost per unit comes out to be Rs 200 per piece. The USD/INR rate at the time of entering the contract was Rs 45 per USD. This means company will make a profit of Rs 5 lakh if the rate remains the same i.e. Rs 45. But at the time of payment XYZ ltd receives payment in terms of USD. At that time INR appreciates and exchange rate comes down to Rs 39. The company will suffer a loss of Rs 1 lakh in the transaction. On the other hand, if INR depreciates and Exchange rate goes to Rs 46, then company will make a profit of Rs 6 lakh.  So it creates a dilemma in the minds of the managers on whether to go for hedging or not. A manager needs to consider factors like objective for hedging, type of risk involved and availability of the hedging instruments available in the market. It needs to maintain balance between uncertainty and opportunity loss.

There are many hedging instruments available which have different trade offs between uncertainty and opportunity loss.

Hedging Techniques-

The hedging techniques could be sub-divided under two heads-

1. In-house management techniques – There are various in-house techniques like Leading, Lagging, Pricing, Netting, Offsetting, Choice of Invoicing Currency etc.

2. Derivative Products available in the market- There are various derivative products that are available in the market. Although these are available Over the Counter (OTC) only and there is no exchange in India which provides such products. The main types of derivative products available in India are Forward Contracts, Options, Currency Swaps, Forward Rate Agreement, and Interest Rate Swaps. These products could be modified according to the needs of a particular company.  

The Reserve Bank has made the following regulations, to promote orderly development and maintenance of foreign exchange derivative market in India. According to these, no person in India should enter into a foreign exchange derivative contract without the prior permission of the Reserve Bank.

The exposures for which the forward contracts are allowed under the existing RBI notification for various participants are as follows:

1. Residents: A person resident in India may enter into a forward contract with an   authorized dealer in India to hedge an exposure to exchange risk. But it is subjected to following terms and conditions-

• There should be genuine underlying exposures out of trade/business. The authorized dealer must be satisfied about the genuineness of the underlying exposure. The maturity of the hedge should not exceed the maturity of the underlying transaction.
• The contract can be booked on the basis of a reasonable estimate if the exact amount of underlying exposure is not ascertainable.
• Exposures due to foreign currency loans and bonds approved by RBI can also be hedged.
• Receipts from GDR issued can be hedged in case issue price has been finalized.
• Balances in Exchange Earners Foreign Currency Accounts (EEFC) can also be hedged, but these can't be cancelled. However, these could be rolled over.

2.  Foreign Institutional Investors

• They should have exposures in India.
• Value should not exceed 15% of equity as of 31 March 1999 plus increase in market value.

 3. Non-Resident Indians/ Overseas Corporate Bodies: The NRI/OCB can enter into a forward- contract for the underlying transactions such as dividends from holdings in an Indian company and for their deposits in FCNR and NRE accounts.

 4. Cross currency forward contracts are also allowed to the companies. For example, a corporate having underlying exposure in Yen, may book forward contract between Dollar and Sterling.

• The RBI has given approval for borrowing in the foreign currency.
• A resident in India who has a liability in foreign currency can enter into foreign currency-rupee swap with an authorized dealer. But once cancelled, it can not be rebooked under any derivative product. Moreover it is restricted to USD 50 million.
• The notional principal amount should not exceed the amount of foreign currency loan.
• A person can enter into a foreign currency option contract (which doesn't involve rupee) with an authorized dealer and it can be easily rebooked or cancelled.

 Remittance related to a Foreign Exchange Derivative contract

An authorized dealer in India may remit outside India foreign exchange in respect of a transaction, undertaken in accordance with these Regulations, in the following cases, namely.

• Option premium payable by a person resident in India to a person resident outside India ,
• Remittance by a person resident in India of amount incidental to a foreign exchange derivative contract entered into in accordance with RBI guidelines.
• Any other remittance related to a foreign exchange derivative contract approved by Reserve Bank.

Conclusion

Indian economy is going through a series of changes and it is showing its effects on the Indian industry. There is high volatility in the value of INR/USD. The recent appreciation in the value of INR has swept away huge chunk of profits of the companies which export from India which mainly comprised of Textile sector, IT Sector, ITES, Gems and Jewellery etc. This is evident from the quarterly results of various Corporates.

There are lots of developments taking place even now. Forex markets are still volatile. The economy is growing at a strong rate of about 9%. The capital inflows are pouring in. Recently issue of Sub-Prime Crisis in US has also emerged which has affected the flow of funds. We are talking about implementing full Capital Account Convertibility in India in the coming years.

But then, we need to agree that Forex markets in India are not fully developed. It is still controlled by RBI indirectly. We need to have strong Forex markets and this could be achieved to a certain extent if Futures market is developed for Currency.

References:

1. www.rbi.org.in

2. www.sebi.com

3. www.apexforex.com

4. www.economictimes.com

5. www.businessline.com

 

Aman Singla
PGDM (2006-08 Batch)
Alliance Business School
Bangalore
 

Source: E-mail September 18, 2007

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