Indian Foreign Exchange Market -Basic Information

Visiting the Foreign Exchange Market

We all know that the Indian Rupee serves as the medium of exchange backed by legal tender status for making payments towards purchases and towards discharging all other types of payment obligations within the country. But as modern trade and commerce extend beyond the boundaries of a country, the question naturally arises as to how to settle payments for cross-border sales, purchases and other money dealings? We also need to incur expenditure in foreign countries towards travel and temporary halt, medical care, educational purposes, maintenance of an office at the foreign centre etc. This is a widespread and frequent need of many persons in every country. But each country has a different currency, serving as a medium of exchange exclusively within its boundaries. Then how to make payment in Indian Rupees in our country and enable the foreign seller to get payment in his currency? Let us look at the answer.

If an exporter in India sells readymade garment, say to a Canadian firm, the Canadian importer can make payment in Canadian Dollars, while the Indian Exporter desires to be provided with Indian Rupees. This problem is solved by the Canadian Importer in the first instance purchasing Indian Rupees against payment of Canadian Dollars in his country from an authorised source dealing with foreign money (foreign exchange) and remitting Indian Rupees to the Indian Exporter. Or in case the consignment is invoiced in Canadian Dollars, the Indian exporter gets Canadian Dollars, which he sells in this country to an authorised dealer (of foreign exchange) to get Indian Rupees. Thus as money is used as a medium of exchange to secure supplies of goods and services, it can also be so used to secure supply of currency/money of another country, which can thereafter be used to discharge our payment obligations in that country.

So in every business deal or other types of money transaction extending outside the borders of a country, there are in fact two set of transactions, i.e. first the one relating to the goods traded and secondly trading (buying/selling) of the foreign money called foreign exchange to settle payment to the overseas seller. In fact in actual practice there would be three sets of transactions. In the above example, since in India, it would be difficult to get Canadian Dollars readily in the spot market, or vice versa to get Indian Rupees in Canada the transaction will be normally settled in US$. The Canadian Importer will buy US$ in his country against payment of Canadian Dollars to remit to his Indian seller. On receipt of US $, the Indian Exporter will exchange it into Indian Rupees in his country by selling the same in the foreign exchange market. Thus there is the movement of readymade garments from India to Canada in the first place. In the second place there is the exchange of Canadian Dollars to US Dollars taking place within Canada. Lastly there is the exchange of US$ to Indian Rupees in India.

The transactions involving the buying and selling of inter-country currencies are called foreign exchange transactions and the term Foreign Exchange Market refers to all the market participants involved in such dealings, i.e. the buyers, sellers, the market intermediaries and finally the Monetary Authority (market Regulator) of the country regulating exchange rate mechanisms. The Indian foreign exchange market is a huge financial market exceeding an annual turnover of 400 bn valued in US$ in terms only by public dealings (i.e. excluding inter-bank transactions). It is the third wing of the Financial markets in India, the others being the money market and the capital market. As per statistics released by RBI, The average monthly turnover in the merchant segment of the forex market increased to US$ 40.5 billion in 2003-2004 from US$ 27.0 billion in 2002-2003. In the inter-bank segment, the turnover has moved up from US$ 103 billion in 2002-2003 to US$ 134.2 billion in 2003-2004. Consequently, the average monthly total turnover increased sharply to US$ 174.7 billion in 2003-2004 from US$ 130 billion in the previous year. The inter-bank to merchant turnover ratio hovered in the range of 2.9 �3.9 during the year.

Mumbai is the principal centre. Other important centres are Calcutta, New Delhi, Madras, Bangalore, Cochin and Pondicherry. Until recently the various centres functioned as fragmented markets leading to wide variations in exchange rates. With the improvement in telecommunication facilities the various centres are being increasingly integrated and they are now functioning as part of a single geographically extended market. In the context of recent developments in telecommunication and computer facilities, individual market centres are just conduits and foreign exchange business can be transacted from any centre without jeopardizing efficiency

Foreign exchanged market in India is totally structured, well regulated both of RBI and also by a voluntary association (Foreign Exchange Dealers Association). Only Dealers authorised by RBI can undertake such transactions. All inter-bank dealings in the same centre must be effected through accredited brokers, who are the second arm in the market-structure. However, dealings between the authorised dealers and the RBI and also between the AD (Authorised Dealers) and overseas Banks are effected directly without the intervention of the brokers. In addition to the authorised dealers covering commercial banks, who undertake comprehensive transactions covering all spheres of foreign exchange, there are also a peripheral market consisting of licensed money changers and travel agents, who enjoy limited authorisation especially for encashment of traveler�s cheques, notes. Specified hotels and Government owned Shops are also given restricted licenses to accept payment from non-residents in foreign currencies. IDBI, and Exim Bank are permitted handle and hold foreign currencies in a restricted way.

In a spot transaction the seller of exchange has to deliver the foreign exchange he has sold 'on the spot' (usually within 2 days). Similarly the buyer of exchange will receive the foreign exchange he has bought immediately. There is another important market, the Forward Market. In a forward market when the bargain is settled, the seller agrees to sell at a certain amount of foreign exchange to be delivered at a future date at a price agreed upon in advance. Analogously a buyer agrees to buy certain amount of foreign exchange at a future date at a predetermined price. Commonly used forward contracts are for duration of one month(30 days) 3 months (ninety days),six months (180 days), nine months (270 days) and one year (360 days). The linkage between the spot and forward exchange rates come from the actions of three groups of economic agents who use the market, viz. arbitrageurs, hedgers, and speculators.

If the Indian Exporter has received US Dollar and desires to convert the same into Indian Rupees, at what would he receive Indian rupees for each US $? This is decided by the prevailing exchange rate between Indian Rupee and US $. Exchange rate is the price of one currency expressed in terms of another. It is the relationship between two monetary units. Exchange rate is the medium though which one currency is exchanged for another. In this exchange two currencies are hold. We are holding one currency, normally the home currency, i.e. Indian rupees in our case. We need to buy foreign currencies like Pound Sterling or U.S. Dollars. Vice versa, we also desire to sell these foreign currencies, whenever we get them to convert into Indian Rupees. In this case the home currency (the Indian Rupee) is the Base currency and the foreign currency that we need to buy say U.S. Dollars is the variable or offered currency.

We have two options. One is to quote so many Rupees for each Dollar and the second option is to quote so many Dollars per rupee or per hundred rupees. The first is called the Direct Method and the second is called the Indirect method. The two methods are further explained as under:

1. Direct Method (Home Currency Quotation):
   Under the above method, the unit of foreign currency remains fixed and local currency varies.

Example
US$ = Rs.43.20 (Spot)
Pound = Rs.75.20 (Spot)

2. Indirect Method (Foreign Currency Quotation):
   Under this method, a given unit of local currency remains fixed and foreign currency varies In India the unit for quoting foreign currencies is always taken as hundred rupees.

   Example
   Rs.100 = US$ 2.35 (Spot)
   Rs.100 � Pound 1.33 (Spot)

Earlier foreign exchange rates for various types of merchant transactions (both spot and forward) were fixed by the Foreign Exchange Dealers Association of India (FEDAI) in consultation with RBI. Recently however this arrangement was abolished and the Individual Banks are permitted to quote competitive rates, based on the on-going inter-bank or overseas market rates. This freedom with the relaxation of some of the provisions of the exchange control gave a fillip to the growth of Indian market.

Authorised Dealers quote exchange rates on daily basis. These dealers are mostly branches of commercial Banks, which are authorised to do all sorts of foreign exchange transactions by the R.B.I. The Bank which offers the exchange rate is known as the Quoting Bank ands the Bank/person/Organization asking for the rate/price is known as the asking bank/firm/person. The quoting Bank always quote two way price,

1. A price at which it buys

2. A price at which it sells.

Both rates are quoted against a common currency.

While quoting rates the Quoting Bank keeps a spread between the buying and selling rate. The spread is kept to cover operational costs and margin of profit.

Example � A Bank quotes:
Rs.100 � US$ 2.3500/50.
This means it is prepared to sell US$2.3500 for Rs.100/- and is
Prepared to buy US$2.3550 for Rs.100
This spread is 50 cents.

The maxim applied is "Buy High and Sell Low" for Indirect quotes. For Direct Quotes the maxim is reversed "Buy Low and Sell High". The objective of buying and selling operations is to cover the operational costs and also to earn an exchange profit. Bankers consider exchange profit as an important source of income. It is earned without the buyer/seller being aware of this income.

In India Exchange Control function is regulated by the Central Bank of the country, i.e. Reserve Bank of India, through its Exchange Control Department.. The various functions of this department are discussed elsewhere in another module dealing with functions of RBI and can be viewed through the link. FEDAI (Foreign Exchange Dealers Association. the Foreign Exchange Dealers Association of India) is a self-regulatory organisation formed by authorised dealers. It plays a constructive role in market development by initiating debates on important issues, organising training programmes and providing technical expertise on various matters

The term exchange rate regime refers to the mechanism, procedures and institutional framework for determining exchange rates at a point of time and changes in them over time, including factors which induced the changes. In theory, there are a very large number of exchange rate regimes are possible. At two extremes, are the perfectly rigid or fixed exchange rates, and the perfectly flexible or floating exchange rates. Between them are hybrids with varying degrees of limited flexibility.

The exchange rate regime in India underwent a major change in March 1993, when after a brief experience with dual exchange rates, the country adopted a unified market determined exchange rate system. Under this system, the exchange rate was left to the determined by the market forces, while the Reserve Bank of India intervened when there was a high degree of volatility or instability in the market. More about Exchange Rate Regime is discussed in another article.

By way of understanding basic concepts relating to the functioning of Indian foreign exchange market, we would be discussing about Current/Capital Account convertibility in the next article .Various other features relating to Foreign Exchange Market of India are discussed in the succeeding articles