Exchange Rate Management

Foreign Exchange Market

The market of exchanging foreign currencies is called as Foreign Exchange Market. Commercial banks, Foreign Exchange brokers, other approved businessmen, monetary officers were the major dealers of foreign exchange market. Foreign exchange rate is the rate of exchange of currencies between different countries. Foreign exchange rate will connect currencies of different countries and helps to compare the expenditure and price on international basis.

Determination of Exchange Rate 

Every nation has a distinct methodology to decide it's currency's exchange rate. In an open economy, the determination of exchange rate is done mainly through three methods - Flexible Exchange Rate, Fixed Exchange Rate and Managed Floating Exchange Rate.

1. Flexible Exchange Rate

Flexible Exchange Rate is also known as Floating or Floating Exchange Rate. The exchange rate is determined based on supply and demand forces of market. The Central bank does not deal with determination of Flexible Exchange Rate. The rise of rate of foreign currency compared to domestic currency is termed as depreciation of domestic currency. Depreciation happens only when the exchange rate increases. In the system of Flexible Exchange Rate, if the rate of domestic currency is increased when compared to foreign currency, then it is termed as Appreciation of domestic currency. The other important factor that determine the exchange rate of market is Speculation. Buying foreign currency in the expectation of increase of currency value in future is called as Speculation. Speculation involves trading a financial instrument involving high risk, in expectation of significant returns. The motive is to take maximum advantage from fluctuations of exchange rate. The major factor that determines the short term exchange rate is flexible interest rate.

Purchasing Power Parity is the theory used for the long term prediction of flexible exchange rate condition. Purchasing Power Parity (PPP) is an economic theory of exchange rate determination. Purchasing Power Parity states that the exchange rates of two countries for long term will reflect the difference of price standards of both countries.

Merits of Flexible Exchange Rate

a. This system gives more flexibility to government.

b. There is no need of storing the foreign exchange reserve currency in large quantity.

c. The changes in exchange rate voluntarily solve the unbalanced state (deficit, surplus) of Balance of Payment.

d. It gives the freedom to government for implementing the financial policy.

2. Fixed Exchange Rate

In Fixed Exchange Rate System, government determine the exchange rate in a special level. Fixed Exchange Rate System is also known as Pegged Exchange Rate System. Fixed Exchange Rate is determined by the central bank of a country (In India, RBI is the Central Bank). If there is any change in exchange rate, then central bank will get involved in Market and bring it to early determined exchange rate. If the exchange rate of a country's currency is determined by the financial authority of that country, then it is called as Fixed Exchange Rate. If the government get involved in the Fixed Exchange Rate and increase the exchange rate (that is, decreasing the value of domestic currency), then it is called as devaluation. Also if the government decrease the exchange rate (that is, increasing the value of domestic currency), then it is called as revaluation.

Merits of Fixed Exchange Rate

a. Government can maintain the exchange rate at a fixed level.

b. If there is any deficit in Balance of Payment, government can fill up it by using the official reserve currency.

3. Managed Floating Exchange Rate

The combined activities of both Fixed Exchange Rate and Flexible Exchange Rate is called as Managed Floating Exchange Rate. This system is not working under the base of any official international understanding. In this system, both flexible rate and fixed rate will work at same time. Managed Floating Exchange rate is also called as Dirty Floating Rate. Here the exchange rate is controlled by the market and central bank together. When the need arises, central government can get involve and can buy or sale foreign currency. So that the official foreign currency reserve does not disappear.

Exchange Rate Management  : International Experience

Gold Standard

Gold Standard is the oldest monetary system where one unit of currency equals a specific amount of Gold. Gold Standard is the exchange system existed from 1870 to 1914 (till the start of first world war) in the majority countries of world. Gold Standard is the most important method of Fixed Exchange Rate. In the Gold Standard System, the value of all currencies is calculated based on Gold. It's exchange rate is determined according to the quantity of gold used to make each currency and fixed price. Every countries in the world accepted to change their currency to gold at fixed rate. It is because the currency can be independently converted to Gold. This simply and easily helped to change one currency to another currency. After the failure of Gold Standard, Gold Exchange Standard came into existence. According to Gold Exchange Standard, the security of currency can be measured to any currency based on gold. 

Example of Gold Standard : 30 dollars = 1 Ounce of Gold

That is, Trader A trades a $300 business with Trader B and Trader B gives 10 ounce of gold to Trader A.

Bretton Woods System

Bretton Woods Conference is the biggest turning point in the history of determining Exchange Rate. The Bretton woods conference was held in America in July 1944. Bretton woods conference formed two international organisations - International Monetary Fund (IMF) and World Bank. Both IMF and world bank are together called as Bretton Woods twins. IMF is established in 1945 to promote international financial co-operation. It starts its operation on March 1, 1947. It's headquarters is at Washington. World Bank is established on December 27, 1945 to help reconstruction and development of member countries. It starts its operation on June 25, 1946. It's headquarters is also at Washington. 

Bretton Woods Conference becomes the reason for carry out the fixed exchange rate system again. This system begin two tier convertibility arrangement in currency change. The Indians participated in Bretton Woods Conference were RK Shanmukham Chetty, CD Deshmukh and BK.Madan. The Bretton woods Agreement established a system through which a fixed currency exchange rate could be created using gold as the universal standard. But the short term liability of american dollar increased. As a result, bretton woods system failed to return 35 dollar for one ounce of gold. Then the central banks of member countries decided to change their reserve dollar to gold. As a result, system failed to keep the word. Among the critics of Bretton wood system, Robert Triffin pointed out the condition like this. So this condition is known in the name of Triffin Dilemman. The opinion of Triffin is that IMF should be changed to deposit bank of alternate central banks. He also said that under the control of IMF, a reserve asset should be started. Following this, the radical change in the working of IMF happened. 

A new currency called Special Drawing Rights instead of Gold is implemented. It was in 1967, the new reserve currency called SDR is formed instead of gold. SDR  is also known as Paper Gold. SDR is not an original currency. It is an accounting unit used for international money transactions. Earlier the value of SDR is determined according to the value of gold. But later it is dropped. Currently the value of SDR is calculated based on the total value of dollar, euro, pound and yen (four currencies). All countries agreed to accept SDR as Research Currency. During the end of 1960s, Bretton Woods system collapsed (abandoned in 1971) and following this, Floating Exchange Rate System becomes active. Advanced countries adopted Managed Floating Exchange Rate System. In 1999, the major countries of European Union accepted to receive a general currency. As a result, Euro Currency came into existence.

International Monetary Fund (IMF)

The major duty of International Monetary Fund is to maintain the stability of foreign currency exchage rate. The organisation deal with the problems on balance of payments of member countries. IMF is the one of the organisation formed after Bretton woods conference, the other being World Bank. IMF is established in 1945 July to promote International Financial Co-operation. It starts its operation on March 1, 1947. It's headquarters is at Washington. Currently, IMF has 191 member countries. Managing Director is the head of International Monetary Fund and he always will be an European. The exchange currency of IMF is Special Drawing Rights (SDR). It was in 1969, IMF formed the new reserve currency called Special Drawing Rights instead of Gold. Special Drawing Rights is also known as Paper Gold. Special Drawing Rights is not an original currency. It is an accounting unit used for international money transactions. 

World Bank

World Bank is one of the organisation formed after Bretton woods Conference. It is established on December 27, 1945 to help reconstruction and development of member countries. It starts its operation on June 25, 1946. Its headquarters is at Washington dc. It is the biggest bank in the world. World Bank is the combination of Five Agencies. International Bank for Reconstruction and Development (IBRD), International Financial Corporation (IFC), International Development Association (IDA), Multilateral Investment Guarantee Agency (MIGA) and International Centre for Settlement of Investment Disputes (ICSID) were the agencies of World Bank. IBRD provides economic assist for the reconstruction and development of basic sectors of member countries. The insurance arm of the world bank is known as Multilateral Investment Guarantee Agency (MIGA). Currently there are 189 member countries are there in the World Bank. Nauru is the 189th member of World Bank. The term 'Third Window' is related to World Bank. The 'Third Window Financing' is approved by World Bank in 1975. The Third Window Financing provides development assistance to eligible countries on terms between those of the IBRD and International Development Association (IDA). 'We exist to create a world free of poverty on a livable planet' is the motto of World Bank. France is the first country which brought debt from world bank.

Exchange Rate Management in India

Even after the independence, the Indian rupee was related to the british currency 'Pound Sterling'. The indian rupee was devalued by 36.5% in 1966. The indian rupee was delinked from the pound sterling in 1975. In 1991, India was plunged into a serious balance of payment crisis. The rupee was devalued by 19% in two phases on July 1 and July 3, 1991. In 1992, India accepted Liberalised Exchange Rate Management System (LERMS). LERMS is a dual exchange rate scheme. LERMS consists of Fixed Exchange Rate and Market Exchange Rate. Under 'LERMS', exporters are required to remit 40% of their export earnings to the Reserve Bank of India at the exchange rate determined by the RBI. The remaining 60% will be at the Market determined Exchange Rate.