International Finance

FOREIGN EXCHANGE MANAGEMENT

IN INDIA

Learning Objectives
After completing this chapter, you should be able to understand:

Foreign Exchange Management in India

Retail vs. Wholesale Foreign Exchange Market
Capital Account Convertibility
Reserve Management
Foreign Exchange Dealers Association of India
(FEDAI)
Foreign Exchange Management in India

Structure
4.1

Introduction to Indian Foreign Exchange Market

4.2

Structure of Indian Foreign Exchange Market

4.3

Management of Foreign Exchange in India

4.4

The components of the Indian Foreign Exchange

Market

4.5

Retail vs. Wholesale Foreign Exchange market

4.6 Capital Account Convertibility

Foreign Exchange Management in India

Structure
4.7

Reserve Management

4.8

Role of FEDAI in the Foreign Exchange Market

4.9

The Liberalized Exchange Rate Management

System (LERMS)

4.10 Pros and Cons of Currency Convertibility

4.11 Summary
4.12 Self assessment questions
Foreign Exchange Management in India

4.1 Introduction to Indian Foreign Exchange Market

Foreign Exchange Management Act, 1999 (FEMA)
provides the Central Government powers to execute
the provisions of this Act, and provides the RBI the
powers to make regulations for executing the
provisions of the Act in terms of section 46 and 47 of
the Act.
Section 41 provides that the central Government may
direct or instruct the RBI who shall comply with such
directions and instructions.
The RBI, therefore, has the sole authority as well as
responsibility to administer foreign exchange business
in the country.
Foreign Exchange Management in India

4.2 Structure of Indian Foreign Exchange Market

Foreign Exchange Management Act 1999
Central Government
RBI
Authorized Persons
Foreign Exchange Dealers
Assn. of India (FEDAI)
Offshore Banks Units Authorized Money Changers
Dealers
OBUs
AMCs
Fully Fledged Money Changers
FFMCs

Authorized
ADs

Restricted Money Changers

RMCs

Foreign Exchange Management in India

4.2 Structure of Indian Foreign Exchange Market

contd.
1. Authorized Person
The Reserve Bank provides licenses to three
categories of persons to transact with public at
different levels. They are
Authorized Dealers
Authorized Money Changers
Offshore Banking Units
Their transactions are governed by the Exchange
Control Regulations provided by the Reserve Bank of
India.
Foreign Exchange Management in India

4.2 Structure of Indian Foreign Exchange Market

contd.
2. Authorized Dealers
The bulk of the foreign exchange transactions
undertaken in the country involve end-users and
banks.
Banks and select entities licensed by the Reserve
Bank of India to undertake these transactions are
called Authorized Dealers.
They are permitted to undertake all categories of
transactions pertaining to both Current and Capital
accounts of the Balance of Payments.
Foreign Exchange Management in India

4.2 Structure of Indian Foreign Exchange Market

contd.
3. Authorized Money Changers
Authorized money changers are sub-classified as full
fledged and restricted money changers.
Full fledged money changers are permitted to both buy
as well as sell foreign exchange; e.g. travel agencies.
Restricted money changers can purchase foreign
exchange in the form of travellers cheques or
currency notes, but they are not allowed to sell; e.g.
five star hotels.
Foreign Exchange Management in India

4.2 Structure of Indian Foreign Exchange Market

contd.
4. Offshore Banking Units
Branches of banks in India established in Special
Economic Zones (SEZs) are accorded the status of
Offshore Baking Units (OBUs)
The OBUs are allowed to undertake banking
operations only in designated foreign currencies
essentially with non-residents.
Each such OBU has a minimum start up capital of US
$ ten million and its balance sheet is prepared in
designated foreign currencies.
Foreign Exchange Management in India

4.3 Management of Foreign Exchange in India

Foreign exchange is a scarce commodity and was
subject to strict control in almost all countries till
1970s.
In India, keeping with the policy of liberalization the
focus has changed to exchange management and not
exchange control.
The term exchange control can be described as the
quantitative control, by the government or centralized
agency of transactions involving foreign currencies.
Effectively, any directive or regulation which restricts
the free play of demand supply forces in foreign
exchange market can be termed as exchange control.
Foreign Exchange Management in India

4.4 The components of the Indian Foreign Exchange

Market

A.

Retail Market

In this segment end-users of foreign currencies

(individuals, exporters, importers, travellers and
tourists) approach ADs for their requirements. ADs
provide committed rates for such transactions. These
rates are called Merchant Rates. Total turnover and
individual transaction size is very small i.e.
transactions are customized in terms of amount and
maturity. Transactions here are governed by the
Exchange Control Regulations of RBI. Tariffs and
commissions are maintained as per FEDAI. Brokers
are not allowed. Foreign Exchange Management in India

4.4 The components of the Indian Foreign Exchange

Market

B.

Wholesale Market

1. This market is also called interbank market. It

includes transactions between ADs as also
between ADs and the RBI.
2. Transactions are conducted in standard market lot
and volume is large; they are carried at interbank
rates. The rates are determined in this market.
3. A large part of transactions are undertaken
through approved/authorized brokers.
4. They are governed by guidelines from RBI and
FEDIA.
Foreign Exchange Management in India

4.5 Retail vs. Wholesale Foreign Exchange Market

Foreign Exchange Management in India

4.6 Capital Account Convertibility (CAC)

The first step in the direction of CAC was taken in
1997 by constituting a committee headed by the
Deputy Governor of RBI.
Its recommendations could not be implements
because of South East Asia crisis, currency failures in
Brazil and Russia and air strikes on the US on
11.09.01.
A second committee was appointed thereafter and its
recommendations are to be implemented by RBI.
Meanwhile RBI has progressively allowed greater
freedom in capital Foreign
transactions.
Exchange Management in India

4.6 Capital Account Convertibility (CAC)

Individual investors are permitted to invest up to US $
100,000 in international securities.
Individuals are allowed to open non-interest bearing
accounts in specified cu
RBI has allowed Indian corporate entities to raise
resources and invest overseas in larger quantities.
Branches of Indian banks in SEZs are permitted to
accept deposits, grant loans in foreign currencies.
At present Indian Rupee is fully convertible for current account
transactions and partially for capital account transactions.
Foreign Exchange Management in India

4.6 Capital Account Convertibility (CAC)

Pre-requisites
Maintenance of domestic economic stability.
Adequate foreign exchange reserves.
Restrictions on non-essential imports.
Comfortable current account position.
An appropriate industrial policy and friendly
investment climate.
Foreign Exchange Management in India

4.7 Reserve Management

Foreign Currency Reserve Management can be
described as a process that ensures adequate foreign
assets are readily available to the authorities for
meeting identified liabilities and a defined range of
objectives for a country.
These objectives are:
i] Exchange rate management represented by the
capacity to intervene in support of the domestic
currency.
Foreign Exchange Management in India

4.7 Reserve Management - objectives

ii] Maintaining adequate foreign currency liquidity to
absorb shocks during times of crisis.
iii] Providing confidence to the international
community that the country can meet its external
obligations / liabilities.
iv] Ensuring that the domestic currency is largely
backed by external assets.
v] Managing Foreign Currency Lines of Credit for
promoting high value exports.
Foreign Exchange Management in India

4.8 Role of FEDAI in the Foreign Exchange Market

The FEDAI was set up in 1958 as an association of
banks dealing in foreign exchange.
Its a regulatory body incorporated under section
25 of the Companies Act 1956.
Its main functions are framing rules governing
the conduct of foreign exchange business
between banks and the public and
liaison with RBI for reforms and development of
foreign exchange market.
Foreign Exchange Management in India

4.8 Role of FEDAI in the Foreign Exchange Market

It trains bank personnel in the areas of foreign
exchange business.
It accredits foreign exchange brokers and reviews
their operations.
Advises and assists members in settling issues in
their dealings.
Represents member banks in discussions with the
Government / RBI and other bodies.
Provides a common platform for authorized dealers
to interact with the Government and RBI.
Foreign Exchange Management in India

4.8 Role of FEDAI in the Foreign Exchange Market

It announces daily and periodical rates to member
banks.
Announces spot rate at the start of the trading day
to ensure uniformity in settlement among different
market participants.
It circulates guidelines for quotations of rates,
charging of commissions etc.
It uses its synergy for smooth functioning of
markets and develops new customized products,
benchmarks against international standards on
accounting, market practices, risk management
systems etc.
Foreign Exchange Management in India

4.9 The Liberalized Exchange Rate Management System

(LERMS)

In March 1992, India adopted a dual exchange rate

system called LERMS. Under the scheme exporters
were required to sell 40% of their export proceeds to
RBI at fixed price to build foreign exchange reserve.
The component of 40% sold to RBI ensured a corpus
of foreign currency that can be used for import of
essential raw materials, defense equipment etc.
Balance 60% could be sold by them at ruling market
price.

Foreign Exchange Management in India

4.10 Pros and Cons of Currency Convertibility

Pros
It represents confidence of the country in maintaining
stable balance of payments position.
It assures international investors about being able to
exit their investments without any restrictions. This
promotes Foreign Direct and Portfolio Investments.
It provides domestic entities with access to
international financial markets and wider avenues for
investment.
Foreign Exchange Management in India

4.10 Pros and Cons of Currency Convertibility

It ensures Interest Parity Condition in the market and
provides depth to domestic foreign exchange and
derivatives market.
Cons
It makes economy vulnerable to withdrawal of capital
by both residents an non-residents.
Exchange rates tend to be more volatile due to larger
volume transactions.
The economy becomes susceptible to international
Hot Money.
Foreign Exchange Management in India

4.11 Summary
Foreign exchange market in India is totally structured,
well regulated both by RBI and also by voluntary
association (FEDAI)
Only dealers authorized by RBI can undertake foreign
exchange transactions.
All inter-bank dealings in the same centre must be
effected through accredited brokers, who are the
second arms in the market structure, however,
between the authorized dealers and RBI and also
between ADs and Overseas Banks are effected
directly without the intervention of brokers.
Foreign Exchange Management in India

4.12 Self assessment questions

1. Enumerate the role of participants in the Indian
foreign exchange market.
2. Discuss the issue of convertibility of INR
3. Describe the role of FEDAI in the Indian Forex
market.
4. What do you mean by LERMS?

Foreign Exchange Management in India

Foreign Exchange Management

In India

Let us now move to chapter 05

Foreign Exchange Quotations
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