International Finance -

Exchange Rate System

Group members
Vaibhav Barick Lalit Chawhan Paras Furia Mamta Pawar Rohan Nilesh

Contents
Introduction to Exchange Rate system Types of Exchange Rate system Gold Standard Bretton Woods System Nixon Shock Foreign Exchange Governing Body Exchange rate system in India

Introduction to Exchange rate system

Exchange Rate is a rate at which one currency can be exchanged into another currency. In other words it is value of one currency in terms of other The exchange rate system is the way a country manages its currency in relation to other currencies and the foreign exchange market It is closely related to monetary policy and the two are generally dependent on many of the same factors For e.g. If you are travelling to Egypt and the exchange rate for U.S. dollars 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds

Types of exchange rate system

 Float A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency Floating rates are the most common exchange rate regime today. For example, the Dollar, Euro, Yen, and British pound all are floating currencies

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Types of exchange rate system

 Float However, since central banks frequently intervene to avoid excessive appreciation or depreciation, these regimes are often called managed float or a dirty float Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing

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Types of exchange rate system

 Pegged float Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. Pegged floats are: Crawling bands: the rate is allowed to fluctuate in a band around a central value, which is adjusted periodically. This is done at a preannounced rate or in a controlled way following economic indicators Crawling pegs: Here, the rate itself is fixed, and adjusted as above Pegged with horizontal bands: The currency is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate

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Types of exchange rate system

 Fixed A fixed or pegged rate is a rate the government (central bank) sets and maintains as the official exchange rate A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies) In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged A pegged currency with very small bands (< 1%) also fall under this category

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Types of exchange rate system

 Dollarization Euroizing or Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the US dollars but generally to the use of any foreign currency as the national currency. For e.g. Zimbabwe

World Wide Scenario

Managed float regime Free float regime Different types of currency peg Usage of foreign currency

Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. The Gold Standard is described in a variety of reference materials as a economic system in which the unit of foreign currency used is a fixed amount or weight of gold. In this technique, each forms of money, together with notes and bank deposits, are freely transformed into gold on the fixed cost.

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Gold standard
There are distinct kinds of gold standard First, the gold specie standard is a system in which the, the unit of currency is related to gold coins which have been in circulation. More specifically, the economic unit is related with the unit of price of a unique gold coin in distribution together with that relating to some secondary coinage (coins made from metal that's priced lower than gold). In a version called Gold Specie Standard, the actual currency in circulation consists of gold coins with a fixed gold content. Similarly, the gold exchange standard typically involves the circulation of only coins made of silver or other metals, but where the authorities guarantee a fixed exchange rate with another country that is on the gold standard.

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Gold standard
Finally, the gold bullion standard is a system in which gold coins do not circulate, but in which the authorities have agreed to sell gold bullion on demand at a fixed price in exchange for the circulating currency.

Gold certificates were used as paper currency in the United States from 1882 to 1933. These certificates were freely convertible into gold coins.

Under a gold standard, paper notes are convertible into pre-set, fixed quantities of gold.

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Gold standard
Some Facts
The gold exchange standard (18701914) Impact of World War I (191425) Governments faced with the need to fund high levels of expenditure, but with limited sources of tax revenue, suspended convertibility of currency into gold on a number of occasions in the 19th century The real test, however, came in the form of World War I, a test "it failed utterly" according to economist Richard Lipsey. In order to finance the costs of war, most belligerent countries went off the gold standard during the war, and suffered significant inflation. Because inflation levels varied between states, when they returned to the standard after the war at price determined by themselves (some, for example, chose to enter at pre-war prices), some countries' goods were undervalued and some overvalued.

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Gold standard
The gold bullion standard and the decline of the gold standard (192531) The gold specie standard ended in the United Kingdom and the rest of the British Empire at the outbreak of World War I. Treasury notes replaced the circulation of the gold sovereigns and gold half sovereigns. However, legally, the gold specie standard was not repealed. Depression and World War II (193246) - Prolongation of the Great Depression Some economic historians, such as American professor Barry Eichengreen, blame the gold standard of the 1920s for prolonging the Great Depression. The gold standard limited the flexibility of Central Banks' Monetary Policy by limiting their ability to expand the money supply, and thus their ability to lower interest rates.

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Gold standard
Post-war international gold-dollar standard (19461971) After the Second World War, a system similar to a Gold Standard and sometimes described as a "gold exchange standard" was established by the Bretton Woods Agreements.

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Advantages of Gold standard

Long-term price stability has been described as the great virtue of the gold standard. Under the gold standard, high levels of inflation are rare. Hyperinflation is nearly impossible as the money supply can only grow at the rate that the gold supply increases. The gold standard limits the power of governments to inflate prices through excessive issuance of paper currency. It provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade. A central bank could not create unlimited quantities of money at will, as there is a limited supply of gold.

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Disadvantages of Gold standard

The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons. This is less than the value of circulating money in the U.S. alone, where more than $8.3 trillion is in circulation or in deposit. Mainstream economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns. Following a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabilize the economy in times of economic recession. Monetary policy would essentially be determined by the rate of gold production. Fluctuations in the amount of gold that is mined could cause inflation if there is an increase, or deflation if there is a decrease Although the gold standard gives long-run price stability, it does in the short run bring high price volatility.

Bretton Woods System

The United Nations Monetary and Financial Conference, commonly known as the Bretton Woods conference, was a gathering of 730 delegates from all 44 Allied nations at the Mount Washington Hotel, situated in Bretton Woods, New Hampshire, to regulate the international monetary and financial order after the conclusion of World War II The conference was held from 1-22 July 1944, when the agreements were signed to set up the International Bank for Reconstruction and Development (IBRD), the General Agreement on Tariffs and Trade (GATT), and the International Monetary Fund (IMF)

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Bretton Woods System

As a result of the conference, the Bretton Woods system of exchange rate management was set up, which remained in place until the early 1970s The Bretton Woods Conference took place in July 1944, but did not become operative until 1959, when all the European currencies became convertible. Under this system, the IMF and the IBRD were established. The IBRD was created to speed up post-war reconstruction, to aid political stability, and to foster peace.

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Bretton Woods System

The planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement The chief features of the Bretton Woods system were An obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and The ability of the IMF to bridge temporary imbalances of payments.

Nixon Shock
The Nixon Shock was a series of economic measures taken by U.S. President Richard Nixon in 1971 including unilaterally cancelling the direct convertibility of the United States dollar to gold that essentially ended the existing Bretton Woods system of international financial exchange. By the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation, the U.S. was running a balance-ofpayments deficit and a trade deficit, the first in the 20th century. By 1971, the money supply had increased by 10%. In the first six months of 1971, $22 billion in assets left the U.S. In May 1971, inflation-wary West Germany was the first member country to unilaterally leave the Bretton Woods system unwilling to devalue the Deutsche Mark in order to prop up the dollar.

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Nixon Shock
In the next three months, West Germany's move strengthened their economy. Simultaneously, the dollar dropped 7.5% against the Deutsche Mark. Due to the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America's "promise to pay" that is, the redemption of their dollars for gold To stabilize the economy and combat the 1970 inflation rate of 5.84%, on August 15, 1971, President Nixon imposed a 90-day wage and price freeze, a 10 percent import surcharge, and, most importantly, "closed the gold window", ending convertibility between US dollars and gold. By March 1976, the worlds major currencies were floating in other words, the currency exchange rates no longer were governments' principal means of administering monetary policy.

Foreign Exchange Governing Body

The Foreign Exchange Regulation Act, 1973 (FERA) There has been a substantial increase in the Foreign Exchange Reserves of India. Since the year 1993, Foreign trade has grown up. Development has taken place such as current account convertibility, liberalization in investments abroad, increased access to external commercial borrowings by Indian Companies and participation by foreign institutional investors in securities markets in India. Keeping in view these changes the Central Government of India has introduced the FOREIGN EXCHANGE MANAGEMENT BILL 1998 (FEMA)to repeal FERA.

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Foreign Exchange Governing Body

The main change between FERA and FEMA is in the approach. FERA seeks to regulate almost all the transactions involving foreign exchange and inbound/outbound investments. In FERA every provision is restrictive and starts with a negative proposition stating that nothing can be done without RBI's permission. In comparison to this existing negative piece of legislation, the provisions of the proposed Bill has a positive approach. This can be found from the provisions of FEMA dealing with capital account transactions which are to be regulated.

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Foreign Exchange Governing Body

Unlike FERA which provides that these transactions cannot be entered into without prior permission of RBI, FEMA provides that any person may sell or draw foreign exchange for such transactions and then specifies the powers of the RBI to regulate the class or limits of such capital account transactions. FEMA classifies foreign exchange transactions into capital account transactions and current account transactions and amongst the two regulates the former more closely. The provisions of the FEMA Bill aims at consolidating and amending the law relating to foreign exchange with the object of facilitating external trade and payments and for promoting the orderly payment and amendments in foreign exchange markets in India.

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Foreign Exchange Governing Body

The FEMA Bill empowers the RBI to authorize persons to deal in foreign securities specifying the conditions for the same. It also provides for a person resident in India in holding, owning, transferring or investing in foreign security and for a person resident out side India in holding, owning, transferring or investing in Indian Securities.

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Foreign Exchange Governing Body

Foreign Exchange Dealer's Association of India (FEDAI) was set up in 1958 as an Association of banks dealing in foreign exchange in India (typically called Authorised Dealers - ADs) as a self regulatory body and is incorporated under Section 25 of The Companies Act, 1956. It's major activities include framing of rules governing the conduct of inter-bank foreign exchange business among banks vis--vis public and liaison with RBI for reforms and development of forex market. Presently some of the functions are as follows: Guidelines and Rules for Forex Business. Training of Bank Personnel in the areas of Foreign Exchange Business. Accreditation of Forex Brokers Advising/Assisting member banks in settling issues/matters in their dealings. Represent member banks on Government/Reserve Bank of India/Other Bodies. Announcement of daily and periodical rates to member banks.

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Foreign Exchange Governing Body

Due to continuing integration of the global financial markets and increased pace of de-regulation, the role of self-regulatory organizations like FEDAI has also transformed In such an environment, FEDAI plays a catalytic role for smooth functioning of the markets through closer co-ordination with the RBI FEDAI also maximizes the benefits derived from synergies of member banks through innovation in areas like new customized products, bench marking against international standards on accounting, market practices, risk management systems, etc.

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Foreign Exchange Governing Body

On March 1, 1992 Reserve Bank of India announced a new system of exchange rates known as Liberalized Exchange Rate Management System. Under LERMS, the rupee become convertible for all approved external transactions. The exporters of goods and services and those who received remittances from abroad were allowed to sell bulk of their forex receipts. Similarly, those who need foreign exchange to import and travel abroad were to buy foreign exchange from market-determined rate. From March 1 1993 modified LERMS under which the all forex transactions, under current and capital account, are being put through by Authorized Dealers at market determined exchange rate.

Exchange rate system in India

The rupee was historically linked i.e. pegged to the pound sterling. Earlier, during British regime and till late sixties, most of Indias trade transactions were dominated to pound sterling Under Bretton Woods system, as a member of IMF Indian declared its par value of rupee in terms of gold The corresponding rupee sterling rate was fixed 1 GBP = RS 18 When Bretton Woods system bore down in August 1971, the rupee was de-linked from US $ and the exchange rate was fixed at 1 US $ = Rs 7.50. Reserve bank of India, however, remained pound sterling as the currency of intervention

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Exchange rate system in India

The US $ and rupee pegging was used to arrive at rupee-sterling parity. After Smithsonian Agreement in December 1971, the rupee was de-linked from US $ and again linked to pound sterling. This parity was maintained with a band of 2.25%. Due to poor fundamental pound got depreciated by 20%, which cause rupee to depreciate. To be not dependent on the single currency, pound sterling on September 25, 1975 rupee was de-linked from pound sterling and was linked to basket of currencies, the currencies includes as well as their relative weights were kept secret so that speculators dont get a wind of the direction of the movement of exchange rate of rupee.

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Exchange rate system in India

From January 1, 1984 the sterling rate schedule was abolished. The interest element, which was hitherto in built the exchange rate, was also de-linked. The interest was to be recovered from the customers separately. This not only allowed transparency in the exchange rate quotations but also was in tune with international practice in this regard. FEDAI issued guidelines for calculation of merchant rates. The liquidity crunch in 1990 and 1991 on forex front only hastened the process. On March 1, 1992 Reserve Bank of India announced a new system of exchange rates known as Liberalized Exchange Rate Management System. LERMS was to make balance of payment sustainable on ongoing basis allowing market force to play a greater role in determining exchange rate of rupee.

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