CHAPTER – 19. RBI’s INTERVENTION AND EXCHANGE RATE MANAGEMENT


CHAPTER – 19.  RBI’s INTERVENTION AND EXCHANGE RATE MANAGEMENT


Q. 1: Explain the various exchange rate systems.
Ans. A) INTRODUCTION
                     The earliest exchange rate system was popularly known as Gold standard, this system existed during 1879-1934. In this exchange rate system the value of currencies of different countries was fixed in terms of gold. Hence under gold standard exchange rate system there could be only fixed exchange rates.
                     After the end of World War II to 1971, another Fixed Exchange Rate System known as Bretton Woods System prevailed.
                     After 1971, the exchange rate system was not purely flexible, hence it was called Managed Float System.
B) EXCHANGE RATE SYSTEMS
   Fixed Exchange Rates
                            IMF was established with the object of stabilising the rates of exchange between the member countries. Under its charter, every member country was required to fix and declare the par value of its currency in terms of gold or dollar and maintain it. The system of fixed exchange is known as pegged exchange rates. The Government determines the exchange rate by pegging operations (i.e. buying and selling foreign exchange at particular exchange rate).
                            In pegging operation, Government fixes an official exchange rate and enforce it through Central Bank. A exchange stabilisation fund may be set up in order to maintain the exchange rate by buying its currency when market exchange rate falls below specified exchange rate and vice versa. The major defect in this system was that if the market exchange rate falls consistently pegging operations will be very expensive as it will lead to heavy reduction in reserves.
                 Under gold standard, rate of exchange varied within a small range of gold export point and gold import point. But gold standard was given up by all countries in 19'30s. Since the fixed exchange rates do not reflect true value of currencies, flexible exchange rates were adopted by countries.
   Flexible Exchange Rate
                            Flexible exchange rates are determined by forces of demand and supply in the foreign exchange market without the interference of Government. The relative positions of demand and supply depends on the deficit or surplus in the balance of payments of the country. The exchange rates are not rigidly fixed up but allowed to float with changing conditions. The relative value of currencies alter far more rapidly with automatic devaluation or revaluation.
                            The free floating rate is allowed to seek its own level as no par of exchange is fixed. Since 1980s as many countries were in favour of the flexible exchange rates IMF was forced to adopt flexible exchange rates.
   Managed Exchange Rate System I Managed Flexibility :-
                            A system of managed flexibility came up to take the merits of fixed and flexible exchange rate and to overcome their demerits. This system is based on the par value concept under IMF guidelines.
                            In managed flexibility of exchange rate system, the range of flexibility around fixed par values is determined by the country as per its economic need and the prevailing trend in international monetary system. This system of exchange rate requires the country to interfere in foreign exchange market from time to time in view of the emerging disequilibrium.
                            The Central Bank of the country holds large amount of foreign exchange. Hence the Central Bank can control the exchange rate by manipulating the magnitude of demand or supply in the forex market. For instance, the Central Bank resorts to large scale buying of foreign currency when there is an excess supply of foreign currency and vice versa.
Q. 2 : Explain RBI’s intervention in exchange rate management in India. (M.2011)           OR
“RBI is the apex body that intervenes and control foreign exchange in India”. Discuss.            OR
How does RBI intervene in the foreign exchange market.
Ans. A) RBI’s INTERVENTION AND EXCHANGE RATE MANAGEMENT :-
                            In 1939, the Exchange Control Department of RBI was set up. In order to conserve the scarce foreign exchange reserves, the Foreign Exchange Regulation Act (FERA) was passed in 1947.
                            India adopted fixed exchange rate of IMF upto 1971, whereby the Indian Rupee external par value was fixed. In 1973, FERA was amended and it came in force on January 1st, 1974. It gave wide powers to RBI to administer exchange control mechanism properly.
                            In 1992, RBI introduced LERMS (Liberalised Exchange Rate Management System) Under LERMS a dual exchange rate was fixed. The 1993-94 Budget made Indian Rupee fully convertible on trade account. LERMS was withdrawn. Developing countries allowed market forces to determine the exchange rate. Under flexible exchange rate system, if demand for foreign currency is more than that of its supply, foreign currency appreciates and domestic currency depreciates and vice versa. To minimise the disadvantages of flexible exchange rate, most of the developing countries including India have adopted the concept of managed Flexible Exchange Rate (MFER).
                            Under MFER, the Central bank intervenes to bring stability in exchange rate. RBI’s intervention involves purchase of foreign currency from market or release (sale) of foreign currency in the market, to bring stability in exchange rates.
ROLE OF RBI IN FOREIGN EXCHANGE MARKET
The role of RBI in the foreign exchange market is revealed by the provisions of FERA (1973).
   Administrative Authority
                            The RBI is the administrative authority for exchange control in India. The RBI has been given powers to issue licences to those who are involved in foreign exchange transactions.
   Authorised Dealers
The RBI has appointed a number of authorised dealers. They are permitted to carry out ail transactions involving foreign exchange. The above provision is laid down in Section 3 of FERA.
      Issue Of Directions
The 'Exchange Control Manual' contains all directions and procedures given by RBI to authorised dealers from time to time.
   Fixation Of Exchange Rates :-
The RBI has the responsibility of fixing the exchange value of home currency in terms of other currencies. This rate is known as official rate of exchange. All authorised dealers and money lenders are required to follow this rate strictly in all their foreign exchange transactions.
   Foreign Investments :-
Non-residents can make investments in India only after obtaining the necessary permission from Central Government or RBI. Great investment opportunities are provided to non-resident Indians.
   Foreign Travel :-
                            Indian residents can get foreign exchange released from RBI upto a specified amount for travelling abroad through proper application.

   Import Trade
                            The RBI regulates import trade. Imports are permitted only against proper licenses. The items of imports that can be imported freely are specified under Open General Licence.
   Export Trade
                            The RBI controls export trade. Export of gold and jewellery are allowed only with special permission from RBI.
                     In recent years, the limits fixed for bringing gold, silver, currency notes etc. has been relaxed considerably.
   Submission Of Returns
                            All foreign exchange transactions made by authorised dealers must be reported to RBI. This enables the RBI to have a close watch on foreign exchange dealings in India.
                            Thus, from above points we can say that RBI is the apex bank that intervens, supervises, controls the foreign exchange markets in order to create an stable and active exchange market.
Q. 3 : Explain the exchange controls administered by RBI under FERA.                          OR
“FERA act was administered by RBI to conserve exchange reserves.” Explain. OR
Write note on FERA I FEMA.
Ans. A) FERA AND EXCHANGE CONTROLS :-
                In 1939, under the Defence of India Rules (DIR), the Exchange Control was imposed. In 1973, FERA was amended. India has accepted a system of multilateral payments, i.e., the rupee should be freely convertible to currencies of all member countries of IMF. But the RBI adopted exchange controls under FERA, in order to conserve India's Foreign exchange reserves.
   Foreign exchange was rationed out strictly according to availability.
   Purchase and Sale of foreign securities by Indians were strictly controlled.
   All external payments had to be made through authorised dealers controlled by RBI.
   Exporters who acquired foreign exchange had to surrender their earnings to authorised deale rs and get rupees in exchange.
      Imports were rigidly controlled and imports of unnecessary items were prohibited.
                            The RBI as the apex bank supervised and controlled the foreign exchange market. The RBI decided the exchange rate of rupee in terms of pound sterling on a day to day basis. It would sell pound sterling against specific demand and would also buy US dollar, pound sterling, German mark and Japanese yen. In 1992, the Pound sterling was replaced by dollar as intervention currency. Hence, RBI would sell only dollar and continue to buy Dollar, Pound, Mark and Yen.
                In New Industrial Policy of 1991, the government announced major concessions to FERA companies.
   FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)
                            The relaxation of FERA encouraged the inflow of foreign capital and the growth of Multi National Corporations (MNC's) in India. FERA was replaced by FEMA in 1999.
          Under FERA RBI's permission was necessary. Under FEMA, except for Section 3 (relates to foreign exchange) no other permission is required from RBI. The purpose of FEMA is to facilitate external trade and payments and promote orderly development and maintenance of foreign exchange market in India.
                            FEMA has simplified the provisions of FERA. The two key aspects of FEMA are the relaxation of foreign exchange controls and move towards capital account convertibility. To facilitate foreign trade restrictions drawals of foreign exchange for current and capital account transactions have been removed. FEMA regulates both import and export trade methods of payment.
                            If any person contravens any provisions of FEMA, he shall be liable to a penalty upto twice the sum involved in such contravention. There would be no punishment by way of imprisonment.


Q. 4: Distinguish between FERA and FEMA.
Ans. A.  FERA V/S. FEMA

FERA
FEMA
1. FERA means Foreign Exchange Regulation Act.
2. RBI’s permission was necessary in respect of most of the regulations.
3. Any person who contravenes FERA is subject to penalty and imprisonment.
4. All transactions with Non-residents were prohibited.

FEMA means Foreign Exchange
Management Act.

RBI’s permission is necessary only for
Section 3.

Any person who contravenes is liable to
penalty but not imprisonment.
Dealings with Non-residents have been substantially diluted.