CHAPTER 31

FOREIGN EXCHANGE
Foreign exchange is the cornerstone of international commerce and finance, representing the
global system of converting one currency into another. It governs everything from an individual's
international travel and remittances to a multinational corporation's trade and investment decisions. This
chapter delves into the fundamental concepts of foreign exchange, exploring various exchange rate
regimes—fixed, flexible, and managed float—and defining key terms like appreciation, depreciation,
devaluation, and revaluation. We will also examine the dynamics of India's external sector by analyzing
measures like NEER and REER, understanding the significance of foreign exchange reserves, and
exploring the legal framework of FEMA. Finally, the chapter will cover contemporary topics such as
the ongoing internationalization of the Rupee and the strategic push for offshore fund management
within India's GIFT City. This exploration provides a comprehensive understanding of the mechanisms
and policies that shape a nation's position in the global economy.
31.1 Exchange Rate:
The exchange rate is the price of one country's currency in terms of another. There are three
main types of exchange rate regimes:
Fixed Exchange Rate:
 Definition: The value of a currency is officially pegged to another currency (e.g., the US dollar),
a basket of currencies, or a commodity like gold. The central bank is legally obligated to
maintain this fixed rate.
 Mechanism: To maintain the fixed rate, the central bank actively intervenes in the foreign
exchange market. If the domestic currency's value falls below the target, the central bank sells
its foreign currency reserves (e.g., USD) to buy its own currency, increasing its demand and
value. Conversely, if the domestic currency's value rises above the target, the central bank buys
foreign currency with its own currency, increasing the supply and lowering its value.
 Historical Example: The Bretton Woods system (1944-1971) saw many major currencies
pegged to the US dollar, which was, in turn, convertible to gold at a fixed price.
 Modern Example: The Saudi Riyal is pegged to the US dollar at a fixed rate of SAR 3.75 per
USD.
 Pros: Provides stability and predictability for international trade and investment, helps control
inflation by "importing" the anchor country's inflation rate.
 Cons: Requires large foreign exchange reserves to defend the peg, the central bank loses
independent monetary policy control (the "impossible trinity"), and it can be vulnerable to
speculative attacks if the market believes the central bank cannot maintain the peg.
Flexible (or Floating) Exchange Rate:
 Definition: The value of a currency is determined solely by the forces of supply and demand in
the foreign exchange market, with no direct intervention by the central bank to target a specific
rate.
 Mechanism: If there is a high demand for a currency (e.g., due to a boom in exports or foreign
direct investment), its value appreciates. If there is a high supply (e.g., due to increased imports
or capital outflow), its value depreciates. The exchange rate acts as a shock absorber.
 Examples: The US dollar, Euro, Japanese Yen, British Pound, and Australian Dollar are all
examples of currencies with floating exchange rates.
 Pros: The central bank can pursue an independent monetary policy (e.g., focus on controlling
domestic inflation), no need for large foreign exchange reserves, and it helps an economy adjust
to external shocks.

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  Cons: Can be volatile and unpredictable, which can create uncertainty for international traders
and investors.
Managed Float (or Dirty Float):
 Definition: A hybrid system where the exchange rate is generally determined by market forces,
but the central bank may intervene periodically to prevent excessive volatility or to steer the
rate in a desired direction. It is the most common system in the world today.
 Mechanism: The central bank sets an informal target or "band" for the exchange rate. If the rate
moves too far outside this band, the central bank intervenes. For example, if the domestic
currency is depreciating too rapidly, the central bank will sell foreign currency to support its
value.
 Example (India): India follows a managed floating exchange rate system. The Reserve Bank of
India (RBI) often intervenes in the foreign exchange market to manage the volatility of the
Indian Rupee (INR) against major currencies like the US dollar. The RBI's actions are often
guided by a desire to ensure a competitive exchange rate for exporters and to control imported
inflation.
 Pros: Combines the flexibility of a floating system with the stability of a fixed system, allows
the central bank some control over the exchange rate while maintaining a degree of monetary
policy independence.
 Cons: Can be opaque, making it difficult for market participants to predict central bank actions.
31.2 Concepts:
 Appreciation: An increase in the value of a currency in a flexible exchange rate system. This
occurs when the market demand for a currency is high relative to its supply.
o Example: If the USD/INR exchange rate falls from ₹80 to ₹75, the Indian Rupee (INR)
has appreciated against the US Dollar (USD). This means that you need fewer rupees
to buy one dollar.
 Depreciation: A decrease in the value of a currency in a flexible exchange rate system. This
happens when the market supply of the currency is high relative to its demand.
o Example: If the USD/INR exchange rate rises from ₹80 to ₹85, the Indian Rupee (INR)
has depreciated against the US Dollar (USD). This means that you need more rupees
to buy one dollar.
 Devaluation: A deliberate downward adjustment of the value of a country's currency in a fixed
exchange rate system. This is a policy decision by the government or central bank.
o Example: In 1991, India's government devalued the rupee by a significant margin to
address a severe balance of payments crisis. The goal was to make Indian exports
cheaper and imports more expensive, thereby correcting the trade deficit.
 Revaluation: A deliberate upward adjustment of the value of a country's currency in a fixed
exchange rate system.
o Example: A country might revalue its currency to combat imported inflation or to make
imports cheaper for its domestic population.
31.3 NEER AND REER:
These are important measures to understand a currency's value in a broader context than just a single
bilateral exchange rate.
 NEER (Nominal Effective Exchange Rate):
o Definition: A weighted average of the bilateral exchange rates of a country's currency
against a basket of its major trading partners' currencies.
o Purpose: It indicates whether a currency has, on average, appreciated or depreciated
against the currencies of its main trading partners as a whole.

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 o Calculation: The weights are typically based on the share of trade (exports and imports)
that each partner country has with the domestic country. For instance, if the US
accounts for 20% of India's trade, the USD/INR exchange rate will have a 20% weight
in India's NEER calculation.
o Data (India): The Reserve Bank of India (RBI) publishes the NEER for the Indian
Rupee, often against a basket of 6 or 40 currencies. An increase in the NEER index
indicates a nominal appreciation of the Rupee.
 REER (Real Effective Exchange Rate):
o Definition: The NEER adjusted for inflation differentials between the domestic country
and its trading partners.
o Purpose: It is a more accurate measure of a country's external competitiveness. A rise
in REER means the country's goods are becoming more expensive relative to its trading
partners, reducing its export competitiveness.
o Calculation:
 REER=NEER×(P foreign / P domestic), where P domestic is the domestic
price index (e.g., WPI or CPI) and P foreign is a weighted average of the price
indices of the trading partners.
 Data (India): The RBI also publishes the REER. A rise in the REER suggests that despite
any nominal depreciation, the Rupee has become stronger in "real" terms due to higher
domestic inflation, eroding the competitiveness of Indian exports. For example, if the
Rupee depreciates by 5% (NEER falls), but India's inflation is 8% while its trading partners'
inflation is only 2%, the REER will still rise, indicating a real appreciation.
31.4 Foreign Exchange Reserves:
 Definition: Assets held by a central bank or monetary authority in foreign currencies. These
reserves are crucial for managing a country's external sector.
Components:
 Foreign Currency Assets (FCA): The largest component, consisting of foreign government
bonds (e.g., US Treasury bills), deposits with foreign central banks and commercial banks,
and foreign equity. The US dollar is the most prominent reserve currency, but others like
the Euro, Yen, and Pound are also held.
 Gold: Held in the form of gold bars. Central banks often hold gold as a traditional safe-
haven asset.
 Special Drawing Rights (SDRs): An international reserve asset created by the International
Monetary Fund (IMF), whose value is based on a basket of five major currencies (USD,
EUR, CNY, JPY, GBP). IMF member countries hold SDRs as part of their reserves.
 Reserve Tranche Position in the IMF: The portion of a country's quota in the IMF that it
can withdraw without any conditions.
Importance:
 Exchange Rate Management: Used to intervene in the foreign exchange market to stabilize the
domestic currency in a managed float system.
 Buffer against Shocks: Provides a safety net against external shocks, such as a sudden stop in
capital flows or a balance of payments crisis.
 Import Coverage: Reserves can be used to finance imports for a certain number of months,
providing a cushion in case of a trade deficit.
 Investor Confidence: A high level of reserves signals a country's ability to meet its external
obligations, boosting investor confidence and credit ratings.

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Trends (India):
 India's foreign exchange reserves have shown a significant upward trend over the last two
decades.
 Data/Stats: According to the RBI, India's forex reserves crossed the $600 billion mark in 2021
and have generally remained above this level. As of mid-2024, they stood at a robust level,
making India one of the largest holders of foreign exchange reserves globally.
 Drivers: This accumulation has been driven by strong capital inflows (Foreign Direct
Investment - FDI and Foreign Portfolio Investment - FPI), and a positive current account
balance in some periods.
31.5 Capital Account Convertibility:
 Definition: The freedom to convert a country's currency into foreign currency (and vice-versa)
for capital transactions, such as investments in foreign assets, borrowing from abroad, or
purchasing real estate overseas.
 Contrast with Current Account Convertibility:
o Current Account Convertibility: This refers to the freedom to convert currency for
transactions related to trade in goods and services, and income flows (e.g., salaries,
interest). India achieved full current account convertibility in 1994.
o Capital Account Convertibility (CAC): This involves the freedom for capital flows.
 India's Status: India has a partially convertible capital account. While there have been
significant relaxations over the years, especially for non-resident investors and Indian
corporations, there are still restrictions. For instance, resident individuals have a cap on how
much they can invest abroad under the Liberalised Remittance Scheme (LRS).
 Tarapore Committee Reports (1997 and 2006): These committees, set up by the RBI, provided
a roadmap for full CAC in India. The reports recommended a phased approach, linking full
convertibility to the achievement of certain macroeconomic indicators like a low fiscal deficit,
low inflation, a strong banking system, and a stable exchange rate.
31.6 Foreign Exchange Management Act (FEMA), 1999:
 Background: FEMA replaced the much stricter Foreign Exchange Regulation Act (FERA),
1973. FERA was a "presumption of guilt" law, treating foreign exchange violations as criminal
offenses punishable by imprisonment. The Act was a relic of India's pre-liberalization "License
Raj" era.
 Key Features of FEMA:
o Objective: To facilitate external trade and payments and to promote the orderly
development and maintenance of the foreign exchange market in India. The shift from
"Regulation" to "Management" in the name signifies its liberalizing intent.
o Decriminalization: Foreign exchange violations under FEMA are considered civil
offenses, leading to monetary penalties rather than imprisonment.
o Regulatory Framework: The Reserve Bank of India (RBI) is the primary regulator and
has the power to frame rules for current and capital account transactions.
o Classification of Transactions: The Act broadly classifies transactions into:
 Current Account Transactions: Largely free, with the central government
having the power to impose restrictions in consultation with the RBI.
 Capital Account Transactions: These are restricted and require specific
permissions from the RBI.
 Enforcement: The Directorate of Enforcement (ED) is responsible for investigating and
prosecuting violations of FEMA.

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31.7 Internationalization of the Rupee:
 Definition: The process of increasing the use of the Indian Rupee (INR) in international
transactions, both for trade and financial purposes, thereby reducing dependence on other
currencies, particularly the US dollar.
 Reasons for Internationalization:
o Reduced Currency Risk: Indian exporters and importers can trade in INR, eliminating
the need to hedge against foreign currency fluctuations.
o Lower Transaction Costs: Eliminates the costs and complexities of currency
conversion.
o Geopolitical Influence: A more prominent currency enhances a country's global
standing and financial influence.
o Reduced Dependence on USD: Reduces India's vulnerability to external shocks
stemming from US monetary policy or the US dollar's dominance in global trade.
 Steps Taken by India:
o RBI's Framework for International Trade Settlement in INR (2022): This landmark
initiative allows Indian exporters and importers to invoice, pay, and settle their
international trade transactions in INR. It enables partner countries' banks to open a
"Vostro account" in India, denominated in Rupees, to facilitate trade payments.
o Bilateral Currency Swaps: India has entered into currency swap agreements with
various countries to facilitate trade and reduce reliance on third-party currencies.
o Efforts to Attract Offshore Rupee Trading: The government is working to create a more
attractive domestic market to bring offshore trading of the Rupee back to India.
 Challenges:
o Volatility: The INR's volatility can be a deterrent for international users.
o Capital Controls: The partially convertible nature of the capital account restricts the
free flow of the INR for financial transactions.
o Economic Size and Stability: The size and stability of the Indian economy and its
financial markets need to be strong enough to inspire confidence in the Rupee's global
role.
31.8 Offshore Fund Management:
 Definition: The practice of managing financial assets for clients from a location outside their
country of residence. This is often done in financial centers with favorable tax and regulatory
environments.
Context for India:
 Gujarat International Finance Tec-City (GIFT City): GIFT City is India's first International
Financial Services Centre (IFSC), established to compete with global financial hubs like
Singapore, Dubai, and Hong Kong. The primary goal is to attract offshore fund management
activities back to India.
 Regulatory Relaxations: The government has introduced various tax exemptions and regulatory
simplifications for entities operating in GIFT City. These include a competitive tax regime,
simplified listing norms, and exemptions from some domestic regulations.
 Objective: To create a domestic alternative to managing funds offshore, thereby generating
employment, attracting capital, and reducing the outflow of financial services.
 Example: An Indian fund manager can set up a fund in GIFT City to manage investments for a
foreign institutional investor (FII) who wants to invest in Indian equities. The fund operates
under a special regulatory and tax framework, offering the FII a more efficient and tax-friendly
way to invest, and simultaneously boosting India's domestic financial services industry. The

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 RBI has also relaxed FEMA regulations to allow Indian residents and entities to invest in funds
and companies located within the IFSC.
Conclusion:
The foreign exchange market is a critical and dynamic component of the global financial system, with
its principles profoundly impacting a country's economic health and international standing. As we have
seen, the choice of an exchange rate regime—whether fixed, flexible, or managed—is a strategic
decision with significant trade-offs regarding stability, monetary policy independence, and external
competitiveness. Concepts like NEER and REER offer a nuanced perspective on a currency's value,
going beyond simple bilateral rates to measure real competitiveness. The management of foreign
exchange reserves remains a crucial tool for central banks to manage volatility and instill confidence,
while the regulatory framework, embodied by acts like FEMA in India, has evolved from a restrictive
stance to one of facilitation. The recent policy pushes for the internationalization of the Rupee and the
creation of offshore fund management hubs like GIFT City signal a proactive effort by India to enhance
its global financial presence. Ultimately, a nation's mastery of these foreign exchange principles is
essential for navigating the complexities of the global economy and fostering sustainable growth.

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Prelims PYQs:

Q.No Question Year

With reference to Balance of Payments, which of the following constitutes/constitute 2014
the Current Account?
1. Balance of trade
2. Foreign assets
3. Balance of invisibles
1 4. Special Drawing Rights
Select the correct answer using the code given below.
(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 4 only
Convertibility of rupee implies 2015
(a) being able to convert rupee notes into gold
2 (b) allowing the value of rupee to be fixed by market forces
(c) freely permitting the conversion of rupee to other currencies and vice versa
(d) developing an international market for currencies in India
With reference to the Indian economy, consider the following statements: 2022
1. An increase in Nominal Effective Exchange Rate (NEER) indicates the
appreciation of rupee.
2. An increase in the Real Effective Exchange Rate (REER) indicates an
improvement in trade competitiveness.
3. An increasing trend in domestic inflation relative to inflation in other
3 countries is likely to cause an increasing divergence between NEER and
REER.
Which of the above statements are correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

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Answer Key:

Q.No Explanation Key

 Balance of trade: This refers to the difference between a country's exports
and imports of goods (visible trade). This is a major component of the current
account.
 Foreign assets: This relates to a country's holdings of foreign currencies,
stocks, bonds, and other assets. Changes in these are recorded in the capital
account and financial account, not the current account.
 Balance of invisibles: This includes the trade in services (like tourism,
1 C
shipping, and banking), as well as income from investments and transfers
(like remittances and foreign aid). This is also a major component of the
current account.
 Special Drawing Rights (SDRs): These are an international reserve asset
created by the International Monetary Fund (IMF). They are held by central
banks and are part of the official reserves within the balance of payments,
typically recorded in the financial account.
 Being able to convert rupee notes into gold: This refers to the historical "gold
standard," which is no longer in use. Rupee convertibility today is about
converting it to other currencies, not gold.
 Allowing the value of rupee to be fixed by market forces: This describes a
floating exchange rate system. While a convertible currency is often part of
a floating exchange rate system, convertibility itself is the ability to exchange
the currency, while the floating rate is the mechanism by which its value is
determined. A country could, theoretically, have a fixed exchange rate and
2 C
still have convertibility (as was the case with the Bretton Woods system for
many currencies), but in today's world, convertibility usually goes hand-in-
hand with a market-determined exchange rate.
 Freely permitting the conversion of rupee to other currencies and vice versa.
 Developing an international market for currencies in India: This is a
consequence of convertibility, not its definition. Having a convertible
currency facilitates the development of an international market for that
currency, but it's not the definition of convertibility itself.
An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation
of the rupee.
 Correct. NEER is a weighted average of a country's currency against a basket
of its trading partners' currencies. A higher NEER index value means that the
domestic currency (in this case, the rupee) has strengthened against this
basket of currencies. This is an appreciation in nominal terms.
An increase in the Real Effective Exchange Rate (REER) indicates an improvement
in trade competitiveness.
 Incorrect. REER is the NEER adjusted for inflation differences between the
domestic country and its trading partners. The formula is approximately:
REER = NEER * (Domestic Price Index / Foreign Price Index).
3 C
 An increase in REER means that the domestic currency has appreciated in
real terms. This makes a country's exports more expensive for foreign buyers
and imports cheaper for domestic consumers. Therefore, an increase in
REER generally indicates a loss of trade competitiveness, not an
improvement.
An increasing trend in domestic inflation relative to inflation in other countries is
likely to cause an increasing divergence between NEER and REER.
 Correct. As seen in the formula above, REER is directly influenced by the
domestic price index. If domestic inflation is rising faster than inflation in
other countries, the term (Domestic Price Index / Foreign Price Index) will
increase.

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  Since NEER is a nominal measure and does not account for inflation, while
REER does, a higher relative domestic inflation rate will cause the REER to
increase faster than the NEER (or even appreciate while the NEER is stable
or depreciating). This leads to a growing divergence between the two indices.

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