Indias Foreign Exchange System: An Analysis

Indias overseas commuting System An AnalysisCHAPTER-2LITERATURE REVIEW2.1 IntroductionIt is a f consummation that the currencies of distinct countries have different think ofs that is based upon their actual frugal and monetary strength. It is from this difference that the genesis of overseas permutation slide bys. contrary switch atomic number 50 be margeed as the act of matching the different encourages of the goods and services that is snarly in the international business operation process in order to attain the exact determine that is to be transferred between the parties of an international trading proceeding in monetary terms. opposed reciprocation as an body process had started the day civilization and independent principalities got constituted in the world. But in those days it was a case of exchanging entertain in the form of transfer of goods and services of identical value that is commonly set with barter establishment. Moreover the minutes were don e on a one-to-one basis, and the terms and conditions were determined by the parties entering into such proceedings. There was no oecumenic system or rule that determined these performances. In that way outside(prenominal) interchange and international monetary system is a modern day mode that gained an institutional form in the first half of the twentieth century and has been developing since then.2.2 abroad ExchangeAccording to International Monetary Fund (IMF), Foreign Exchange is defined as different forms of pecuniary instruments like orthogonal cash notes, deposits held in inappropriate banks, debt obligations of foreign banks and foreign establishments, monetary gold and especial(a) Drawing Rights (SDR) that atomic number 18 resorted to make payments in lieu of business minutes that is done by two business entities or otherwise, of nations that have currencies having different integral monetary value (www.imf.org).Leading economist Lipsey Richard G.,1993 has mentioned that the foreign flip-flop deeds atomic number 18 basically a form of negotiable instrument that are resorted to support the cost of goods and services that form a part of trading transactions and otherwise, between business and public entities of nations of the planetary economy.Sarno, Taylor and Frankel, 2003 gives the definition of foreign central as denoting the act of purchase and sale of currencies of different economies that is performed over the counter for various purposes that includes international payments and deliverance of cost of various business transactions, where the value is usually thrifty by tallying the value of the currencies involved in the foreign transfigure transaction with that of the value of U.S. Dollar.According to Clark and Ghosh 2004, Foreign Exchange denotes transactions in international specie i.e. currencies of different economies. In such transactions the value of a funds of one country is tallied and flipd with similar value of the currency of the country in order to exchange the cost of a business transaction or public monetary transfer that is taking tail end between two entities of these economies.2.2.1 Foreign Exchange TransactionsTransactions in foreign exchange are done through various types and various modes between different countries of the world.According to training mentioned in the Reuters Financial Training Series, 1999,tod Transactions, tom turkey Transactions, Swap Rates, Spot Rates, Forward Rates, Margin Trading and Buy / Sell on Fixed Rates foreign exchange transaction methods are some of the commonly utilize methods that are widely used by world(a) managers for their foreign exchange transaction activities.2.2.1.1 TOD Operations TOD Operations are foreign exchange transaction methods where the trader uses the exchange site of the day on which the foreign exchange transaction order is to be executed. In other words TOP operations are commonly used in intra-day foreign exchange trans actions. As a result they are commonly resorted to by speculators in foreign exchange transactions and those who general speculate on the measures of different foreign exchange grocerys of the globe.2.2.1.2 TOM OperationsIn this type of transactions the transaction process carried forward to the next day instead of it being an intra-day trading. TOM transactions send is fixed on the day the transaction is signed, simply the calculate of exchange is agreed upon to be that of the next day.2.2.1.3 soilTransactionsSPOT Transactions can be compared with TOM transactions because here also the exchange rate is fixed at a value that prevails over the exchange rate of intra-day trading of shares. But SPOT transactions have been separated as a different category because unlike TOM transactions, SPOT transactions contracts are executed on the troika day after the signing of agreement between the Bank and the lymph gland.2.2.1.4 Forward Contract Forward contracts are those exchange rat e contracts where the currency conversion exchange rate agreement is decided at a certain rate at a time that is well before the date of execution of the exchange contract. In that way they are similar to TOM transactions. The only differ from them in the fact that these transactions are make for a long term i.e. generally for one year, and the parties involved in making this foreign exchange transaction deposit five percent of the contract value with the bank involved in facilitating the transaction at the time of executing the contract which is then returned to the client after execution of the exchange transaction. The need for depositing this amount is to secure the transaction against any loss due to market fluctuations.2.2.1.5 SWAP The greatest advantage of SWAP transactions is that the clients involved in the foreign exchange get preliminary information ab knocked out(p) the exchange rate of the currencies that are part of the transaction. In this type of transaction the ban k first buys the amount of transaction form the client and resells it to the client after a few days after disclosing the exchange rate of the currencies involved in the transaction process. SWAP transactions are lots sought after by traders because here they get to know beforehand the exchange rate of the currencies involved in the transaction process that helps them in avoiding fluctuations in market rate and gives them the advantage of determining the prices of goods, the nature of the currency market notwithstanding. .2.2.1.6 MarginTradingThe key element of Margin trading is that any trader can select for SPOT trading round the clock by going through the margin trading mode. The other key element of margin trading is that the traders can make deals with a minimal spread for a huge amount of funds by projecting fraction of the needed amount. In that way it is a unique form of world-wide financial transaction where the threshold value that can be transacted through the margin tr ading mode is $ 100000 with bigger deals being multiples of $ 100000. But in order to deal in margin trading the trader has to make a security deposit of five new-made of the contract value that has to be replenished from time to time in order to maintain the amount from which the probable losses from margin trading transactions are accommodated.2.2.1.7 Buying/Selling on Fixed Rate Order This is a mutual agreement between the buyer and seller of foreign exchange. Neither its rate nor its other terms and conditions are based upon actual conditions. Rather the deal is based belongings the mutual profitability of the buyer and seller intact where some(prenominal) of them get their desired amount.2.3 Global Foreign Exchange marketplaceAccording to the table depicting the triennial Bank Survey of Foreign Exchange and Derivatives Market guessivity done by Bank for International closings (BIS)2007, as shown below the global foreign exchange market has an average daily turnover of ov er $ 2 trillion, which is an plus of around forty percent in terms of volumes . This revive in foreign exchange transactions it is observed has been due to rise in the volume of trading in Spot and Forward markets. This is indicative towards improver in volatility of foreign exchange markets around the world. (www.bis.org).Global Foreign Exchange Market TurnoverDaily averages in April, (in billions $)Year198919921995199820012004Spot Transactions317394494568387621Outright Forwards275897128131208Swaps in Foreign Exchange190324546734656944Gaps in Reporting (Estimated)5644536026107Total Turnover (Traditional)5908201,1901,4901,2001,880Memo Turnover (At April 2004 Exchange Rates)6508401,1201,5901,3801,880(BIS Triennial Central Bank Survey, 2004)As observed by Jacque Laurent L.1996, Studies in foreign exchange point to the fact that the volume involved in foreign exchange transactions in the total markets around the globe has the potential to affect the overall functioning of the global financial system due to the systematic risks that are part and parcel of the foreign exchange transaction system. Most of the transactions occur in the major markets of the world with the London Exchange followed by brisk York and Tokyo Stock Exchange accounting for over sixty percent of the foreign exchange transactions done around the globe. Among these transactions the largest share is carried out by banks and financial institutions followed by other business transactions i.e. exchange of value for goods and services as well as dealers involved in securities and financial market transactions. According to the studies by Levi Maurice D., 2005, in foreign exchange transactions most of the transactions happen in the spot market in the farming of OTC derivative contracts. This is followed by hedging and forward contracts that are done in large numbers. The central banks of different countries of the world and the financial institutions operating in multiple markets are the main pl ayers that operate in the foreign exchange market and provide the risk exchange control mechanism to the players of the exchange market and the system where around $ 3 trillion amount of money is transacted in 300000 exchanges located around the globe. The largest amount of transactions takes place in the spot rate and that too in the liquidity market. The quotation on price in these markets sometimes r individuallyes to around two thousand times in a superstar day with the maximum quotations being done in Dollar and Deutschemark with the rates fluctuating every two to three minutes with the volume of transaction for a dealer in foreign exchange i.e. twain individual and companies going to the range of $ 500 million in normal times. In recent eld the derivative market is also gaining popularity in OTC dealings with regards to the foreign exchange market.2.4 Global Foreign Exchange Market Management bumpsAccording to the detective Kim S. H., 2005, Foreign exchange transactions a re identified by their connection with some financial transactions occurring in some overseas market or markets. But this interconnectivity does not affect the inherent value of the currency of the country which is determined by the economic strength of that country. This means that the inherent value of each currency of the world is different and unequal. So when the need arises to exchange the value of some goods or service between countries engaged in such activity it becomes urgent to exchange the exact value of goods and services. Considering the complexity and volume of such trading and exchange activity occurring in the global market between countries it is but natural that the currencies of individual countries is subject to continual readjustment of value with the currency with which its value has to be exchanged. This gives rise to the importance of foreign exchange transactions as a separate area of study and thereby needs much focus for its understanding (Frenkel , Homm el and Rudolf , 2005). In addition to this it is to be realized that with the growing gradation globalization and integration of global economic order there has been a tremendous increase in international business transactions and closer integration of economic systems of countries around the world especially between the members of WTO, that has led to the increase in economic transactions and consequent activity in international foreign currency exchange system (Adams, Mathieson and Schinasi, 1998). Added to this is the fact that the exchange value of currencies in the transactions is not determined by the respective countries but by the interplay of value of the currencies engaged in an international foreign exchange transaction and the overall value of each currency in the transaction prevailing at that time. In fact each country in the global economic order would want to determine the value of its currency to its maximum advantage, which was possible a few years ago in when the countries used to determine the value of their currency fit in to the existing value of their economy. The individual countries till the early nineties used to follow a policy of total or partial control over the exchange value of their currency in the global market. At the kindred time there also were a group of countries that followed the policy or system in determining the exchange value of their currency i.e. left(a) it to the interplay of global economic activity where the value was determined by its economic execution. The currencies of countries that provide full or partial amount of control in the international exchange value of its currency are known to follow a Fixed Rate whereas the currencies of countries that allow its currency to seek its inherent value through its performance in the global economic system are termed as following the Floating Rate of foreign exchange conversion mechanism. Though logically both the type of mechanism of foreign exchange face the eff ect of exchange rate fluctuations and consequent volatility in rate it is the currencies having a floating rate that are continually affected by the fluctuations in exchange rate in the global market when in the case of currencies with a fixed rate it is more(prenominal) of a controlled and regulated affair (Chorafas Dimitris N., 1992).2.5 Foreign Exchange Risks Prevailing in the Global MarketRisks connect to the exchange rate of a currency in the global market as has been mentioned, occurs due to the interplay of inherent value of each currency of the respective countries that are part of the global financial mechanism. Risks related to foreign exchange come into picture and are also inevitable in this world marching towards increased interaction due to globalization. The risks will occur due to business interaction and consequent exchange of value for goods and services.According to Kodres LauraE., 1996, the risks related to foreign exchange occur when there is increased interac tion between the currency of a country with that of other countries in the international market and that too if the currency has a floating exchange rate. In that case the value of the currency is continually affected by its business and financial performance. This relation with other currencies in the market affects it during the time when the need arises to exchange it with another currency for settlement of financial transaction in some business or financial purposes and gives rise to various types of risks. The prominent risks associated during this situation are Herstatt Risk, and Liquidity Risk.2.5.1 Herstatt RiskHerstatt risk is a risk that is named after a German Bank that got liquidated by the German Government in the seventies of the last century and made to return all the claims accruing to its customers. This is because its creditworthiness was affected and it could not pay the settlement claims to its customers and also on behalf of its customers to their clients. It is basically connected to the time aspect of foreign exchange value claim settlements in which the foreign exchange transactions do not get realized as the bank loses its ability to honour the transaction in the intervening period due to some causes. In the particular case the German bank failed to honour the financial settlement claims of its clients to their counter parties that were to be remunerative in values of U.S Dollars. The main issues that arose were regarding quantifying the amount to be delivered and the time of the transaction process due to the two countries financial systems being located and working agree to different or separate time zones. This case has established a phenomenon in foreign exchange market where there may erupt situations in which the working hours of banks located in different time zones may never match with each other leading(a) to foreign exchange settlement transactions getting affected during the mismatch of the two banks closing and opening t ime. In fact the Alsopp Report that studied this phenomenon in detail said that though the foreign exchange transactions are made in pen and paper on a single day the actual transfer of value takes place within three to four days. And with the exchange value of currencies operating in the international market always remaining in a state of commix they either get jacked up or devalued. In either case it affects the clause of transactions that was decided on an intra-day rate, as the value of both the currencies in the international market has changed during these days.2.5.2 Risks related to LiquidityThere can crop up different problems related to the banking systems operations and dynamics i.e. in both expert and watchfulness systems as well as inability in terms of volume of available liquidity strength or in mismatch in tallying of time etc that can affect the capacity of banks to honour foreign exchange transactions in terms of transfer of liquidity. These types of risks are be ing commonly witnessed in newly emerging economies that are being unable to cope with the sudden surge in volume of global business transactions thereby leading to exchange rate settlement and payment delays, outstanding payments and dishonouring of financial commitments in the exchange rate transaction market.2.5.3 Financial RepercussionsAccording to the Studies in foreign exchange related risks by Dumas and Solnik, 1995 aver that risk related to transactions in foreign exchange have increased with globalization and the rise of global economic integration process with the countries getting affected in relation to the volume of their transactions in the global financial and business marketplace. This is because the market is now more oriented towards market value driven convertibility of currencies that is influenced by the global financial movements and transactions, and any independent transaction especially of transnational and multinational companies will automatically affect o ther transactions happening in the global financial marketplace (Klopfenstein G.,1997).However, according to another study by Gallati Reto R., 2003, these multinational and transnational companies are simultaneously being affected by the fluctuations in exchange rate of different currencies of the global market that is exposing their business operations in different global markets to exchange rate related risks especially due to difference in Spot and Forward rates and the inevitable fluctuations (Choi , 2003) that give rise to foreign exchange settlement related problems.2.5.4 Remedies to Foreign Exchange Settlement RisksAs there risks that have cropped up in foreign exchange transactions due to increase in volume and frequency of transactions mainly as a result of globalization so, also there have come up remedies to decrease the risk related to adverse conditions in foreign exchange transactions.The Bank for International Settlements (BIS) in one of its studies in 1999 has said that settlement of claims is the most rife risk that is related to foreign exchange transactions, especially the speed with which these transactions are materialized and the roadblocks that they may face in the process due to tremendous increase in volume of foreign exchange transactions that cannot be cleared in expected times. The solution to these risks according to the study is to simultaneously clear transactions on either side i.e. for both the parties side so that they simultaneously give and receive payments at the agreed rate of exchange. This would solve the problem of drawn-out time of actual payment when the rate of exchange fluctuates, thereby creating problems for both the parties. This arrangement is related to deals being processed simultaneously, which requires the concurrence and common cause of both the parties. This is because the party that is expecting a hike in value of its currency may not agree to such a proposal. In that case there should be some law or a rrangement that would make it mandatory for both the parties to settle their intra-day payments on that day itself so that there is no scope left for speculation by them. According to the study, such arrangements have been made in USA and Europe where systems like Fedwire and Trans- European Automated Real-Time Gross Settlement Express Transfer (TARGET) have been established. Fedwire facilitates payments in foreign exchange transactions under the mode of Real Time Gross Settlements (RTGS)and TARGET facilitates intra-day transfer of foreign exchange between parties of member countries of Europe on the same day itself.But, for simultaneous release of funds by both the parties and the intra-day settlement of claims to succeed it is imperative that the member countries of the global economic system should come together have concurrence on these issues. This is because all said and done the foreign exchange transaction related rules and laws are still governed by the respective countries . And most of these countries are reluctant to make any headway in linking their currency system to the global currency system for speedy disposal of foreign exchange transactions for fear that such a move would expose their currency end financial system to the baneful effects of risks and volatility of global foreign exchange system (Hagelin and Pramborg, 2004).At the level of international trading corporations there has been initiated some move whereby they have formed a private arrangement known as Group of Twenty. They are a group of twenty internationally acclaimed global glade banks who have formed an system called the Global Clearing Bank that acts as a connection between the payment systems of different countries and verifies international foreign exchange transactions in order to simultaneously satisfy both the parties regarding authenticity of the process of transaction. The thing is that this system puts a high amount of strain on the financial and foreign exchange syst em as well as reserves of individual countries along with requiring them to bring about some amount of vulgarism between the financial rules and regulations of individual countries which is easier said than done. All the same the establishment of Bilateral Netting System and Multilateral Netting Systems as well as of Exchange Clearing House (ECHO) are trying to facilitate foreign exchange transactions and minimize the inherent risks involved (McDonough ,1996).2.6 Indian Foreign Exchange System2.6.1 Historical BackgroundThe historical background of foreign exchange system in India was a saga of excess control and monitoring with even diminished transactions being made to undergo the rigorous scrutiny of concerned government authorities to avoid any risks associated with such transactions and save the peculiar foreign exchange reserves from being frittered away in some transactions considered unimportant or anti-national by the government. The Foreign Exchange Regulation Act (FERA) that was enacted in 1947 and made more soused in 1973 was the embodiment of the prevailing sentiment of the governments of those days, which was to completely regulate and control all the foreign exchange transactions and protect the foreign currency reserves. (Mehta, 1985)All these changed in the nineties of the last century with the opening up of Indian economy in 1991 in keeping with the recommendations of the High Level Committee on Balance of Payments set up under the chairmanship of Dr C. Rangarajan by the Ministry of Finance, Government of India and subsequent entry of India into World Trade ecesis (WTO) in 1994. This was preceded by the liberating of current account transactions and establishing full convertibility of current account transactions in 1993. In 1994 also the Government of India accepted oblige VIII of Agreement of the International Monetary Fund that established the system of current account convertibility and the exchange value of rupee came to be determin ed according to the market rates with only the convertibility of capital account being under the control of the government (Krueger,2002) as the Tarapore Committee on Capital Account Convertibility of 1997 (Panagariya A., 2008) suggested the government to keep adequate safeguards before allowing the convertibility of capital account to be determined according to the market forces as there was need to consolidate the financial system and have an accepted inflation target before such a venture.The Tarapore Committee also suggested that the legal framework governing the foreign exchange transaction system in India also needs to be modernized before going for total convertibility of the capital account due to which the Government repealed the FERA Act of 1973 and promulgated the Foreign Exchange Management Act (FEMA) in 2000.This new act did away with the system of regulation and control and established a system of facilitation and management of foreign exchange transactions thereby pro moting all the activities related to foreign exchange transactions. The most important thing that was done by FEMA was to recognize violations or mistakes in foreign exchange transactions as a civil offence instead of a criminal offence as was done by FERA. FEMA also shifted the responsibility of proving the violation or mistake in foreign exchange transaction and related rules from the prosecutor to the prosecuted. And if the prosecuted was proved guilty he or she was to pay only monetary fine or compensation instead of being jailed as was the earlier provision under FERA. FEMA also change many of the rules and notified specific time frames for delivering judgments related to violations of foreign exchange rules and regulations and provide rules for establishing special tribunals and forums to deal with such cases. The compounding rules were also made less stringent and all matters related to compounding rules were notified to be dealt by Reserve Bank of India (RBI) instead of the previously assigned Enforcement Directorate. RBI was made the designated Compounding Authority in all related matters. Only the cases involving hawala transactions were left from its purviewAs per Mecklal and Chand