Foreign Exchange, FDI & External Debt (Part – III)

India's foreign exchange reserves comprise of;

• Foreign currency assets (FCAs): These are maintained in currencies like the US dollar, euro, pound sterling, Australian dollar and Japanese yen.
• Gold
• SDR (Special Drawing Rights): This is the reserve currency with IMF.
• RTP (Reserve Tranche Position): This is the reserve capital with IMF.
• The biggest contributor to India's Forex reserves is foreign currency assets, followed by gold.

Purpose:

• They are used to back liabilities on their own issued currency, support the exchange rate and set monetary policy.
• To ensure that RBI has backup funds if their national currency rapidly devalues or becomes altogether insolvent.
• If the value of the Rupee decreases due to an increase in the demand of the foreign currency, then RBI sells the dollar in the Indian money market so that depreciation of the Indian currency can be checked.
• A country with a good stock of forex has a good image at the international level because the trading countries can be sure about their payments.
• A good forex reserve helps in attracting foreign trade and earns a good reputation with trading partners.

Conceptually, the REER, defined as a weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries (the weighted average of NEER adjusted by the ratio of domes- tic prices to foreign prices), relates to the purchasing power parity (PPP) hypothesis. Hence, an increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. Furthermore, an increase in REER implies that exports be- come more expensive and imports become cheaper; there- fore, an increase in it indicates a loss in trade competitive- ness. Hence, statement 3 is correct, while statement 2 is incorrect.

• The exchange rate of a floating currency is determined by supply and demand on the international currency exchange market known as the forex.
• Fixed exchange rates are pegged to another currency or a commodity.
• Trading in exchange rates grew after the gold standard was phased out by the U.S. beginning in 1968.

Factors Affecting Exchange Rates

• Intervention of the Reserve Bank of India: During high volatility in the rate of exchange, the RBI intervenes
  to keep that in control. e.g. it sells US Dollars when the Indian Rupee depreciates too much, or purchases US Dollars when the Indian Rupee appreciates beyond a certain level.
• Inflation Rate: The increase in inflation rate can lead to an increase in the demand for foreign currency, thus negatively impacting the rate of exchange of the domestic currency. For example, an increased price of petroleum oil can increase the demand for foreign currency, thus leading to the depreciation of Indian Rupee.
• Interest Rate: Interest rates on corporate securities, or government securities and bonds, impact the inflow and outflow of foreign currency. When interest rates on government bonds are higher compared to those in other countries, it can attract foreign currency inflows, while lower interest rates may lead to outflows. This, in turn, impacts the rate of exchange of the Indian rupee.
• Exports and Imports: Exports earn foreign currency whereas imports require payments in foreign currency. Therefore, if exports rise, the national currency tends to appreciate, whereas an increase in imports usually results in the depreciation of the national currency.
• Other Factors: Indian foreign exchange market is also affected by other factors such as inflow in the capital account such as FDI, receipts in the accounts of exports in invisible in the current account,, external commercial borrowings, foreign institutional investments, NRI deposits, tourism activities etc.

 It is clear from the given data, that Indian rupee's condition was fluctuating (sometimes appreciated and sometimes depreciated) against the Euro, the Yen and the Pound Sterling. While, in comparison to US dollar, the Indian rupee's position was continuously appreciated. Hence, option (c) is the correct answer.

Factors Affecting Exchange Rates

• Intervention of the Reserve Bank of India: During high volatility in the rate of exchange, the RBI intervenes
  to keep that in control. e.g. it sells US Dollars when the Indian Rupee depreciates too much, or purchases US Dollars when the Indian Rupee appreciates beyond a certain level.
• Inflation Rate: The increase in inflation rate can lead to an increase in the demand for foreign currency, thus negatively impacting the rate of exchange of the domestic currency. For example, an increased price of petroleum oil can increase the demand for foreign currency, thus leading to the depreciation of Indian Rupee.
• Interest Rate: Interest rates on corporate securities, or government securities and bonds, impact the inflow and outflow of foreign currency. When interest rates on government bonds are higher compared to those in other countries, it can attract foreign currency inflows, while lower interest rates may lead to outflows. This, in turn, impacts the rate of exchange of the Indian rupee.
• Exports and Imports: Exports earn foreign currency whereas imports require payments in foreign currency. Therefore, if exports rise, the national currency tends to appreciate, whereas an increase in imports usually results in the depreciation of the national currency.
• Other Factors: Indian foreign exchange market is also affected by other factors such as inflow in the capital account such as FDI, receipts in the accounts of exports in invisible in the current account,, external commercial borrowings, foreign institutional investments, NRI deposits, tourism activities etc.

• Exchange Rate, or the rate of exchange, is the price of the currency of a nation in terms of another currency i.e. the price at which one currency can be traded for another.
• The rate of exchange of a currency w.r.t. another currency reflects the relative demand of the two currencies.
• For example, if the US Dollar is stronger than the Indian Rupee, it implies that value of the US Dollar is higher w.r.t. the Indian Rupee).
  ∗    This, in turn, shows that the demand for US Dollars (by those holding Indian            Rupees) is more than the demand for Indian Rupees (by those holding US                  Dollars).
• The relative demands of the two currencies depend on the relative demand for the goods & services of the two countries.