So, in the previous class, we discussed about
the exchange rate determination and as well as the foreign exchange market in India, who
are those participants, and how the foreign exchange market functions, how the trading
takes place, what are the different platform which are available for the investment in
the foreign exchange market. So, today we will be discussing about certain
issues related to the how the central bank intervenes into the foreign exchange market,
and why this interbank inter
venes, and what is the basic objective behind that and all
those issues. See, if you see already what we have discussed
that we have three types of systems. We have a fixed exchange rate system, we have
fixed exchange rate, you have a floating exchange rate system, then you have a managed exchange
rate system. So, already what we have discussed that fixed
exchange rate system, the government basically fixes the range of exchange rates, that how
the exchange rate basically moves from one particul
ar range with respect to a particular
currency. And in the floating exchange rate, it is purely
market driven or market determined factors. But in whenever it is managed, here basically
it is a mixture of the floating and as well as plus the government intervention. So, why basically government intervention
to the system whenever there is any kind of fluctuations happens in the market, and one
particular currency is highly depreciated or a particular currency a value is going
to decline, then in
that particular point of time, the central bank of that particular
economy tries to intervene into that particular system. And they try to see that whether really this
particular concept or particular price fluctuations, which is happening that is that can be any
way can be controllable or can be controlled. So, in that context the central bank intervention
comes into the picture. So, that basically is always a phenomena we
discussed with respect to the managed exchange rate system in the econo
my. So, therefore, the basic objective of central
bank intervention is to make this particular price table or to control any kind of uneven
fluctuations of the prices in a particular direction. So that is why a the in the central bank interventions
objective are to influence the trend movements in the exchange rate, because the central
bankers perceive that the long-run equilibrium values to be different from the actual values. So, which is exchange rate which is prevailed
in the market at that
particular point of time; that basically is not driven by the
actual fundamentals. There must be some external forces which is
which makes this particular price away from the equilibrium level. So, in that particular of time, the central
bank tries to intervene in to that to make this particular price level the equilibrium
level or to make this particular level stable. Another objective of central bank intervention
is to make this kind of exchange rate in a particular level by that the export ca
n be
competitive. The export market can be competitive, so that
means, they can increase or decrease the export in that particular market with respect to
the requirement of that particular economy. Because in a particular if the exchange rate
of a home currency is highly depreciated, then obviously, there is a increase in the
performance of the export, but that export performance may not be on that particular
point of time be good for the economy in a larger extent or in a longer period of time.
So, because the price is highly fluctuating,
the commodities price became very cheaper with respect to the other currency, but the
question is that here the economy also to some extent gets affected because the prices
we are basically whenever we are going for importing or something, then we have to pay
large amount of money. So, because of that, that particular discrepancy
makes this particular system unstable. So, to maintain this export competitiveness,
we always or there is a requirement of
the central bank intervention into the system. You see if the home currencies depreciating,
so let per dollar rupee if you convert, then 70 rupees. So, we are it has gone to 75, then what is
happening that the export basically become very cheaper in that particular context, but
in the import become costlier. So, if the import become costlier, then it
is difficult to maintain that current account balance in that particular system. So, because of that what is happening this
interbank tries to int
ervene into that, so that is basically the another objective or
another requirement of the central bank intervention. Then another objective is central bank or
a intervention is also required to manage the volatility in the financial market more
particularly with respect to the foreign exchange market. Because sometimes the exchange rate fluctuations
are so large, and because of certain external bank factors may be the market is not able
to control that particular fluctuations, then central bank
central bank takes certain steps
to make this particular exchange rate fluctuations stable in a particular range. By that it will not have much adverse impact
on the export and import. And another objective is to protect the currency
from speculative attack and the crisis. So, these are the different objectives of
the central bank intervention and that is why the central bank central bank tries to
intervene into the market to make this particular market more stable. So, then we will see that ho
w the central
bank intervenes in the foreign exchange market. So, there are two types of intervention foreign
exchange market does. One is we call it the sterilised intervention,
and another one is we call it the non-sterilised intervention. We have a sterilised intervention, then we
have a non-sterilised intervention. So, whenever you talk about the sterilised
intervention, what exactly it means, it means that or sterilised intervention occurs when
the purchase or the sale of the foreign curren
cy is offset by a corresponding sale or purchase
of the domestic government debt to eliminate the effect of the domestic money supply. What it exactly means it means that whenever
the central bank tries is to buy a particular foreign currency or tries to sell a particular
foreign currency, then it will have the impact on the money supply. Because if you are buying, if you are the
foreign currency is bought by the central bank, then what will happen, it will increase
the money supply in the econo
mic system. So, increase the money supply will lead to
the price rise or we can say that inflation. If inflation will increase, then what will
happen it will have the adverse impact and other real economic factors within the economic
system. So, because of that we have to make a certain
kind of step by that whatever increase is there in terms of the foreign assets, so that
foreign assets increase can be offset by any kind of decisions, which is taken by the central
government to reduce the domes
tic money supply in the economy in that particular point of
time. So, therefore, in that particular point of
time, what they do they try to use this open market operation which is a major instrument
of the monetary policy. So, what they do they buy or sell depending
upon the positions whatever they have taken in the foreign exchange market. By that whatever increase will be there in
terms of the foreign currency and or in terms of the any kind of other currencies to create
that particular gap so
to minimize that gap in that particular point of time at the simultaneously,
they take certain steps in terms of the buying and selling of the foreign the government
dated securities to control the money supply within the system, by that the net effect
will be 0. That means the amount of money supply in the
economy will be same as usual That means, for example, they are buying if
they are buying then what is happening the foreign assets will increase in the economic
system that means, the money
supply should increase. But in that particular point of time, what
they will do they will basically try to extract certain money in the domestic market what
already it is there. So, in that time whatever they will do, they
will sell the bond. If they will sell the bond, then the people
or public will take the bond and against that they will pay the money to the central bank. So, in the economy they can extract they can
absorb certain moneys money supply within the domestic market. So, whatever
money basically has increased
in terms of the foreign assets, the same amount of the money can be reduced by taking this
kind of steps. So, then the total effect will be nullified
in the system. So, here what is happening, whenever we are
we know that in the open market operation, we can buy or the sell depending upon the
requirement in the economic system. So, that particular; that means, they are
sterilised this, the money supply has been sterilised, so the net effect will be 0. So, another on
e is the non-sterilised intervention,
non-sterilised intervention basically what there the authorities purchase or the sell
foreign exchange, normally against their own currency, without any offsetting actions. So, they only go and try to buy or sell the
foreign exchange from the foreign exchange market, but they do not take any positions
in the domestic market to control the money supply. So, here what we are doing we are basically
taking that buying or selling of the securities, if you remembe
r in the money market or in
the monetary policy instrument we have discussed, in the open market operation what we do either
you buy or you sell the domestic dated securities or government dated securities. So, when you buy, what you do, you buy the
security buy the bonds from the public, whenever you buy it, you have takeaway the bonds and
inject the money supply in the system, give the money to the public. And whenever you are selling the bonds, basically
what you are giving the bonds, and aga
inst that you are taking away the money from them. So, whatever money you are taking away from
the system that will basically reduce the money supply in the economic system. So, that positions if they will take simultaneously
with this buying and selling of the foreign assets, then we call it that is the sterilised
intervention. But if this kind of steps they do not take,
they simply buy or sell foreign exchange to fulfill that particular gap in terms of that
particular currency, then we can cal
l it the non-sterilised intervention. So, this is what basically this, what we can
say that the types of intervention in the system always we look at. Then if you see what is the impact we have
already discussed that the non-sterilised foreign exchange intervention whenever they
make, they purchase it. So, the effect on net foreign assets will
be positive will increase, effect on net domestic asset will be 0. So, it will be effect will be positive; the
money supply will increase if it is non-ste
rilised. But if it is a sterilised foreign intervention,
and they are going for purchasing, this one will increase, this thing will decline, net
effect will be 0. So, if you go both go for selling, then it
will have a negative impact, it will be 0, then obviously money supply will go down. Then whenever you go for sterilised intervention
in terms of the selling, then effect is negative; here it is positive. They have to take the reverse, position, then
finally the effect will be 0. So, this is t
he way the intervention works
in the foreign exchange market by the central bank. So, here what basically here we are trying
to see that the exchange rate intervention in the foreign exchange market is an inevitable
thing in terms of central bankers point of view, because sometimes the fluctuations also
happens not because of any economic fundamentals that may also happen because of certain other
external forces which is not in that way in control of the monetary authority. So, in the another is
sue with respect to the
foreign exchange market is the currency convertibility which is the very popular issue always we
discuss about. What do you mean by this currency convertibility? Here also the central bank plays a significant
role in terms of the policies, in terms of norms, in terms of regulations. So, if you define the currency convertibility,
then it is nothing but it is the freedom, it is freedom to convert the local financial
assets into the foreign financial assets and vice versa at
market-determined rates of exchange. So, here what is happening we are trying to
convert our local currency or local assets into the foreign assets or we are converting
the foreign assets into the local assets, how practically or how easily we are able
to convert this things at a market-determined rate of exchange, then accordingly we can
measure the degree of currency convertibility. So, currency convertibility is basically associated
with the degree of ownership in foreign domestic financial
assets, foreign or domestic financial
assets and the liabilities, and basically always it is embodies the creation and liquidation
of the claims, by the rest of the world. How fast the particular assets can be liquidated,
how fast the particular assets can come into the market for the trading and how far the
particular assets valuation can be possible, so that is the way the currency convertibility
is defined in the economic sense. So, whenever we talk about the currency convertibility,
we have
two types of currency convertibility; we have partial and we have the full. Whenever we have a complete freedom to convert
the local financial assets into the foreign financial assets, then we can call it is the
full convertibility, the complete freedom as a market-determined rate of exchange we
are completely free to convert our assets into the foreign assets or foreign assets
can be converted into the domestic assets, then we can call it the full convertibility. The partial convertibility mean
s that it is
again the freedom to buy or sell the currency, but up to a limited amount. And it is only for the foreigners foreign
assets point of view that means, here the 100 percent you are allowed to convert your
asset into the foreign asset, and foreign assets can be converted into the local or
the domestic assets. But whenever it is partial convertibility,
we have certain kind of restrictions in terms of the conversion. So, whenever the restrictions are put on this
we define that particular
term as a partial convertibility or partial capital convertibility
or partial currency convertibility in that particular market. There are some researchers, they basically
according to them, the full convertibility means removing the trade and exchange controls
completely, and shifting away from the fixed, managed, pegged exchange rate system towards
the flexible or the floating exchange rate system in the economy. Completely you can remove all those restrictions
into the market, at any point o
f time any foreign assets can be converted into the domestic
asset or the value of the domestic assets can be converted into also the local assets. So, this is the way the convertibility in
a economic sense is defined or this is the way the there are two types of convertibility
we can come across whenever we deal with the foreign exchange market. Then if you see the different characteristics,
the capital convertibility or the currency convertibility, already one thing we have
discussed that that
is basically we want to make exchange rate completely free or it should
be completely market-determined, this is number one. It is the elimination of the import licensing,
custom duties, import taxes, tariffs, advance import deposits, export incentives, multiple
exchange rates, all kinds of things basically we can eliminate that means, completely the
exchange rate is floating, exchange rate is completely free. All kind of restrictions are not available
in the foreign exchange market. For tradin
g or any other thing or any other
operations which is related to the foreign exchange market investments. It is also deals with the restrictions removal
of the restrictions on international services transactions, use, availability, retention,
and holding of the foreign exchange at home and abroad, and on international capital movements
as well as buying and selling of the foreign exchange. You see capital convertibility is also dealing
with the international capital mobility, capital movements,
there should be free capital mobility. There should not be any restrictions with
respect to sectors or with respect to any kind of other kind of characteristics like
a industry or particular product and all these things. No restrictions, the 100 percent is allowed,
any time, anybody can convert their asset in to the foreign asset; and foreign assets
can be converted into the local or the domestic assets, then we can say that is a full convertibility
which is happening in this So, it also gives t
he freedom to remit the
abroad profit, dividends, and other legitimate income in the foreign currencies. If any multinational which is working abroad,
and they have the parent operation in a hosting country, so they are also free to distribute
their dividends or any kind of income whatever they are generating in that country to their
parent country and the free of cost. And there is no such kind of restrictions
in terms of that kind of payments to the stake holders or the investors who are avail
able
in this particular parent country. So, in that context, we can see that there
should not be any kind of restrictions in terms of exchange rate point of view and as
well also the other financial cash flows which are happening in the economic system. So, that is the way the convertibility or
currency convertibility is defined in the financial system. Then what are those prerequisites, what we
need to make this particular system convertible. With the exchange rate must be realistic,
in the sen
se that should be not driven by any kind of factors which are not economical
driven; this is number one. The country should enjoy the low inflation
rate and there should be stability in terms of internal financial market. Within the market the economy should not be
highly volatile, and should not be that kind of instability in terms of the price fluctuations,
the other or other economic parameters which are affecting this particular pricing or exchange
rate in that particular system. Foreign exc
hange reserve should be large in
practice. The amount of foreign exchange reserves whatever
the company or the country has that should be very large amount. The trading partner should open up the trade
and payment systems. All the trading partner should be open in
the sense the openness of that particular economy should be quite high, because this
particular country is trying to do unlimited trade or unlimited transactions with respect
to that country with respect to the different sectors. So, i
f there is any restrictions of that foreign
country, then here the kind of facilities or this kind of relaxation is not going to
help in terms of the capital mobility and as well as the other factors mobility. The debt level particularly external debt
of the country should be low, unless they have always a fixed obligations, and the balanced
of payment of the country will becoming worse and worse, if the interest payments and all
these things over the year will increase or we can say that the de
bt level is quite high
for that particular country. The fiscal and monetary austerity, prudence,
consolidation, and drastic reduction of fiscal deficits should be achieved. The fiscal deficit should be less. If the fiscal deficit is high, then we have
the different kind of deficit where the largest deficit all the broader deficit definition
is the fiscal deficit. If the fiscal deficit is already high, then
there is a high pressure on the other kind of items which are a part of the fiscal definit
ion
which includes the current account deficit or the capital account deficit. If those deficits are getting affected because
of the aggregate deficit in the system is quite large, then also it is very difficult
to make this particular convertibility in the easier way. So, that is why we have to look at that what
kind of deficit we have. If deficit is more, then convertibility will
be again be a again a burden or challenge for the regulator or the policy makers. The labor market should be reform
ed, the unemployment
insurance basically should be always there for the economic system, jobs should be retained
and the wage discipline should be achieved.. So, whenever we are paying the wage to the
different customers that discipline of per payment of the wage also should be there. There should not be a much disparity in terms
of the same type of job or in terms of the particular operation that individual or that
entity is doing in that particular point of time. So, if all those prerequisites
are maintained,
then only what we can say the country is suitable, country is eligible to go for capital convertibility
in that particular point of time. But there are certain problems with respect
to this capital convertibility or the currency convertibility. What are those problems? First of all it increases the risk of the
capital flights in both ways. If there is a risk increase in the risk, then
it increase the volatility in exchange rate and the financial market. And this risk are very re
al in practice due
to the fact that 90 percent of the transactions in the foreign exchange market are not related
to trade. Here already I told you there are two things
we have a current account, and we have a capital account. But if all kind of mostly transactions are
done through export and import business, then maybe there, there may be some kind of control,
but mostly the foreign exchange transactions are related to NRIs, NRI deposits, the FDIs,
FFIs and all these things. So, if there is a f
ull capital convertibility,
then the fluctuations and amount of flow to the economy will be very uneven. In one day, it will be very high other day
it will be large may be it is because of certain kind of stocks, certain kind of rumors or
there is no such specific reason behind that, but that possibility is there which make certain
kind of problem in the economic system as a whole. It may increase the inflationary pressure
because of foreign goods become available at a higher prices. It can resu
lt in the flooding of domestic
markets with imports particularly non essential ones. So, if there is there is no restrictions in
terms of the import may be the the tendency towards the import may increase, so they may
be people will not try to produce that particular product in that home country, they try to
always go for trading. And because of that this all those price and
as well as the demand for domestic products will be getting negatively or adversely affected
by that. It can also misuse t
he foreign exchange not
only for the luxury and the leisure industry, but also the smuggling of the goods, drugs,
arms and other nefarious activities can increase in the economic system. So, the controlling those things also relatively
will be more difficult for the concerned persons and concerned authorities in that particular
point of time. Unlimited access to the short-term external
borrowings, and giving unrestricted freedom to domestic residence to convert that domestic
bank deposits and id
le assets in response to market developments and exchange rate expectations
should cause extreme domestic financial volatility as the experience of the Asian crisis has
already thought us. Because the Asian crisis what has happened
this was the same reason why that South East Asian crisis has happened in 96-97 because
of the full capital convertibility. There was no restrictions in terms of the
buying and selling of any kind of domestic product and conversion of any asset into one
different kind
of currencies. So, what has happened in that particular point
of time, although in the short-term the countries; where getting very high amount of growth,
but that particular model was not sustainable. So, within a short span of time the particular
model get collapsed, and finally, there is a big crisis we have we have witnessed we
have experienced in that particular point of time. So, these are the different problems or dangers
with respect to CC or the capital convertibility or currency conve
rtibility. So, there are some recommendations, different
committees have given with respect to capital convertibility. We can go through these things. The there is a spot and forward markets for
both. Then bank margin on foreign exchange transactions
for smaller customers need to be reduced. Then the interest rate parity in forward market
should be there. Currency futures may be introduced the existing
guaranteed settlement platform of CCIL needs to be extended for the forward markets. Banking s
ectors should be allowed to his currency
swaps. A monitoring exchange rate band of plus or
minus 5 percent around the neutral real effective exchange rate may be considered. Then as an operative role if the current account
deficit possessed beyond the 3 percent of GDP the exchange rate policy should be reviewed. So, these are the committee’s recommendation
in term of the adaptation of the full capital account convertibility in India. Then another important thing is foreign exchange
reserve. So,
here what is happening, why we need a
reserve foreign exchange reserve in the system, it is because we have the main objective is
to managing a stock of reserves for any developing country or reserving their long-term value
in terms of the purchasing power over goods and services, and the minimizing and the risk
and volatility in returns. So, there are four factors or five factors
which mostly effect the foreign exchange reserve. One is your size of the economy; second one
is your vulnerability
of the current and capital accounts; the exchange rate flexibility; opportunity
cost and the financial market integration, these are the major factors which affect the
foreign exchange reserves. And it if you talk about India then the major
sources of the foreign exchange reserves are the NRI deposits foreign investments, external
assistant what we get it from other countries, and external commercial borrowings, these
are the major components of the foreign exchange reserve in India. So, the if
you see the India there are high
level of foreign exchange reserve, there are reasons for that. It shows the India’s ability to meet the
financial obligations and maintain the countries mental stability. It is shows also the India’s ability to
import more goods or to absorb the shocks and uncertainty in the world economy. Ability to cope up with crisis and capital
flight; greater availability of liquidity and confidence and they can get higher sovereign
rating better rating and greater backing o
f domestic currency and finer terms of the debt. So, these are the different advantages of
the high foreign exchange reserve. There are some negative impact also. Maintaining high exchange high foreign exchange
reserve is costly because the cost of holding foreign exchange reserves is the opportunity
cost of investing them in the productive activities. It augments the domestic money supply that
is why this we have to take some sterilised intervention step. It also increase the interest rate burd
en
of the economy, because the larger part of them are from NRI deposits. Increase the volatility or the in the market
vulnerability in the market. The reserves have not been built of due to
favorable balance of trade or the surplus in the current account. So, these are the adverse implications of
the high foreign exchange reserves in the economic system. How to know that whether the foreign exchange
reserves in the system is adequate or not, we have the different measures, we have import
cover
of reserves. Foreign exchange reserve to reserve money,
foreign exchange reserve to broad money, foreign exchange reserve to external debt, foreign
exchange reserve to short-term debt, then foreign exchange reserve to GDP. For example, it is measured that if your foreign
exchange reserve is able to cover up the 3 to 4, 5 months import demand or import requirements
then we can say that it is adequate, but India is now having around 9 months import coverage
of the foreign exchange reserves. So, in
that context, we are adequately or
may be more than that reserve we have in the economic system. So, in that case we have a high amount of
foreign exchange reserve we these are the limits and the advantages who always just
now we have seen or we have discussed. Then we can say that whether this really foreign
exchange reserve is good or bad in the economic system as a whole or the financial system
in particular. These are the references what you can go through
for this. Thank you.
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