Foreign Exchange and Exchange Rate: Concepts and Policy
Complete notes on foreign exchange for competitive exams: exchange rate systems, depreciation and devaluation, NEER, REER, convertibility, FEMA and India's reserves.
By GK24 Editorial Team· Published · 4 min read
Foreign exchange means claims on other countries held in their currencies, and the exchange rate is simply the price of one currency in terms of another. When a paper asks about the rupee, it is asking one of five things: how the rate is fixed, what moves it, what depreciation does to trade and prices, how far the rupee is convertible, and who holds and regulates the country's reserves. This note takes them in that order.
How an exchange rate is decided
Three systems are compared in every textbook. Under a fixed or pegged rate the government announces a value and defends it by buying and selling foreign currency; the Bretton Woods arrangement of 1944 worked this way. Under a floating or flexible rate the market decides from the demand for and supply of the currency, demand coming from importers, travellers and those repaying foreign loans, supply from exporters, foreign investors and remittances. Under a managed float the rate is market determined but the central bank intervenes to smooth sharp swings. India moved from a pegged rate to the Liberalised Exchange Rate Management System in 1992, a dual rate arrangement, and to a unified market determined rate in March 1993, so the present system is a managed float with the Reserve Bank intervening only to curb volatility, not to defend a level.
Depreciation, devaluation and their opposites
Depreciation is a fall in the market value of a currency under a floating system, and appreciation is a rise. Devaluation is a deliberate reduction of the official value by the government under a fixed system, and revaluation is a deliberate increase. India devalued the rupee in 1949, again in 1966, and in two steps on 1 and 3 July 1991 during the balance of payments crisis. A falling rupee makes Indian goods cheaper for foreign buyers and should help exports, but it makes imports dearer, raises the bill for crude oil, fertiliser and electronics, adds to imported inflation, and increases the rupee cost of repaying external commercial borrowings. A rising rupee does the reverse and can hurt exporters.
NEER and REER
A single bilateral rate against the dollar does not show whether the rupee is strong overall. The nominal effective exchange rate, the NEER, is an index of the rupee against a basket of trading partner currencies weighted by trade. A rise in the NEER means the rupee has appreciated in nominal terms. The real effective exchange rate, the REER, adjusts the NEER for relative inflation, so a rise in the REER means the rupee has become expensive in real terms and export competitiveness has weakened. When domestic inflation runs higher than that of trading partners, the REER rises relative to the NEER and the two indices diverge.
Convertibility of the rupee
| Account | What it covers | Position in India |
|---|---|---|
| Current account | Trade in goods and services, remittances, travel, interest | Fully convertible since India accepted the obligations of Article VIII of the IMF in August 1994 |
| Capital account | Investment, loans, borrowing and repayment of capital | Partly convertible, opened in stages |
The Tarapore Committee, which reported in 1997 and again in 2006, drew up the road map and the preconditions for fuller capital account convertibility, among them fiscal discipline, low inflation and a sound banking system.
The law and the regulator
The Foreign Exchange Regulation Act of 1973, a strict control law that treated foreign exchange as a scarce resource, was replaced by the Foreign Exchange Management Act, FEMA, passed in 1999 and brought into force in 2000. FEMA treats violations as civil matters rather than criminal offences and fits a liberalised economy. The Reserve Bank of India administers the exchange control framework, authorises dealers, and holds and manages the country's foreign exchange reserves.
Reserves and the market
- Reserves have four parts: foreign currency assets, gold, special drawing rights and the reserve tranche position in the IMF
- Special drawing rights are the reserve asset created by the IMF, valued from a basket that contains the US dollar, the euro, the Chinese yuan, the Japanese yen and the pound sterling
- A spot rate settles almost immediately, while a forward rate is agreed today for delivery on a future date and is used to hedge risk
- A hard currency is widely accepted and easily exchanged, such as the dollar; a soft currency is not
- Purchasing power parity explains the long run rate by the relative price levels of two countries
Foreign investment is one of the main sources of foreign exchange. Foreign direct investment brings a lasting interest in an enterprise and is comparatively stable, while foreign portfolio investment in shares and bonds can leave quickly and is called hot money. Tight money abroad, for example a rate increase by the United States Federal Reserve, can pull portfolio money out of India, weaken the rupee and raise the cost of external borrowing, which is why examiners connect global interest rates with the exchange rate.
Exam Point of View
The commonest question is the difference between devaluation and depreciation, usually as a statement pair. Next come the full forms and the direction of movement: what a rise in the NEER or the REER means, and why higher domestic inflation makes the two diverge. Learn the dates, because they are asked directly: FERA in 1973, the dual rate in 1992, the unified rate in March 1993, current account convertibility in August 1994, FEMA in 1999 and the Tarapore reports of 1997 and 2006. Banking papers add the four components of reserves and the currencies in the SDR basket. A frequent trap is the effect of a weaker rupee: it helps exporters and those earning remittances, but raises the import bill and the rupee burden of external commercial borrowings, so an option saying depreciation reduces currency risk on foreign loans is always wrong.
Important Facts
| Exchange rate system in India | Managed float, market determined with Reserve Bank intervention |
|---|---|
| Unified exchange rate | March 1993, after LERMS in 1992 |
| Current account convertibility | Accepted with Article VIII of the IMF in August 1994 |
| FEMA | Passed in 1999, in force from 2000, replacing FERA of 1973 |
| Devaluations of the rupee | 1949, 1966 and twice in July 1991 |
| NEER | Trade weighted index of the rupee against partner currencies |
| REER | NEER adjusted for relative inflation; a rise means lower competitiveness |
| Components of reserves | Foreign currency assets, gold, SDRs, reserve tranche position |
| SDR basket | US dollar, euro, Chinese yuan, Japanese yen and pound sterling |
| Capital account convertibility | Partial; road map given by the Tarapore Committee in 1997 and 2006 |
Practice MCQs on this topic
With reference to the Indian economy, consider the following statements: 1. An increase in the 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 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
Show answer
Statement 1 is right because the NEER is a trade weighted index of the rupee against a basket of partner currencies, so a rise in the index means the rupee has appreciated in nominal terms.
Read the full explanation →Consider the following statements: 1. Tight monetary policy of US Federal Reserve could lead to capital flight. 2. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs). 3. Devaluation of domestic currency decreases the currency risk associated with ECBs. Which of the statements given above are correct?
- A.1 and 2 only
- B.2 and 3 only
- C.1 and 3 only
- D.1, 2 and 3
Show answer
Statement 1 is right because when the United States Federal Reserve tightens, returns there become attractive and portfolio money flows out of emerging markets, which is capital flight.
Read the full explanation →What challenge does foreign investment often face in India?
- A.Excessive foreign competition
- B.Inconsistent regulatory environment
- C.Lack of skilled labour
- D.Lack of consumer base
Show answer
Foreign investors bring in foreign exchange and look for predictable rules, and the difficulty most often listed for India is regulatory uncertainty: changing rules, clearances spread across departments and states, and disputes that take long to settle.
Read the full explanation →The Foreign Exchange Management Act, FEMA, replaced which of the following laws?
- A.Foreign Exchange Regulation Act, 1973
- B.Banking Regulation Act, 1949
- C.Monopolies and Restrictive Trade Practices Act, 1969
- D.Securities and Exchange Board of India Act, 1992
Show answer
FERA treated foreign exchange as a scarce resource, forbade most dealings unless permitted and made breaches criminal offences.
Read the full explanation →In which year did India accept the obligations of Article VIII of the IMF, making the rupee fully convertible on the current account?
- A.1991
- B.1993
- C.1994
- D.1999
Show answer
India accepted the obligations of Article VIII of the Articles of Agreement of the International Monetary Fund in August 1994, which means the rupee can be exchanged freely for trade in goods and services, travel, education, remittances and interest payments.
Read the full explanation →Which of the following is not a component of India's foreign exchange reserves?
- A.Foreign currency assets
- B.Gold
- C.Special drawing rights
- D.Small savings collected by the government
Show answer
Small savings such as deposits in post office schemes are domestic rupee liabilities of the government and have nothing to do with the country's external assets.
Read the full explanation →The exchange rate system followed by India at present is best described as
- A.A fixed peg to the US dollar
- B.A managed float
- C.A currency board arrangement
- D.A gold standard
Show answer
Since the unification of the exchange rate in March 1993 the value of the rupee has been determined by demand and supply in the foreign exchange market, while the Reserve Bank intervenes by buying or selling dollars to curb sharp volatility rather than to defend any particular level.
Read the full explanation →A depreciation of the Indian rupee against the US dollar is likely to
- A.Make Indian exports cheaper for foreign buyers and imports costlier
- B.Make Indian exports costlier for foreign buyers and imports cheaper
- C.Reduce the rupee cost of repaying dollar loans
- D.Have no effect on the price of imported crude oil
Show answer
When the rupee depreciates, each dollar buys more rupees, so an Indian good priced in rupees costs a foreign buyer fewer dollars and exports become more competitive, while every imported item costs more rupees than before.
Read the full explanation →The Tarapore Committee is associated with which of the following?
- A.Reform of agricultural credit
- B.Capital account convertibility
- C.Goods and services tax design
- D.Restructuring of public sector banks
Show answer
The committee headed by S. S. Tarapore reported in 1997 and again in 2006 and set out a phased road map for making the rupee convertible on the capital account, together with the preconditions to be met first, such as fiscal discipline, low and stable inflation and a strong banking…
Read the full explanation →Special Drawing Rights, which form part of a country's foreign exchange reserves, are issued by
- A.The World Bank
- B.The International Monetary Fund
- C.The World Trade Organization
- D.The Bank for International Settlements
Show answer
Special drawing rights are an international reserve asset created by the IMF and allotted to member countries in proportion to their quotas; a member can exchange them with other members for usable currencies.
Read the full explanation →Frequently Asked Questions
What is the difference between devaluation and depreciation of the rupee?
Devaluation is a deliberate reduction of the official value by the authorities under a fixed rate system. Depreciation is a fall in value brought about by market demand and supply under a floating or managed float system.
What does a rise in the REER indicate?
That the rupee has become expensive in real terms once relative inflation is taken into account, so Indian goods are less competitive abroad. A rise in the NEER alone means only nominal appreciation.
Is the Indian rupee fully convertible?
It is fully convertible on the current account, accepted with Article VIII of the IMF in August 1994, and only partly convertible on the capital account, which has been opened in stages.
Which law governs foreign exchange transactions in India today?
The Foreign Exchange Management Act of 1999, in force from 2000, administered by the Reserve Bank of India. It replaced the Foreign Exchange Regulation Act of 1973 and treats breaches as civil matters.
How does a weaker rupee affect the economy?
Exports and remittances gain because Indian goods become cheaper abroad, but imports of crude oil, fertiliser and electronics cost more, imported inflation rises, and repaying external commercial borrowings takes more rupees.
Sources
- Introductory Macroeconomics (Class XII), Chapter 6: Open Economy Macroeconomics — NCERT
- Foreign Exchange Management Act, 1999 — Ministry of Finance, Government of India
- Functions of the Reserve Bank: Manager of Foreign Exchange — Reserve Bank of India
