Foreign Exchange System
With the advent of globalisation, there has been a rapid increase in cross-border transactions. The increased number of international transactions created a need for a common platform for countries to exchange their currencies. Consequently, a system was formed for exchanging currencies. The Foreign Exchange System, commonly known as FOREX, deals with the conversion of one currency into another. It constitutes the biggest financial market in the world. Unlike other financial markets, FOREX is not linked to any stock exchange.
Table of Content
- 1 Foreign Exchange System
- 2 Factors Affect the Fluctuation in Exchange Rate
- 3 Fixed Exchange Rate System
- 4 Flexible (Floating) Exchange Rate System
- 5 Capital and Current Account Convertibility
- 6 Various Methods of Exchange Rate Regimes
It is an over-the-counteror off-exchange market. In the FOREX market, currencies are valued relative to one another and exchanged. An investor or institution purchases one currency and sells another in a parallel transaction. Therefore, the trading of currencies always takes place in pairs, where one currency is exchanged for another. It is represented as—EUR/USD or INR/USD. The rate of exchange of two currencies is determined through the impact of market forces that affect the demand and supply of these currencies.
The FOREX market operates 24 hours a day and has no definite opening and closing timings. The market operates according to geopolitical events, important information from key central banks and economic reports government statistical bureaus, etc. When foreign exchange traders are not trading in one part of the world (due to different time horizons), traders in other parts engage in FOREX deals in their locations. FOREX traders make profits/losses by speculating whether a currency value would rise or fall in comparison to another currency in the near future.
A trader purchases the currency that is speculated to increase in value or sells the currency that is expected to fall in value as compared to another currency. The currency value is a reflection of the condition of that country’s economy against other economies. The foreign exchange market does not depend on any one economy but gains a value based on different economies and their economic conditions. Whether an economy grows or falls prey to recession, a FOREX trader could earn a profit by either buying or selling its currency.
Earlier, the FOREX market was dominated by commercial banks, portfolio managers, foreign exchange brokers, large organisations and few private traders. However, with advancement in technology and liberalisation of trade policies, the trend is changing and many individual traders are entering the FOREX market for speculation and profit making. There are several other reasons for participating in the FOREX market. These include facilitating commercial deals, diversifying portfolios for both big and small participants, etc.
Factors Affect the Fluctuation in Exchange Rate
The following factors affect the fluctuation in the exchange rate:
Foreign capital movements from one economy to the other are made for short periods to avail a high rate of interest. It is also made for long periods for the purpose of long-term investment in the foreign country. An export/import of capital from one country to the other, results in a change in the exchange rate.
For example, if a considerable amount of capital is moved from the US to India, the demand for INR (or the supply of USD) in the exchange market would increase in a way that the exchange value of INR with respect to USD would increase. Thus, INR would appreciate in value against USD. The opposite would be true in case there is a movement of capital from India to the US.
The pattern of imports or exports results in a change in the currency exchange rate. In case, imports exceed exports, the demand for foreign currency would rise. Therefore, the rate of exchange would move against the economy. On the other hand, if the exports are more than imports, the demand for domestic currency would increase and the rate of exchange would move in favour of the said economy.
Banks constitute major dealers of the foreign exchange market. They sell demand drafts, transfer funds, issue credit, accept foreign bills of exchange, carry out arbitrage operations, etc. These operations affect the demand for and supply of foreign exchange and thus exchange rates. Bank rates also have a significant impact on the rate of exchange. An increase in bank rate attracts foreign funds. This results in an increase in the demand for domestic currency and the rate of exchange goes up. The opposite is true in case the bank rate decreases.
Inflation and deflation affect the internal value of money. This reflects a similar change in the external value of money. Inflation refers to a rise in the domestic price level, fall in the purchasing power of money, and thus, a decrease in the exchange rate. On the other hand, deflation results in a fall in domestic prices and increase in the exchange rate.
Political conditions within a country have a significant and direct impact on the rate of its currency. This is because a favourable political condition attracts foreign capital. This in turn increases the foreign exchange rate. Political instability, on the contrary, results in a panic flight of capital from the domestic country. This results in depreciation of its value and consequently, a fall in the exchange rate of the domestic currency. In fact, the political conditions of a nation are also a strong factor both in exchange rate speculation and movement of foreign capital.
Stock Exchange Operations
These operations consist of the grant of loans, payment of interest on foreign loans, return of foreign capital, buying and selling foreign securities, etc. Stock exchange transactions affect the demand for foreign funds. This eventually affects the rate of exchange for foreign currency. If a loan is granted by the domestic country to a foreign country, the demand for foreign currency rises. In turn, the exchange rate tends to move against the domestic country. However, when foreign investors repay their loan, the demand for domestic currency exceeds its supply. This results in increase in the exchange rate.
These include transactions arising out of the expectation of cyclical changes in the rate of exchange. In times of political uncertainty, there is increased speculation in the foreign currency. Investors promptly buy certain currencies, while sell off certain currencies. These speculations bring about wide fluctuations in the exchange rates. There are various theories of determining the exchange rate. Let us discuss few of the most popular of them.
Fixed Exchange Rate System
In the fixed exchange rate system, the exchange rate is determined by the government of a country. This approach is used to ensure stability in foreign trade with smooth capital movement. To stabilise the exchange rate, the government makes transactions pertaining to the sales and purchase of foreign currency.
The government buys foreign currency when the exchange rate becomes weak and sells it when the rate of exchange gets strong. For making these transactions, the government is required to maintain large reserves of foreign currencies so that the exchange rate can be kept at the desired level.
It becomes important to discuss the Bretton Woods System while discussing the fixed exchange rate system. The Bretton Woods System was an exchange rate regime that succeeded the Classical Gold Standard. The Bretton Woods System is also called the ‘fixed exchange rate regime’. Bretton Woods derives its name from the site of the 1944 conference that formed IMF and IBRD, which are a part of the World Bank Group. The Bretton Woods System was formed to establish legal obligations with multilateral decision making with the help of an international organisation.
The Bretton Woods System came into existence due to the collapse of the Classical Gold Standard during the First World War and the Great Depression of the 1930s. At that time, the US had over half of the world’s manufacturing capacity and held most of the world’s gold. By the end of the Second World War, the US had emerged as the most powerful economy of the world. The policy makers of the US and other countries started reviewing the international monetary system to formulate new plans for the post Classical Gold Standard era.
Their aim was to create a monetary system that may integrate the economies of the world by allowing the countries to freely exchange their currencies. The policy makers of 44 nations held a conference in Bretton Woods to draft a new monetary system, called the Bretton Woods System, to replace the Classical Gold Standard system. The Bretton Woods System is also known as the dollar exchange standard.
The important objectives of the Bretton Woods System were to:
- Make the US dollar and the British pound international currencies so that other nations start keeping reserves of these currencies to settle international financial transactions.
- Allow nations to increase or decrease the value of their currencies by up to 10% against the dollar in case of unfavourable economic conditions but with the permission of the IMF.
- Lay emphasis on a fixed but adjustable exchange rate system. The extreme forms of the international monetary system, i.e. fully fixed and free floating exchange rates should not be followed.
- Allow free conversion of the US dollar into gold at a fixed value of $35 per ounce and the US was not allowed to change it.
- Establish the IMF and IBRD. The IMF helps member countries to overcome their balance of payment deficit and credit crisis. In return, member countries needed to follow the guidelines of the IMF. IBRD aimed to help the countries who suffered in the Second World War to gain stability and in economic development.
- Introduce a new measure called the system of capital control to protect the nations from capital flight. The IMF got its funds in the form of gold (25%) and currency of the respective country (75%) through the subscriptions of member countries.
The US dollar was having a direct exchange relation (pegging) with gold and if any other currency was pegged to the dollar, it meant that this currency was indirectly pegged to gold. For example: $35=1 ounce of gold which means that $1=1/35 ounce of gold; suppose $1= 40, then 40=1/35 ounce of gold, i.e. 1400= 1 ounce of gold. Each country was allowed to determine a par rate or an exchange rate between its currency and other currencies. Also, each currency was allowed to rise or fall by 1% of the par value by buying and selling of dollars and/ or gold.
The Bretton Woods System gave the US dollar the status of international money. Other countries started conducting all their financial transactions in terms of money. This arrangement worked till the time other countries had faith in the ability of the US monetary authorities to convert dollars into gold. However, the status of the US dollar as an international currency became a problem for countries due to the trade deficit in the US economy and rise in the price of gold.
On August 15, 1971, the monetary authorities of US stopped converting dollar into gold and abandoned the Bretton Woods System. With the failure of the Bretton Woods System, the world moved to an era of a new exchange rate regime called the flexible exchange rate system. In 1971, Japan, West Germany and the US withdrew from this system of fixed exchange rates as the efforts to maintain a fixed exchange rate were creating many local disturbances in the world economy. Thus, this system came to a halt. There were attempts to revive the system in 1973 but they failed miserably.
Following a system of fixed exchange rates is a difficult task as it involves the coordination of the monetary and fiscal policies of the members. The coordination is difficult to achieve as all countries today are independent. When the fixed exchange rate is followed, but there is no cooperation among the nations on monetary and fiscal policies, the exchange rate would not remain fixed, which means that the sole purpose of having such a system would not be fulfilled. After that, since 1973, countries are working on the basis of the managed float system.
Flexible (Floating) Exchange Rate System
The post Bretton Woods era of the exchange rate regime witnessed the rise of liberalisation in some parts of the world and significant growth in international trade. The flexible exchange rate regime allows the market forces of demand and supply to determine the exchange rate of different currencies.
The currency that uses the floating condition of exchange is called floating currency. The flexible exchange rate automatically adjusts the currency to the market conditions and helps the nation to avoid the balance of payment deficit. The central bank of a nation can also intervene to stabilise the condition of the excess increase or decrease in the exchange value of the currency
Floating Exchange Rate System is an exchange rate system in which exchange rates are determined by the forces of demand and supply. But the free-floating exchange rates can be achieved in two different ways. The difference is only based on one parameter, that is, government intervention. In one system, the government does not interfere at all. But, in the second system, the government takes part in the currency market or it can also affect the market by the use of some policy measures.
The two varieties of the floating exchange rate are:
Freely Floating Exchange Rate System
It is the system in which the exchange rate determination is left solely dependent on market forces. The government and the central bank do not themselves participate in the operations of the market. The only role that the government and the central bank of the concerned country play is to regulate and monitor the market so that no scams or frauds occur.
In reality, such a system is not possible but the US has adopted the system of minimum interference in the currency market; therefore, it is the only nation which is closest to being called as an economy that follows a freely floating exchange rate determination system. The primary disadvantage of adopting such a mechanism is that exchange rates are highly unpredictable. Therefore, it means that international transactions and trade become much more risky.
Managed Float System
Traditionally, international monetary economists remained focussed towards the fixed or a flexible exchange rate system. With the end of the Bretton Woods System, the concept of managed floating exchange rate was introduced and adopted by several countries. This system is known as the hybrid system of determining the exchange rate as it comprises the features of the fixed and floating systems.
Under the hybrid system, the determination of foreign exchange rate takes place by market forces. After that, the intervention by the central bank takes place in the foreign exchange market to restrict fluctuations in the exchange rate within the desired targeted value. For following this system, the central bank is required to maintain the reserves of foreign exchange so that buying and selling transactions can take place to stabilise the currency value. It is also known as dirty floating.
One more important concept need to be discussed is the partial and full convertibility of INR.
Capital and Current Account Convertibility
Convertibility of a currency refers to the freedom, for both residents and non-residents, to freely purchase, use and exchange currency for whatever purpose they desire. This means that there are no restrictions enforced on the convertibility or usage of the currency by the authorities of the country that has issued the currency.
Many of the developed countries like the US have their currency freely convertible for various purposes like international trade, financial investments, remittances, etc. The transactions that require convertibility of currency need not pertain only to exports and imports. A resident or a non-resident may like to purchase financial assets, make foreign direct investments, etc. If a currency is fully convertible, it should be possible to carry out any such transactions. However, the degree of convertibility varies across countries.
In some countries, there could be restrictions even for trade transactions or on the usage of foreign exchange proceeds. In other countries, there may not be any restrictions on export and import related transactions but convertibility for the purpose of investment activities could be restricted.
For the purpose of promotion of international trade, it is necessary that countries make their currencies convertible for at least trade and related transactions. However, free convertibility for such transactions might imply an implicit floating exchange rate arrangement. For developing countries, it may not be possible to allow free convertibility for trade transactions as it might be undesirable for them to allow exchange rates to be determined by market forces.
Such countries may not have sufficient foreign reserves to maintain a fixed exchange rate as well. Hence, the degree of convertibility varies across countries. At present, many countries have their currency fully convertible for trade-related transactions but not for the purchase or sale of financial assets. In other words, there are two types of currency convertibility: current account convertibility and capital account convertibility. Using BoP terminologies, we can differentiate these two types of convertibility.
Current account convertibility means that there are no restrictions imposed by the authorities for the following transactions:
- Merchandise exports and imports
- Export and import of service (or invisibles trade)
- Receipt and payment of income related to investments
All the above transactions form part of the current account segment of the BoP statement. If a country allows all the above transactions to be freely carried out between its residents and rest of the world, then the country’s currency is convertible under the current account.
Similarly, capital account convertibility means that there are no restrictions imposed by authorities for carrying out following transactions by its residents and non-residents:
- Foreign direct investments from abroad
- Direct investments by residents abroad
- Portfolio investments by residents and non-residents
- Short-term investments and loans
If a currency is fully convertible under the capital account, then any individual – whether resident or non-resident (i.e. both ways) – will be able to undertake any of the above transactions without any restrictions or a need for approval from any government authorities.
Various Methods of Exchange Rate Regimes
The member countries of the IMF have been classified into seven heads in accordance to the exchange rate regime they have adopted.
Following are various methods of exchange rate regimes:
It is the exchange rate regime in which a country pegs its currency to a basket of foreign currencies with a variation of ± 1% around the central parity. The government of a domestic nation decides the adjustment in the peg rate. There are 49 members in this regime out of which 44 follow the single currency system.
It is the arrangement in which the currency of a domestic nation is pegged against the foreign currency but is periodically adjusted for any kind of over-valuation or undervaluation. These adjustments may be declared in advance or made according to situations, such as inflation or recession. Therefore, it lies in between the fully-fixed and fully-floating systems of exchange rate determination. The advantage of this system is that it does not allow speculators to gain excessively. The disadvantage with this system is that small amounts of adjustments may not be able to correct over or under valuations.
Currency Board Method
It is the legislative commitment of the domestic nation to exchange its currency with a specific foreign currency at a fixed rate. The currency board method is followed by seven countries, in which donors have their independent monetary systems and policies.
Independently Floating Method
It is the exchange rate regime, which determines the exchange value of the domestic currency on the basis of the foreign exchange market. The monetary authority, that is, the central bank of the domestic nation does not manipulate the exchange rate but can control excess fluctuations in the currency. There are 26 countries that follow the independently floating method.
Managed Floating Method
It is the exchange rate regime that is determined by the intervention of the monetary authority of the domestic nation. In the managed floating method, the monetary authority of the domestic nation fixes the exchange value of the domestic currency. The central bank of the domestic nation can buy or sell foreign currency at any rate to adjust the exchange value of the domestic currency at the desired level. There are 53 countries that follow the managed floating method.
No Separate Legal Tender Method
It is the exchange rate regime in which the domestic nation either adopts a foreign currency as its legal tender (legally valid currency) or a group of countries forms a union to follow a particular currency, such as the euro. There are 41 countries that follow the no separate legal tender method.
Pegged With Band Method
It is the exchange rate regime in which the domestic currency is pegged against foreign currency but variation is allowed within limits. The limit is determined by the monetary authority of a country and is not influenced by market conditions