Fixed Regime to Market Determined Floating Regime

During the period 1991 to 1995, India moved from a fixed exchange rate system to partial float exchange rate system to a free float or floating rate market determined exchange rate system.

In the fixed exchange regime, which India followed till 1991, the exchange rate was fixed by the RBI and was pegged to a basket of currency - US Dollars, Pound Sterling (UK), Deutsche Marks (Germany) and few other currencies.

After the Balance of Payment crisis in 1991, as part of the IMF's stabilization program, India moved to a partial float mechanism. As per this mechanism, the inward flow of foreign currency into the country by way of exports was converted into Rupee in the following ratio - 60% at a rate fixed by RBI which was around Rs.28 to a USD and the balance 40% at a market determined rate - which was generally higher at Rs.32 to a USD. However, anyone in India who wants to buy foreign currency for importing goods has to pay the market determined higher rate of Rs, 32 to a USD.

This partial float of the currency was later changed to fully floating or a market determined exchange rate system, where neither RBI nor the Government of India fixed the exchange rate and allowed the players in the market determine the exchange rate. So any foreign exchange that was brought into the country was converted at a rate determined by the market.

Historic Perspective on India's Forex Position

India's approach to foreign exchange reserve management, until the balance of payments crisis of 1991 was to maintain an appropriate level of reserves required for importing goods and services. It was defined in terms of number of months of imports equivalent of reserves.

For example, let us say India's import for a year was USD 36 billion and India had a foreign exchange reserve of USD 4.5 billion, then it was expressed as our reserves being the equivalent of one and a half months of imports. Emphasis on import cover constituted the primary concern to managing foreign exchange reserves till 1993-94.

The approach to reserve management underwent a paradigm shift in the mid 90s.

The relevant extracts are:

It has traditionally been the practice to view the level of desirable reserves as a percentage of the annual imports-say reserves to meet three months imports or four months imports. However, this approach would be inadequate when a large number of transactions and payment liabilities arise in areas other than import of commodities.

These started happening with the liberalization that led to foreign investors investing in Indian companies either through the Foreign Institutional Investor (FII) route (Morgan Stanleys of the world investing in Indian stock markets) or through Foreign Direct Investment (FDI) route (Enron investing in Dabhol Power Corporation!!). These were instance of foreign currency coming into the country. For each of these inflows, there will be a future outflow either when the FIIs repatriate their investments or the FDIs taking back profits of their investments.

In addition, liabilities may arise either for repaying loans or paying interest on loans. The new approach was aimed at determining the level of forex reserve, by paying attention to the loan repayment and interest payment obligations in addition to the level of imports.

In addition, with the opening up of the economy since the early 90s, the impact of changes in global currency markets is bound to affect Indian shores as well. Further, emphasis was placed on gaining the ability to take care of the seasonal factors in any balance of payments (foreign exchange inflows - foreign exchange outflows) transaction with reference to the possible uncertainties in the monsoon conditions of India and to counter speculative tendencies or anticipatory actions amongst players in the foreign exchange market.

Why hold forex reserves

Technically, it is possible to consider three motives

1. Transaction - International trade gives rise to currency flows, which are generally handled by private banks driven by the transaction.
2. Speculative - Individual or Corporates trade and invest in foreign currencies for gain.
3. Precautionary - Reserve Bank's reserves are characterized primarily as a last resort stock of foreign currency for unpredictable flows, which can classified as a precautionary motive

A list of objectives in broader terms may be encapsulated viz.,

1. Maintaining confidence in monetary and exchange rate policies - i.e the value of Rupee vis a vis major foreign currencies like the dollar, euro etc does not nosedive suddenly.
2. Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis including national disasters or emergencies;
3. Providing confidence to the markets especially credit rating agencies that external obligations (like borrowings from IMF, World Bank etc) can always be met.

Convertibility can be related as the extent to which a country's regulations allow free flow of money into and outside the country.

For instance, in the case of India till 1990, one had to get permission from the Government or RBI as the case may be to procure foreign currency, say US Dollars, for any purpose. Be it import of raw material, travel abroad, procuring books or paying fees for a ward who pursues higher studies abroad. Similarly, any exporter who exports goods or services and brings foreign currency into the country has to surrender the foreign exchange to RBI and get it converted at a rate pre-determined by RBI.

After liberalization began in 1991, the government eased the movement of foreign currency on trade account. I.e. exporters and importers were allowed to buy and sell foreign currency, as long as the items that they are exporting and importing were not in the banned list. They need not get permission on a CASE TO CASE basis as was prevalent in the earlier regime. This was the first concrete step the economy took towards making our currency convertible on trade account.

In the next two to three years, government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purposes like travel abroad, studying abroad, engaging the services of foreign consultants etc. This set the first step towards getting our currency convertible on the current account. What it means is that people are allowed to have access to foreign currency for buying a whole range of consumable products and services. These relaxations coincided with the liberalization on the industry and commerce front - which is why we have Honda City cars, Mars chocolate bars and Bacardi in India.

There was also simultaneous relaxation on the restriction on the funds that foreign investors can bring into India to invest in companies and the stock market in the country. This step led to partial convertibility on the Capital Account.

"Capital Account convertibility in its entirety would mean that any individual, be it Indian or foreigner will be allowed to bring in any amount of foreign currency into the country and take any amount of foreign currency out of the country without any restriction."

Indian companies were allowed to raise funds by way of equities (shares) or debts. The fancy terms like Global Depository Receipts (GDRs), Euro Convertible Bonds (ECBs), Foreign currency syndicated loans became household jargons of Indian investors. Listing in Nasdaq or NYSE became new found status symbols for Indian companies. However, Indian companies or individuals still had to get permission on a case to case basis for investing abroad.

In 2000, the forex policy was further relaxed that allowed companies to acquire other companies abroad without having to go through the rigmarole of getting permission on a case to case basis. Further, Indian debt based mutual funds were also allowed to invest in AAA rated government /corporate bonds abroad. This got further relaxed with Indians being allowed to hold a portion of their foreign exchange earnings as foreign currency, subject to a limit in the recent monetary policy in October 2002.

In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With India's forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts.

The last few steps as and when they happen will allow an individual to invest in Microsoft or Intel shares that are traded on Nasdaq or buy a beach resort on Bahamas without any restrictions.

Forex Reserves

The amount of foreign currency, SDRs and gold that are held by the Reserve Bank of India or the Central Bank of any country is known as the foreign exchange reserves of a country.

The foreign exchange reserves include three items; gold, SDRs and foreign currency assets. As of November, 2002 India has over US $ 65 billion of total reserves, foreign currency assets account the major share. Gold accounts for about US $ 3 billion. In July 1991, as a part of reserve management policy, and as a means of raising resources, the RBI temporarily pledged gold to raise loans. The gold holdings, thus have played a crucial role of reserve management at a time of external crisis. Since then, Gold has played passive role in reserve management.

The level of foreign exchange reserves has steadily increased from US$ 5.8 billion as at end-March, 1991 to US$ 54.1 billion as at end-March 2002 and further to US$ 65 billion as of November, 2002. The traditional measure of trade based indicator of reserve adequacy, i.e., the import cover (defined as the twelve times the ratio of reserves to merchandise imports ) which shrank to 3 weeks of imports by the end of December 1990, has improved to about 11.5 months as at end-March 2002.

The debt-based indicators of reserve adequacy show remarkable improvement in the 1990s. The proportion of short term debt (i.e., debt obligations with an original maturity up to one year) to foreign exchange reserves has substantially declined from 147 per cent as at end-March 1991 to 8 per cent as at end-March 2001. i.e. most of the foreign exchange reserves that we have right now have a repayment obligation that exceeds three years - which reflects a higher quality of reserves.