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  • Mrittunjoy Guha Majumdar

Intricacies of Foreign Exchange and India’s Recent Surge


An artist's impression of a medieval bazaar.


From the Byzantine bezant in the medieval ages [1] to the Gold Bullion standard in contemporary times [2], the historical evolution of currency dynamics and exchange rates has seen various forms over the centuries [3, 4]. Kollybistẻs or ‘money changers’ used to live between the Jordan River and the Mediterranean Sea in the times of the Talmudic writings [5]. Papyri PCZ I 59021 from around 260 BCE show that exchange of coinage used to take place in Ancient Egypt [6, 7]. In the 15th century, the famous Medici family opened banks in various places around the world that were given the Nostro accounts book, which kept accounts of local and foreign currencies [8], while Amsterdam maintained an active foreign exchange market in the 17th and 18th centuries [9, 10].


The modern golden standard came into use in 1880 [11-14]. At the end of 1913, almost half of the world's foreign exchange was conducted using the pound sterling [15, 16]. The Bretton Woods Accord was signed in 1944, allowing currencies to fluctuate within a range of ±1% from the currency's par exchange rate, thereby resulting in a free-floating currency system [17]. Due to the eventual ineffectiveness of the Bretton Woods Accord and the European Joint Float, there was a sterling crisis and turmoil in the foreign exchange markets in 1972-1973 [18]. In various nations, state control of foreign exchange trading ended in 1973 and completely floating and relatively free market conditions began, which remain till this day [19].


The modern foreign exchange market is a decentralized, global market for the trading of currencies, at current or determined prices [20]. It is the largest market in the world, with regards to trading volume, with international banks being the main participants in this market [21]. It is the most liquid financial market in the modern world [22]. Currencies are traded in pairs and therefore the foreign exchange market always determines the relative value of one currency with regard to others, and does not set a currency’s absolute value per se. The foreign exchange market helps and facilitates international trade and investments by enabling currency conversion. The foreign exchange market has a significant geographical dispersion, around-the-clock operation, low margins of relative profit as compared to other markets of fixed income and is also what A. J. C. Britton referred to as the ‘market approximates as closely as any to a perfect market’ [23]. As per the Bank for International Settlements, the preliminary global results from the 2019 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $6.6 trillion per day in April 2019, with $2 trillion in spot transactions, $1 trillion in outright forwards, $3.2 trillion in foreign exchange swaps and $108 billion in currency swaps [24, 25]. Today, the largest currency pairs traded are Euro-US Dollar, US Dollar-Yen and Pound-US Dollar.


Exchange rates are affected by myriad factors: inflation, interest rates, public debts, political stability and economic performance, terms of trade and current account deficit. Changes in market inflation influence in changes in currency exchange rates [26, 27]. A country with a lower inflation rate than another country’s sees an appreciation in the value of its currency. The prices of services and goods increase at a slower rate in the countries where the inflation is low. Low inflation rates, therefore, translate to rising currency values, while higher inflation leads to depreciation in a country’s currency and is accompanied by higher interest rates, which affect currency values. Interest rates have a close correlation with inflation and increase in interest rates causes a country’s currency to appreciate since higher interest rates provide higher rates to lenders and this in turn attracts more foreign capital, which causes exchange rates to rise [28, 29]. The balance of trade and earnings on foreign investment is reflected in the country’s current account, which consists of the total number of transactions including import, export and debt. If a country is spending more of its currency on importing products than earning through sale of exports, this causes a deficit in current account which in turn causes depreciation [30, 31].


Governments could also own public debt or national debt, which is regarded as government debt. If a country has a government debt, it is less likely to acquire foreign capital, which leads to inflation [32-34]. Foreign investors would rather sell their bonds in the open market if the market predicts government debt within a particular country. This will lead to a decrease in the value of its exchange rate. Also closely related to the current account and balance of payments are the terms of trade, which refer to the ratio of export prices to import prices [35, 36]. The terms of trade of a country improve when the price of its exports rise at a rate greater than import prices. This leads to higher revenues, which in turn causes higher demand for the country’s currency and thereby an increase in the value of the currency. This results in an appreciation of the exchange rate.


The state of a country, in terms of political stability and economic performance, can affect the strength of its currency [37]. Political economic theories highlight that a nation that lacks political stability has an incentive ceteris paribus to let its exchange rate float as it lacks the political ability and the support to defend the decisions associated with an exchange peg [38]. Moreover, where there is less risk of political turmoil, there is a greater chance that foreign investors shall invest therein more than where is an absence of political and/or economic stability [39-41]. Increase in foreign capital, in turn, leads to the appreciation in the value of the domestic currency. Any country that has sound trade and financial policies leave little room for uncertainty when it comes to the value of its currency [42], whereas a country prone to political upheaval and lack of sound economic policies may see a depreciation in exchange rates. The lack of resilient and robust economic policies is felt more acutely when a country experiences recession [43]. This can lead to interest rates falling and lower changes of acquiring foreign capital. As a result, the currency weakens in comparison to that of other nations, thereby lowering the exchange rate. Speculation technical trading and expectations can also lead to variations in foreign exchange [44-46]. If a country’s currency is expected to rise, investors shall demand more of the currency to make a profit in the near future. Therefore, the value of the currency will rise due to the increase in demand, and this in turn leads to a rise in exchange rate. Other major factors affecting foreign exchange include productivity and competitiveness in the market and economy of a nation [47]. Higher labor productivity leads to appreciation of the real exchange rate, with a recent study by Lee and Tang showing that this is due to the positive productivity effect being transmitted through the relative price between tradable goods [48].


Foreign exchange is primarily required for payment for import of goods and services, interest payments and repayment of overseas borrowing, speculative demand and investment overseas, among other avenues of demand for foreign exchange. Foreign exchange is usually obtained through channels such as that accruing from the receipt of exports of goods and services, receipt of both direct as well as portfolio foreign direct investment, grants and donations, speculative sources and receipt by way of interests. There are various kinds of products in the foreign exchange market: spot (transactions completed on the second working date after date of contract), outright forward (contracts entered where the exchange rate is fixed on date of contract but delivery is after two working days), forex swaps (contracts where first leg is spot and second leg is forward or both could be forward but exchange bits are fixed on date of contract, and such contracts are usually short term contracts), currency swaps (contracts that involve exchange of interest payments, and at times principal as well, that are denominated in different currencies, and usually for long terms, between 2 to 15 years) and currency option (contract that gives the buyer the right, but not obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date). Forex trading is mostly done over-the-counter (OTC), usually on a digital terminal like Eikon and Bloomberg, where market players quote rates and trades are concluded between parties. The ratio of exchange to OTC forex trading in Indian foreign exchange markets has increased from 2015-16 to 2018-19. As per a recent Bank of International Settlements (BIS) survey, the Indian Rupee market has most of the transactions happening via spot and forward contracts. An important aspect to consider in all this is the management of forex risk, which needs to be hedged, keeping in mind the ratio of relative currency depreciation to interest differentials.


With regards to Indian Rupee – US Dollar exchange rates, some of the primary factors that have influenced the variations in the rates are: trade balance, moderation in foreign investment flows, strengthening dollar, global crude oil prices and market expectations/sentiments. On the front of trade deficit, India has done tremendously well recently, with India's trade deficit having narrowed to USD 4.83 billion in July 2020 from USD 1343 billion in July 2019. This was since the imports plunged 28.40% with purchases down for coal, machinery, petroleum, organic and inorganic chemicals and electronic goods, even as exports declined as well, by 10.21%. The total FDI equity inflow to India in fiscal year 2020 was roughly $50 billion. In recent years, FDI has been growing, with India jumping from 12th position in 2018 to ninth in 2019 in the list of the world’s largest recipients of Foreign Direct Investment, although global FDI flows are forecast to decrease by up to 40% in 2020, from their 2019 value of $1.54 trillion as per United Nations Conference on Trade and Development (UNCTAD) – Ref : World Investment Report 2020 by UNCTAD.


On the other hand, the US Dollar Index (DXY) has slowly started to rebound from its 4-month downturn, on 21 August 2020, with the dollar increasing by 1.3% from $92.28 to $93.20. Recently, crude oil prices have also edged higher (to $46 per barrel mark) soon after the shutting down of most offshore outputs by US producers in the Gulf of Mexico. Global tensions, the COVID pandemic and weak domestic macros have been weighing down market sentiments in India. Consumer Price Index (CPI) data showed inflation for July 2020 stood at 6.93 per cent, even as the Indian Rupee fell to 74.90 against US dollar in the second week of August 2020, as data showed slow economic recovery and higher inflation dampened market sentiments.


Even with the complex interplay of all these factors, India’s foreign exchange reserves have recently jumped by a record $11.9 billion in the week ending July 31, taking it to a high of $534.5 billion, thereby taking it to the fifth position in terms of size of foreign exchange reserves in the world. This had a lot to do with Finance Minister Nirmala Sitharaman’s decision to cut corporate tax rates in September 2019, coupled with the government’s decision to reverse its budget decision related to higher surcharge impact on Foreign Portfolio Investment (FPI). This played an important role in turning the investors’ mood and drawing them to invest in the Indian markets and economy. Foreign exchange inflows into India through Foreign Direct Investment (that amounted to $5.9 billion in April and May 2020) and Foreign Portfolio Investment has been supported by a decline in the import bill over the last four to five months due to dips in crude prices in that period (Brent crude oil prices fell to $20 per barrel towards the end of March 2020 and further to between $9 and $20 in April 2020, in contrast to the price being $60 to $70 in January 2020) besides trade being impacted due to the COVID-19 pandemic. According to the Reserve Bank of India, FPIs pumped in a net $15.1 billion between April and December 2019.


As we move to a time when we must address the challenges thrown our way by the onset of the COVID pandemic, foreign exchange reserves can play a crucial role in helping us recover and stabilize the economic boat. Awareness of factors that affect and influence forex as well as the ground realities, as they stand, is a very important step in this regard. Hedging of risks is crucial on this front, even as India’s forex reserves surge in this critical period, ushering in an element of hope and positivity in an otherwise uncertain and tumultuous time.

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