Foreign Exchange Management

Unit 1

Introduction to Foreign Exchange Management

1.1 Foreign Exchange Management

1.2 Foreign Currency Accounts.
1.3 Fixed and Floating exchange rate.
1.4 Exchange rate system prior to IMF and Exchange rate system under IMF.
1.5 Functions of IMF
1.6 Convertibility of Rupee.
1.7 Balance of payments- Meaning, Definition and features, Importance,
Types, Components.
1.8 World Bank – Meaning, Definition objectives, functions, Differences
between IMF and World Bank, Merits and demerits.
1.9 Foreign Exchange markets - Meaning, Definition, features, Factors ,
Functions, Advantages and Disadvantages
1.10 Spot exchange rates – Meaning , Definition , Features , Factors, Functions
1.11 Merits and Demerits of spot exchange rates.

1.1 Introduction

Foreign Exchange Management Act (FEMA) is an act which aims to liberalize

the foreign exchange market in India and provide a framework for the
management of foreign exchange transactions for trade, payments, and other
business activities.

The act also defines certain offenses, such as contraventions of foreign

exchange regulations, and provides for penalties and fines. The act also

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provides for the creation of an appellate tribunal to hear appeals against the
decisions of the enforcement directorate.

History

The Foreign Exchange Management Act (FEMA) was enacted in India in 1999,
replacing the Foreign Exchange Regulation Act (FERA) which was in effect from
1973. FERA was enacted during a time of severe foreign exchange shortage in
India. FERA imposed strict regulations on various foreign exchange
transactions, and also imposed penalties for non-compliance.

However, as India's economy began to liberalize in the 1990s, the government

recognized that FERA's strict regulations were hindering economic growth and
investment. In 1998, the government set up a committee to review FERA and
recommended changes to the law and the enactment of a new law, which
became the Foreign Exchange Management Act (FEMA).

Main Features of Foreign Exchange Management

1. It gives powers to the Central Government to regulate the flow of

payments to and from a person situated outside the country.
2. All financial transactions concerning foreign securities or exchange
cannot be carried out without the approval of FEMA. All transactions
must be carried out through “Authorised Persons.”
3. In the general interest of the public, the Government of India can restrict
an authorized individual from carrying out foreign exchange deals within
the current account.
4. Empowers RBI to place restrictions on transactions from capital Account
even if it is carried out via an authorized individual.

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5. As per this act, Indians residing in India, have the permission to conduct a
foreign exchange, foreign security transactions or the right to hold or
own immovable property in a foreign country in case security, property,
or currency was acquired, or owned when the individual was based
outside of the country, or when they inherit the property from individual
staying outside the country.

Objective of FEMA

The main objective of FEMA was to help facilitate external trade and payments
in India; but also has following secondary objectives: -

1. To help orderly development and maintenance of foreign exchange

market in India.
2. To facilitate transactions involving foreign exchange or foreign security
and payments from outside the country to India only through an
authorised person.
3. To encourage dealings in foreign exchange under the current account
through an authorised person and to keep restrictions with the help of
Central Government based on public interest.
4. To authorise Reserve Bank of India to subject the capital account
transactions to a number of restrictions.
5. To carry out transactions in foreign exchange by residents of India,
foreign security or to own or hold immovable property abroad if the
currency, security or property was owned or acquired when resident
was living outside India, or when it was inherited by that resident from
someone living outside India.

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Scope of FEMA (the foreign exchange management)

The scope of FEMA envisages applicability of FEM to:

1. Foreign Exchange in India

2. Imports of Goods and Services from Outside India To India

3. Exports of Any Foods and Services from India To Outside

4. Foreign Currency i.e., Any Currency other than Indian Currency Securities as
defined in The Public Debt Act 1994

5.Foreign Security Any Overseas Company that is Owned 60% Or More By An

NRI (Non-Resident Indian)sale, Purchase, and Exchange of Any Kind (i.e.
Transfer) of property in India or outside India by Any Citizen of India whether
residing in the country or outside (NRI)

6. Foreign banking and finance related activities (Current Account

Transactions, Capital Account Transactions etc.)

Fundamental Principle

The Foreign Exchange Management Act (FEM) aims to regulate the foreign
trade in the country and promote economic growth. Some of the fundamental
principles of the act include

1. Simplification of regulations − The act simplifies the regulations

governing foreign exchange transactions in India, making them more
conducive to the country's economic development.
2. Liberalized regime − The act provides a liberalized regime for foreign
exchange transactions, allowing for greater flexibility in the use of
foreign exchange resources.
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3. Promotion of external trade and payments − The act aims to facilitate

external trade and payments and promote the proper growth of the
foreign exchange market.
4. Encouragement of foreign investment − The act aims to encourage
foreign investment in India by providing a more predictable and
transparent regulatory framework.
5. Compliance and enforcement − The act provides for compliance and
enforcement mechanisms to ensure that foreign exchange regulations
are followed, including penalties for non-compliance.
6. Appellate Tribunal The act provides for the creation of an appellate
tribunal to hear appeals against the decisions of the enforcement
directorate.

Rules and Regulations under FEM

1. The Foreign Exchange Management (FEM) - lays down the regulations

and rules for various foreign exchange transactions and activities in
India. As per FEMA there are two types of foreign transactions. These
are
a. Current Account Transactions − These transactions include trade-related
transactions, invisibles such as software services and remittances, and
other transactions that do not result in a change in foreign exchange
assets.
b. Capital Account Transactions − These transactions include foreign
investments, external commercial borrowings and foreign currency
loans, and other transactions that result in a change in foreign exchange
assets.

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Some of the key regulations and rules under the act that guides the foreign
transaction include

1. Foreign Exchange Management (Current Account Transactions) Rule,

2000 − These rules provide the procedures for various current account
transactions including imports, exports, and foreign remittances.
2. Foreign Exchange Management (Capital Account Transactions)
Regulations, 2000 − These regulations provide the procedures for
various capital account transactions including foreign investments and
external commercial borrowings.
3. Foreign Exchange Management (Transfer or Issue of Security by a
Person Resident outside India) Regulations, 2000 − These regulations
provide the procedures for transfer or issue of securities by a person
resident outside India.
4. Foreign Exchange Management (Acquisition and Transfer of
Immovable Property in India) Regulations, 2000 − These regulations
provide the procedures for acquisition and transfer of immovable
property in India by a person resident outside India.

FEM Act’s Applicability

FEMA (Foreign Exchange Management ) applies to the entire country of India

as well as agencies and offices operating outside of India (which are owned or
managed by an Indian Citizen). The Enforcement Directorate, FEM’s
headquarters, is located in New Delhi.

The Foreign Exchange Management Act (FEM) is responsible for:

1. Foreign currency exchange.

2. Foreign security.

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3. Any commodity and/or service exported from India to a country outside

of India.
4. Importation of any product or service from a country other than India.
5. Securities in the sense of the Public Debt Act, 1994.
6. Any form of purchase, sale, or exchange (i.e. Transfer).
7. Banking, financial, and insurance services are all available.
8. Any NRI (Non-Resident Indian) who owns 60% or more of a company in
another country.
9. Any Indian citizen, whether residing inside or outside the nation (NRI).
1.2 Foreign Currency Accounts

Foreign Currency Account (FCA) is a transactional account denominated in a

currency other than the home currency and can be maintained by a bank in the
home country (onshore) or a bank in another country (offshore).

Types of Foreign Currency Accounts

1. Nostro Account:
In Latin, ‘Nostro’ means “our account with you”. Nostro account is the account
maintained by an Indian bank with an overseas/foreign bank. For example,
PNB may maintain an account with Citibank, New York. The account would be
in the host country’s currency, i.e., in US dollar. All foreign exchange
transactions are routed through Nostro accounts by Indian Bank.

2. Vostro Account:
In Latin, ‘Vostro’ means “your account with us”. A foreign bank, say Citibank,
New-York, may open Rupee account with State Bank of India. The account
would be maintained in home currency where account is opened, i.e., Indian
Rupees.

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3. Loro Account:
Loro account’ word stands for ‘Their account with you’, in Latin. Say, State
Bank of India is maintaining an account with Citibank, New York. When
Syndicate Bank of India likes to refer this account during the course of
correspondence with Citibank, it would refer to it as ‘Loro Account’.

1.3. Fixed and floating exchange rate

Fixed exchange rate

A fixed exchange rate is a system in which the government tries to

maintain the value of its currency. In other words, the government or central
bank tries to maintain its currency’s value in relation to another currency. The
government may also try to maintain its currency’s value in relation to a basket
of currencies. If the currency’s value changes too much, the government or
central bank intervenes.

The term ‘fixed exchange rate’ may also refer to a currency whose value
closely follows that of gold or silver.

Definition:

A fixed exchange rate is an exchange rate system in which the rate of a

country's currency is established at a particular level in relation to other
currencies.

Advantages of fixed exchange rates

 Certainty - with a fixed exchange rate, firms will always know the
exchange rate and this makes trade and investment less risky.

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 Absence of speculation - with a fixed exchange rate, there will be no

speculation if people believe that the rate will stay fixed with no
revaluation or devaluation.
 Constraint on government policy - if the exchange rate is fixed, then the
government may be unable to pursue extreme or irresponsible macro-
economic policies as these would cause a run on the foreign exchange
reserves and this would be unsustainable in the medium-term.

Disadvantages of fixed exchange rates

 The economy may be unable to respond to shocks - a fixed exchange

rate means that there may be no mechanism for the government to
respond rapidly to balance of payments crises.
 Problems with reserves - fixed exchange rate systems require large
foreign exchange reserves and there can be international liquidity
problems as a result.
 Speculation - if foreign exchange markets believe that there may be a
revaluation or devaluation, then there may be a run of speculation.
Fighting this may cost the government significantly in terms of their
foreign exchange reserves.
 Deflation - if countries with balance of payments deficits deflate their
economies to try to correct the deficits, this will reduce the surpluses of
other countries as well as deflating their own economies to restore their
surpluses. This may give the system a deflationary bias.
 Policy conflicts - the fixed exchange rate may not be compatible with
other economic targets for growth, inflation and unemployment and this
may cause conflicts of policies. This is especially true if the exchange rate
is fixed at a level that is either too high or too low.

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Floating exchange rate

A floating exchange rate is an exchange rate system where a country’s

currency price is determined by the foreign exchange market, depending on
the relative supply and demand of other currencies. A floating exchange rate is
not restrained by trade limits or government controls, unlike a fixed exchange
rate.

 A floating exchange rate refers to an exchange rate system where a country’s

currency price is determined by the relative supply and demand of other
currencies.
 Currencies with floating exchange rates can be traded without any restrictions,
unlike currencies with fixed exchange rates.
 Although the floating exchange rate is not entirely determined by the
government and central banks, they can intervene to keep the currency at a
favourable price for global trade.

Benefits of a Floating Exchange Rate

1. Stability in the balance of payments (BOP)

A balance of payments is in the statement of transactions between entities of a

country and the entities of the rest of the world over a time period. In theory,
any imbalance in that statement automatically changes the exchange rate.

For example, if the imbalance is a deficit, it would cause the currency to

depreciate. The country’s exports would become cheaper, resulting in an
increase in demand and eventually attaining equilibrium in the BOP.

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2. Foreign exchange is unrestricted

Floating exchange rate currencies can be traded without any restrictions,

unlike currencies with fixed exchange rates. Hence, governments and banks do
not need to resort to a continuous management process.

3. Market efficiency enhances

A country’s macroeconomic fundamentals affect the floating exchange

rate in global markets, influencing the flow of portfolios between countries.
Thus, floating exchange rates enhance the efficiency of the market.

4. Large foreign exchange reserves not required

For a floating exchange rate, central banks are not required to keep large
foreign currency reserve amounts for defending the exchange rate. Hence, the
reserves can be utilized for promoting economic growth by importing capital
goods.

5. Import inflation protected

Countries with fixed exchange rates face the problem of importing inflation
through surpluses of the balance of payments or higher prices of imports.
However, countries with floating exchange rates do not face such a problem.

Limitations of a Floating Exchange Rate

1. Exposed to the volatility of the exchange rate

Floating exchange rates are prone to fluctuations and are highly volatile by
nature. A currency value against another currency may deteriorate only in one

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trading day. Furthermore, the short-term volatility in a floating exchange rate

cannot be explained through macroeconomic fundamentals.

2. Restricted economic growth or recovery

The lack of control over floating exchange rates can limit economic growth or
recovery. The negative currency exchange rate movements may lead to serious
issues. For example, if the dollar rises against the euro, it will be more difficult
to export to the euro zone from the U.S.

3. Existing issues may worsen

If a country is suffering from economic issues, such as unemployment or

high inflation, floating exchange rates may intensify the existing problems. For
example, depreciation of a country’s currency already suffering from high
inflation will cause inflation to increase further due to an increase in demand
for goods. Moreover, expensive imports may worsen the country’s current
account.

Difference between Fixed and Floating Rates

Fixed Exchange Rates Floating Exchange Rates

It ensures stability in exchange rate Deficit or surplus in Balance of

which encourages foreign trade. Payment is automatically corrected

A fixed exchange rate ensures that

major economic disturbances do There is no need for the government
not occur. to hold any foreign exchange reserve

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It prevents capital outflow &

speculation in foreign exchange It helps in optimum resource
market. allocation

Fixed exchange rates are more

conducive to expansion of world
trade because it prevents risk and It frees the government from the
uncertainty in transactions problem of balance of payment.

1.4 Exchange rate system prior to IMF

International Monetary Fund came into existence on 27th December 1945

and has its headquarters located in Washington DC, United States. It has 190
countries as its members as of December 2022. Its board is constituted of
members from as many as more than 180 countries worldwide, thus each
representing its own nation. Such representation is congruent to the level of
importance a particular nation holds as regards to its financial position in the
world.
The major idea underlying the setting up of IMF is to evolve an orderly
international monetary system, thereby facilitating a system of international
payments and adjustments in exchange rates among national currencies.
Furthermore, its policies and practices aimed at bringing down the global
poverty rate and promoting international trade, thus supporting the
economies worldwide.

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Objectives of International Monetary Fund (IMF)

 International Monetary Cooperation:
The most important objective of the IMF was to establish monetary
cooperation among the various member countries. One of the major
causes of the Second World War was the absence of monetary
cooperation amongst the countries of the world. Hence it was considered
necessary to establish international monetary cooperation to prevent the
outbreak of war in future.
 To Ensure Stability in Foreign Exchange Rates:
There was a lot of instability in foreign exchange rates before the
Second World War, which produced adverse repercussions on
international trade. So, IMF was established to eliminate this instability of
foreign exchange.
 To Eliminate Exchange Control:
Every country has resorted to exchange control as a device to fix its
exchange rate at a particular level before the Second World War, which
produced adverse effects on international trade. So IMF came up to
remove or relax these exchange controls.
 To Promote International Trade:
Another important objective of the IMF was to promote international
trade by removing all the obstacles and hindrances, which had the effect
of restricting it.
 To Promote Investment of Capital in Backward and Underdeveloped
Countries:
IMF exports capital from the richer to the poorer countries so that the
poor countries can develop their economic resources for achieving a
higher standard of living.

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 To Eliminate or Reduce the Disequilibrium in the Balance of Payments:

IMF helps to reduce the disequilibrium in the balance of payments by
selling or lending foreign currencies to the member nations.

Functions of International Monetary Fund

The functions of the International Monetary Fund are as follows:

 Stability in Foreign Exchange Rate:

IMF helps to achieve stability in foreign exchange rates. The rates of
exchange under the IMF had not fluctuated as much as they used to before
the establishment of the IMF.
 Currency Reservoir:
IMF serves as a repository for all of the member countries’ currencies, from
which a borrowing nation may borrow funds from other countries. All
member countries can park their surplus funds with the IMF. These parked
funds are then utilized to extend credit to the members, which need funds
the most at a given point of time.
 Advisory and Technical Assistance:
IMF helps its member countries through its policy advice and technical
assistance in formulating sound policies and building strong institutions.
 Support for Low-Income Countries:
IMF provided help to its low-income members with policy advice, technical
assistance and loans for poverty reduction and reducing the debt burden.
 Establishment of a Monetary Reserve Fund:
IMF helps to establish monetary reserve by accumulating a sizeable stock of
the national currencies of different countries. It is out of this stock that the
Fund meets the foreign exchange requirements of the member countries.

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 Setting up of a Multilateral Trade and Payment System:

IMF helps to set up multilateral trade and payment system. Member
countries were allowed to impose exchange control on commercial
transactions, but it was hoped that these restrictions on foreign trade would
be eliminated.
 Check on Competitive Currency Devaluation:
For boosting exports, different countries of the world would often resort to
competitive currency devaluation before the establishment of the IMF. IMF
helps to keep a check on competitive currency devaluation.

Responsibilities of the International Monetary Fund:

i. Promoting international monetary cooperation

ii. Facilitating the expansion and balanced growth of international trade

iii. Promoting exchange stability

iv. Assisting in the establishment of a multilateral system of payments.

v. Making its resources available, under adequate safeguards to members

experiencing balance of payments difficulties. The Fund seeks to promote
economic stability and prevent crises; to help resolve crises when they do
occur, and to promote growth and alleviate poverty. To meet these objectives,
it employs three main functions, as discussed here.

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1.5 Convertibility of Rupee

Meaning
Convertibility of currency means when currency of a country can be freely
converted into foreign exchange at market determined rate of exchange that
is, exchange rate as determined by demand for and supply of a currency.
For example, convertibility of rupee means that those who have foreign
exchange (e.g. US dollars, Pound Sterlings etc.) can get them converted into
rupees and vice-versa at the market determined rate of exchange. Rupee is
both convertible on capital account and current account.
What is a current account?
It means all exports and imports of merchandise and invisible (like services
etc).
What is a capital account?
By capital account convertibility we mean that in respect of capital flows
(that is, flows of portfolio capital, direct investment flows, flows of borrowed
funds and dividends and interest payable on them) a currency is freely
convertible into foreign exchange and vice-versa at market determined
exchange rate.

Advantages of Currency Convertibility

1. Encouragement to exports:

Market rate remains generally higher than the officially determined exchange
rate. This implies that from given exports, exporter can get more rupee against
foreign exchange. This will help to increase exports.

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2. Encourages import substitution:

Imports become expensive due to convertibility of rupee. So it discourages
imports and boosts import substitution.

3. Incentive to remittances from abroad:

Earlier, NRIs used to send money illegally to India such as Hawala money and
gold etc. But due to removal of restrictions, NRIs can easily remit money to
India. It will help to improve Balance of payment.
4. Reduction in Malpractices:
The malpractices like under-invoicing of exports may not arise as rupee is fully
convertible and they will get full value for their exports
5. A self – balancing mechanism:
Another important merit of currency convertibility lies in its self-balancing
mechanism. When balance of payments is in deficit due to over-valued
exchange rate, under currency convertibility, the currency of the country
depreciates which gives boost to exports by lowering their prices on the one
hand and discourages imports by raising their prices on the other. In this way,
deficit in balance of payments get automatically corrected without
intervention by the Government or its Central bank. The opposite happens
when balance of payments is in surplus due to the under-valued exchange
rate.
Current Account Convertibility of Rupee:
This is the next phase for attaining full convertibility of rupee. The removal of
restrictions on payments relating to the international exchange of goals,
services and factor incomes, while capital account convertibility refers to a
similar liberalization of a country’s capital transactions such as loans and
investment, both short term and long term.

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Current account convertibility has been defined as the freedom to buy or sell
foreign exchange for the following international transactions:
(a) All payments due in connection with foreign trade, other current business,
including services and normal short term banking and credit facilities;
(b) Payments due as interest on loans and as net income from other
investments;
(c) Payments of moderate amount of amortization of loans or for depreciation
of direct investment; and
(d) Moderate remittances for family living expenses.
Capital Account Convertibility of Rupee:
This refers to a liberalization of a country’s capital transactions such as loans
and investment, both short term and long term as well as speculative capital
flows. In a way, capital account convertibility removes all the restrains on
international flows on India’s capital account.
Advantages of capital account convertibility
1. Unrestricted mobility of Capital:
Capital account convertibility allows free mobility of Capital into a country
from the foreign investors. It allows converting the foreign exchange brought
into as Capital to convert into rupees at market determined rates, which makes
the investors encouraging. It allows the foreign investors to easily move in and
move out from an economy. This enables the domestic companies to raise
funds from abroad.
2. Ability to invest in abroad easily:
Capital account convertibility allows the individuals of a nation to invest in
abroad by easily converting their rupees into foreign exchange at the rates
determined by the Market. This enables those potential domestic investors to
acquire & own the assets in abroad.

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3. Improved access to global financial markets:

One can easily invest in the equity and debt markets of another economies
alongside a reduction in the cost of capital
Disadvantages of capital account convertibility
1. Easier access to Hawala money:
As it allows converting any foreign receipt into Indian rupees at market
determined rates there may be chance that domestic economy will be flooded
with foreign exchange which in long run may damage the financial health of an
economy.
2. High volatility of markets:
During the times when the financial markets of an economy are doing good , a
country may receive huge foreign investment. But during the adverse times
the reverse scenario may happen. For example when the federal reserve Bank
of America gave a sign that they are going increase the interest rates the
foreign Institutional investors who invested their dollars in Indian stock market
had withdrawn their investment from India which adversely impacted the
rupee value.
1.6 Balance of payment

Meaning

The balance of payments (BOP) is like a country's financial report card, tracking
its international transactions over time. It shows how much a nation earns,
spends, and invests globally through three main components: current, capital,
and financial accounts.

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Definition

The balance of payments is a comprehensive and systematic record of a

country's economic transactions with the rest of the world, encompassing
goods, services, and capital flows within a specified time frame. It comprises
the current, capital, and financial accounts, each reflecting different types of
transactions.
Features of Balance of payment:
1. It is a systematic record of all economic transactions between one country
and the rest of the world.

2. It includes all transactions, visible as well as invisible.

3. It relates to a period of time. Generally, it is an annual statement.

4. It adopts a double-entry book-keeping system. It has two sides: credit side

and debit side. Receipts are recorded on the credit side and payments on the
debit side.
Importance of Balance Of Payments
1. BOP records all the transactions that create demand for and supply of a
currency.

2. Judge economic and financial status of a country in the short-term.

3. BOP may confirm trend in economy’s international trade and exchange rate
of the currency. This may also indicate change or reversal in the trend.

4. This may indicate policy shift of the monetary authority (RBI) of the country.

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Components of Balance of payments:

BoP can be classified as:

1. Current Account
Current Account refers to the account, which records all the transactions that
relate to the actual receipts and payments of the visible items, invisible items,
and unilateral transfers during a specific period of time. It is a statement that
records the trade of goods & services and current transfers during a specific
period. In simple words, the current account focuses on the transactions
related to tangible items(goods), intangible items( services), and one-sided
transfers(gifts and grants).
Components of Current Account
It can be further categorized into:
1. Export and Import of Goods (Visible Trade or Merchandise Transactions)
Transactions in foreign trade mostly include the export and import of goods or
visible items. Payment for the import of visible items or goods is recorded on

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the debit side and receipt from exports of visible items is recorded on the
credit side of the Balance of Payment Account. The balance of the visible
export and imports of goods is called Balance of Trade or Trade Balance.
2. Export and Import of Services (Invisible Trade)
It is also known as Invisible Trade because the services being intangible can
not be spotted moving across the border.
For example, insurance and banking. The balance of the invisible items
(exports – imports) is known as the Balance of Invisible Trade. The payments
of services are recorded on the debit side and receipts on the credit side of the
Balance of Payment Account. Services can be categorized into three parts; viz.,
Banking, Insurance, and Shipping.
3. Unilateral or Unrequited Transfers to and from abroad (One-sided
Transactions)
These transfers occur between a resident and a non-resident in the form of
gifts, grants, and donations. It also includes official transfers, like grants in cash
and donations. These are one-sided transactions and are commonly named
transfers for free. These are payments and receipts that occur without
receiving any in-kind services. It is generally considered as a part of ‘invisible’ in
the BoP account. The receipt of unilateral transfers from the rest of the world
is recorded on the credit side and payments on the debit side of BoP.
4. Income receipts and payments to and from abroad
It involves investment income in the form of rent, profits, and interest.
Balance on Current Account

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2. Capital Account
It comprises all the transactions, which has a direct or indirect impact on the
assets and liabilities of the country or government with regard to the outside
world. Under this, transactions like loans and investments are recorded among
a country and the outside world. Thus, it can be concluded that capital
accounts cause potential claims. Sometimes, there is confusion regarding
whether the export and import of capital goods are to be included in the
Capital account or not. But the answer to this question is ‘No’. It is so because
the export and import of goods (whether capital or consumer) are included in
the current account. Thus, it is irrelevant in the case of the capital account. In
simple terms, a capital account includes those transactions, which cause a
change in the assets or liabilities of a country’s residents or its government.

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Types of Balances

1. Trade Balance

Merchandise: exports - imports of goods

Services: exports - imports of services

2. Income Balance

Net investment income: net income receipts from assets

Net international compensation to employees: net compensation of

Employees

3. Net Unilateral Transfers

Gifts from foreign countries minus gifts to foreign countries

Components of Capital Account
1. Borrowings and Lending’s to and from abroad
The capital account consists of all the transactions related to borrowings from
abroad by the government, private sector, etc. The receipts and repayments of
such loans are recorded on the credit side of the BoP. Similarly, all the
transactions related to ‘lending to abroad’ by the government and private
sector is included in the capital account. These transactions are recorded on
the debit side of the BoP.
2. Investments to and from abroad
The second component of the Capital Account consists of all the investments
by the rest of the world in shares of Indian companies, real estate, etc. These
transactions from the rest of the world are recorded on the credit side of BoP,
as these transactions bring foreign exchange to the country. Besides, it also
includes all the investments made by Indian residents in shares of foreign

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companies, real estate abroad, etc. These transactions are recorded on the
debit side of the BoP, as they result in the outflow of foreign exchange.
There are two types of investments to and from abroad:
1. Foreign Direct Investment: FDI consists of the purchase of an asset,
which gives direct control to the buyer over the asset.
For example, purchase of land, building, etc.
2. Portfolio Investment: It consists of the purchase of an asset that does
not give any direct control over the asset to the purchaser.
For example, purchase of shares. Portfolio Investment also consists of FII
(Foreign Institutional Investment).
3. Change in Foreign Exchange Reserves
The financial assets of the government held in the central bank are known as
the Foreign Exchange Reserves. If there is a change in the reserves, it serves as
the financing item in India’s BoP. Hence, any withdrawal from the reserves is
recorded on the credit side of BoP, and any addition to these reserves is
recorded on the debit side of BoP. Also, any change in the reserve is recorded
in the BoP account and not in ‘Reserves’.
Balance of Capital Account

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Balance of Trade

The difference between a country's imports and its exports. Balance of trade is
the largest component of a country's balance of payments.

Debit items include imports, foreign aid, domestic spending abroad and
domestic investments abroad.

Credit items include exports, foreign spending in the domestic economy and
foreign investments in the domestic economy.

When exports are greater than imports than the BOT is favourable and if
imports are greater than exports then it is unfavourable.

Difference between Balance of Payments and Balance of Trade

1. It is a broad term. 1. It is a narrow term.

2. It includes all transactions related 2. It includes only visible items.
to visible, invisible and capital
transfers.

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3. It is always balances itself. 3. It can be favourable or

unfavourable.
4. BOP = Current Account + Capital 4. BOT = Net Earning on Export - Net
Account + or - Balancing item (Errors payment for imports.
and omissions)
5. Following are main factors which 5. Following are main factors which
affect BOP affect BOT
a) Conditions of foreign lenders. a) cost of production
b) Economic policy of Govt. b) availability of raw materials
c) all the factors of BOT c) Exchange rate
d) Prices of goods manufactured at
home

1.7 World Bank Group

The World Bank provides funding, advice and other resources to developing
countries in education, public security, health and other necessary areas.
Countries, organizations and other institutions often work with the World Bank
to sponsor development projects.
World Bank is an international financial institution that is globally known. It
was established at the 1944 Bretton Woods Conference, along with the
International Monetary Fund (IMF). Both IMF and the World Bank work in
tandem. The World Bank provides loans and grants to low and middle-income
countries for various projects.

Functions of the World Bank

 It helps the war-devasted countries by granting those loans for

reconstruction.

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 Thus, they provide extensive experience and the financial resources of the
bank help the poor countries increase their economic growth, reducing
poverty and a better standard of living.

 Also, it helps the underdeveloped countries by granting development loans.

 So, it also provides loans to various governments for irrigation, agriculture,

water supply, health, education, etc.

 It promotes foreign investments to other organizations by guaranteeing

the loans.

 Also, the World Bank provides economic, monetary, and technical advice
to the member countries for any of their projects.

 Thus, it encourages the development of of-industries in underdeveloped

countries by introducing the various economic reforms.

Objectives of the World Bank

 This includes providing long term capital to its member nations for
economic development and reconstruction.

 Thus, it helps in inducing long term capital for improving the balance of
payments and thereby balancing international trade.

 Also, it helps by providing guarantees against loans granted to large and

small units and other projects for the member nations.

 So, it ensures that the development projects are implemented. Thus, it

brings a sense of transparency for a nation from war-time to a peaceful
economy.

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 Also, it promotes the capital investment for member nations by providing a

guarantee for capital investment and loans.

 So, if the capital investment is not available than it provides the guarantee
and then IBRD provides loans for promotional activities on specific
conditions.

Purposes of the World Bank

 It wants to create an environment that is a pro-investment.

 Also, it wants to improve the omic stability by reducing poverty.
 So, it is working towards achieving sustainable growth.
 Increasing the opportunities for jobs and business in member nations
which are underdeveloped.
 Through investment, it plans to promote the socio-economic status of the
society.
 Also, it wants to ensure that the judicial and legal systems are developed
and individual rights are protected.
 Strengthen the government of its member nations by promoting education.
 Combating corruption and to ensure that there are adequate training
opportunities and research facilities.
 It wants to provide loans with low-interest rates and interest-free credits.
Branches of World Bank Group
 International Bank for Reconstruction and Development (IBRD)
 International Development Association (IDA)
 International Finance Corporation (IFC)
 Multilateral Investment Guarantee Agency (MIGA)
 International Centre for Settlement of Investment Disputes (ICSID)

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Difference between IMF and World Bank

World Bank IMF

An international bank that

A financial institution that oversees
Meaning provides funding to emerging
the global monetary system.
nations.

Founded in 1944 but started

Founded December 27, 1945
working in 1946.

To remove poverty in developing To solve the global financial and

Purpose
countries. macroeconomics issues.

Promoting economic growth Maintaining financial stability in the

Focus
through lending. world.

Size 7000 staff members 2300 members

Member
189 190
nations

1.8 Foreign Exchange markets

The foreign exchange market is over a counter (OTC) global marketplace that
determines the exchange rate for currencies around the world. This foreign
exchange market is also known as Forex, FX, or even the currency market. The
participants engaged in this market are able to buy, sell, exchange, and
speculate on the currencies.
These foreign exchange markets are consisting of banks, forex dealers,
commercial companies, central banks, investment management firms, hedge

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funds, retail forex dealers, and investors. In our prevailing section, we will
widen our discussion on the ‘Foreign Exchange Market’.
The Major Foreign Exchange Markets −

 Spot Markets

 Forward Markets

 Future Markets

 Option Markets

 Swaps Markets

Let us discuss these markets briefly:

 Spot Market

In this market, the quickest transaction of currency occurs. This foreign

exchange market provides immediate payment to the buyers and the sellers as
per the current exchange rate. The spot market accounts for almost one-third
of all the currency exchange, and trades which usually take one or two days to
settle the transactions.

 Forward Market

In the forward market, there are two parties which can be either two
companies, two individuals, or government nodal agencies. In this type of
market, there is an agreement to do a trade at some future date, at a defined
price and quantity.

 Future Markets

The future markets come with solutions to a number of problems that are
being encountered in the forward markets. Future markets work on similar
lines and basic philosophy as the forward markets.

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 Option Market

An option is a contract that allows (but is not as such required) an investor to

buy or sell an instrument that is underlying like a security, ETF, or even index at
a determined price over a definite period of time. Buying and selling ‘options’
are done in this type of market.

 Swap Market

A swap is a type of derivative contract through which two parties exchange the
cash flows or the liabilities from two different financial instruments. Most
swaps involve these cash flows based on a principal amount.

Features of Foreign Exchange Market

This kind of exchange market does have characteristics of its own, which are
required to be identified. The features of the Foreign Exchange Market are as
follows:

1. High Liquidity

The foreign exchange market is the most easily liquefiable financial market in
the whole world. This involves the trading of various currencies worldwide. The
traders in this market are free to buy or sell the currencies anytime as per their
own choice.

2. Market Transparency

There is much clarity in this market. The traders in the foreign exchange
market have full access to all market data and information. This will help to
monitor different countries’ currency price fluctuations through the real-time
portfolio.

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3. Dynamic Market

The foreign exchange market is a dynamic market structure. In these markets,

the currency values change every second and hour.

4. Operates 24 Hours

The Foreign exchange markets function 24 hours a day. This provides the
traders the possibility to trade at any time.

Methods of Foreign exchange Market

 Establish trading objectives

Investors trading in forex markets set goals that outline the purpose and
performance indicators of investment plans. Financial goals are necessary to
develop a trading style that helps investors achieve expected returns.
Establishing objectives also gives direction in strategy development for
maximizing transactions within foreign exchange markets.

 Evaluate trading strategies

Trading in foreign exchange markets effectively also depends on strategies that

investors use to find, purchase and sell suitable currencies. For instance, an
investor may consider strategies that maximize their trades within highly
liquidate markets. Investors also evaluate strategies that lead to higher gains
when trading on forex volatility. Strategies like position trading and futures
trading are also beneficial to consider for forex trading, as they offer more
approaches to optimizing foreign exchange instruments.

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 Perform risk assessments

Risk is inherent when trading within any market exchanges, and effective
trading forex requires analysing the risks relating to the currencies traders
purchase. Performing a risk analysis is crucial to understanding how
fluctuations in currency values affect investment outcomes.

 Calculate return expectancy

Understanding the frequency rate of investment returns versus losses is

essential when developing strategies for trading in foreign exchange markets.
Expectancy can give an estimation that indicates how likely traders are to
generate profits when buying and selling forex instruments. By calculating the
difference between profit-and-loss averages, you can better evaluate the
probability of increasing returns based on past trading activities.

Factors of Foreign Exchange Market

 Interest and inflation rates

Inflation is the rate at which the cost of goods and services rises over time.
Interest rates indicate the amount charged by banks for borrowing money.
These two are linked by the fact that people tend to borrow and spend more
when the interest rates are low, which results in an increase in costs. These
rates are direct indicators of the current and future economic performance of
a country and can influence the decisions of forex investors and traders
throughout the globe

 Current account deficits

The current account is the balance of trade between a country and its trading
partners. It describes the difference in value between the goods and services

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traded with other countries. If a country buys more than it sells then the
balance of trade is a deficit. It directly affects the exchange rate since a country
will need more foreign capital, thus diminishing the demand for local currency.

 Government debt

This is the total national or public debt owed by the central government. A
country with a large amount of government debt is less likely to attract foreign
investment and acquire foreign capital, leading to inflation. It may also happen
that existing foreign investors will sell their bonds in the open market if they
foresee an increase in government debts.

 Terms of trade

Terms of trade are the ratio of the export prices of a country to its import
prices. When the export prices of a country rise at a greater rate than its
import prices, its terms of trade improves.

 Economic performance

One of the many factors that affect the economic performance of a country is
its political stability. A country, which has a stable political environment,
attracts more foreign investment and vice versa. An increase in foreign capital
results in appreciation in the value of its domestic currency.

 Recession

During a recession, a country’s interest rates are likely to fall, thus decreasing
its chances to acquire foreign capital. This in turn weakens the currency of the
country in question, weakening the exchange rate.

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 Speculation

Investors demand more of a country’s currency when its value is expected to

rise to make a profit in the near future. As a result, the value of the currency
rises due to its increased demand.

Functions of Foreign Exchange Market

The various functions of the Foreign Exchange Market are as follows:

 Transfer Function: The basic and the most obvious function of the
foreign exchange market is to transfer the funds or the foreign
currencies from one country to another for settling their payments. The
market basically converts one’s currency to another.

 Credit Function: The FOREX provides short-term credit to the importers

in order to facilitate the smooth flow of goods and services from various
countries. The importer can use his own credit to finance foreign
purchases.

 Hedging Function: The third function of a foreign exchange market is

to hedge the foreign exchange risks. The parties in the foreign exchange
are often afraid of the fluctuations in the exchange rates, which means
the price of one currency in terms of another currency. This might result
in a gain or loss to the party concerned.

Who are the Participants in a Foreign Exchange Market?

The participants in a foreign exchange market are as follows:

 Central Bank: The central bank takes care of the exchange rate of the
currency of their respective country to ensure that the fluctuations

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happen within the desired limit and this participant keeps control over
the money supply in the market.

 Commercial Banks: Commercial banks are the channel of forex

transactions, which facilitates international trade and exchange to its
customers. Commercial banks also provide foreign investments.

 Traditional Users: The traditional users consist of foreign tourists, the

companies who carry out business operations across the globe.

 Traders and Speculators: The traders and the speculators are the
opportunity seekers who look forward to making a profit through
trading on short-term market trends.

 Brokers: Brokers are considered to be the financial experts who act as a

sure intermediary between the dealers and the investors by providing
the best quotations.

Advantages of Foreign Exchange Market

The whole world economy is relying upon this foreign exchange market for
obvious advantageous reasons. Let us check what are the advantages gained in
the foreign exchange market-

 There are very few restrictive rules; this allows the investors to invest in
this market freely.

 There are no central bodies or clearinghouses that head the Foreign

Exchange Market. Hence, the intervention of the third party is less.

 Many investors are not required to pay any commissions while entering
the Foreign Exchange Market.

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 As the market is open 24 hours, the investors can trade here without any
time-bound.

 The market allows easy entry and exit to the investors if they feel
unstable.

Disadvantages of Foreign Exchange Market

 Counterparty Risks

Forex market is an international market. Therefore, regulation of the Forex

market is a difficult issue because it pertains to the sovereignty of the
currencies of many countries. This creates a scenario wherein the Forex market
is largely unregulated. Therefore, there is no centralized exchange which
guarantees the risk free execution of trades. Therefore, when investors or
traders enter into trades, they also have to be cognizant of the default risk that
they are facing i.e. the risk that the counterparty may not have the intention or
the ability to honour the contracts. Forex trading therefore involves careful
assessment of counterparty risks as well as creation of plans to mitigate them.

 Leverage Risks

Forex markets provide the maximum leverage. The word leverage

automatically implies risk and a gearing ratio of 20 to 30 times implies a lot of
risk! Given the fact that there are no limits to the amount of movement that
could happen in the Forex market in a given day, it is possible that a person
may lose all of their investment in a matter of minutes if they placed highly
leveraged bets. Novice investors are more prone to making such mistakes
because they do not understand the amount of risk that leverage brings
along!

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 Operational Risks

Forex trading operations are difficult to manage operationally. This is because

the Forex market works all the time whereas humans do not! Therefore,
traders have to resort to algorithms to protect the value of their investments
when they are away. Alternatively, multinational firms have trading desks
spread all across the world. However, that can only be done if trading is
conducted on a very large scale.

 High Volatility
One of the disadvantages of forex trading could include the high volatility
of the foreign exchange market. A highly volatile forex market means that
there are large swings in currency prices, and this can be a disadvantage to
traders who are not prepared for it. The high volatility of the forex market
can also make it difficult to predict price movements, which can lead to
losses.
1.9 Spot exchange rates

A spot exchange rate is the current price at which a person could exchange
one currency for another, for delivery on the earliest. The exchange can be
made directly between two parties, eliminating the need for a third party.

1. Traders can use electronic brokering systems for automated order

matching.
2. Traders can also use electronic single- or multi-bank trading systems.
3. Trades can be made by voice over the phone with a foreign exchange
intermediary possible value date.

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Factors determining spot exchange rates

The spot exchange rate is the current rate at which one currency can be
exchanged for another currency. Based on the demand and supply of
currencies, it reflects the price of one currency in terms of another currency
and is the most commonly quoted exchange rate in the foreign exchange

market.

1. Balance of Payments:

Balance of payments is a statement which shows the total demand and supply
of a foreign currency which helps in determining the value of the currency.
Various exports (whether of goods or services) and the imports, affect the
balance of payment continuously.

2. Inflation:

Inflation rate means the rate at which the cost of living of people of a country
is increasing. Putting it in different words, the inflation rate depicts the rates at
which the cost of various goods and services under its scope are increasing.
The case where they are reducing it is known as deflation. The relative changes
in the inflation rates of different countries results into different value of the
local or domestic currency.

3. Interest Rates:

The interest rates on various deposits and on loans are different across the
countries of the globe. This is due to the economics concept of demand and
supply. If the capital is available in abundance in a country, then the rate

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offered on deposits will be low. And if the requirement of capital is more than
its supply, the rates of which loans will be given will be high.

4. Money Supply:

The total money quantum available in a country during a period is known as

money supply. The money supply shows the total money available in an
economy during a period, which helps in determining the rates of interest,
inflation, etc.

Increase in money supply, is normally taken as increase in spare money in the

country. The money supply increase with increase in domestic production and
service capacity of the country. This results into increase in spending on
foreign goods and purchase of foreign investments.

5. National Income:

National income shows the total income of the residents of an economy. The
increase in national income results into increase in supply of money and in turn
results into increase in production or creation of production capacities.

The increase in production results into increase in exports, directly or

indirectly. The increase in incomes of the residents of economy results into
increase in imports. This in turn results into dilution of the domestic currency
of the country in the foreign exchange market. Thus, in turn increase in
inflation will also affect exchange rate

6. Resource Discoveries:

When a country discovers resources, and starts exporting them, it results into
their strong position in exchange market. A good example can be of the oil,

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which plays a significant role in foreign exchange market through its export
and import in the International market, through International Trade Thus,
when the supply of oil, in raw or finished form from its major suppliers, such as
Middle East, becomes insecure, the demand of the currencies of this countries
increase.

7. Capital Movements:

Short-term movement of capital from one country to another is normally

influenced by the interest rates in a country. As seen in the discussion of
interest rates, the country with higher rate of interest will get more capital
supply in comparison to the countries providing lower rate of interest.

If interest rate in a country rises due to change in various key indicators of

economy and policies of the country, there will be a flow of short-term funds
into that country and the exchange rate of the currency will increase in the
foreign exchange market. Reverse will happen in case of fall in interest rates.

8. Political Factors:

The look out of government towards the foreign market and international
trade and commerce define their policies. A steady government of a country
provides more time to investors of different countries to decide their
strategies and take steps of investing.

9. Psychological Factors and Speculation:

The perception and speculative motives in the mind of an individual player or

firm will play a significant role in the movement of prices of the foreign
currency.

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Many a times, the market maker in the market can influence the rate, to move
differently from that determined by long-term economic forces, by buying or
selling a particular foreign currency or group of freeing currency on large scale
and conversion to take place immediately from one currency to another.

Advantages of the spot exchange rate

The advantages of the spot exchange rate are as follows:

1. Simplicity: The spot exchange rate is straightforward enough to understand.

It is simply the price at which one currency can be exchanged for another
currency on the spot date.

2. Flexibility: This exchange rate is a flexible option for businesses that need to
exchange currencies short term. It allows companies to take advantage of
favourable exchange rates as they arise.

3. Speed: Transactions using this exchange rate are completed quickly,

typically within two business days. This is an advantage for companies needing
to pay for goods or services promptly.

4.Cost-effective: The spot exchange rate is generally a cost-effective option for

businesses that need to exchange small amounts of currency, as it does not
require any upfront payment or deposit.

5. Real-Time Pricing: The rate reflects the current market conditions and is
updated in real-time, allowing companies to make informed decisions about
their currency exchanges.

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Disadvantages of the spot exchange rate

1. Exchange rate fluctuations:

Spot exchange rates are subject to fluctuations, which can be unpredictable.

This can impact the profitability of businesses involved in international trade.

2. No protection against adverse movements:

Spot exchange rates do not offer any protection against adverse movements in
exchange rates. This means businesses are exposed to the risk of losses due to
fluctuations in exchange rates.

3. High transaction costs:

Spot exchange rates involve high transaction costs, which can eat into the
profits of businesses. These costs can include exchange fees and commissions,
which can be significant.

4. Time constraints:

Spot exchange rates require businesses to act quickly and make decisions in a
short period. This can be challenging for businesses that need to make large
currency transactions.

Difference between Spot Exchange Rate and Forward Exchange Rate

The difference between the spot exchange rate and the forward exchange rate
is as follows:

Spot exchange rate Forward exchange rate

It refers to the current rate. It refers to the rate at some point in
the future.

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It provides flexibility and real-time It provides certainty and protection

pricing. against currency fluctuations.
Exchange happens on the spot date, Exchange happens at an agreed-upon
typically within two business days. date in the future.

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