Fixed and Floating exchange rate

Presentation on Fixed and Floating exchange rate

1. 2021
Fixed
and
Flexible
Exchange Rate
Classroom Deliberations
CA Dr. PrithviRanjanParhi
1CA DR Prithvi Ranjan Parhi

2. 703-INTERNATIONAL TRADE AND BUSINESS
MODULE-I
InternationalTrade:Concept,Importance,BenefitsofInternationalTrade,international
Markingvs.DomesticMarking(differences).
TheoryofInternationalTrade:theoryofcomparativeCost,factorproportionTheory.
MODULE-II
Multinationalcorporations(MNCs):Definition,RoleofMNCsinInternationalmarking.
InternationalTradebarriers:Meaning,tariffandnon-TariffBarriers,ImpactofNon-tariff
barriers.
MODULE-III
OrganizationalandAgreements:WTO(Functions,Principle,agreements),IMF(Purposes,
FacilitiesProvidedbyIMF),WorldBank(Purpose,Principle,Policies).
MODULE-IV
ForeignTradeofIndia:OrganizationalSetup(AutonomousBodies,Attachedand
subordinateoffices),MajorExportandImports,ConceptofExportHouse,EXIMPolicy
(2002-2007)ofIndia(FeaturesandObjectivesofthePolicy).
MODULE-V
ForeignExchangemarket:Concept,Functions,MethodsofinternationalPayment,concept
ofBalanceofPayment,ConceptofFixedandFlexibleExchangeRateandConvertibilityof
Rupee.
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3. Forex
•Importingcountrypaysmoneytoexportingcountriesin
returnofgoodseitherindomesticcurrencyorinhard
currency.
•Thiscurrencywhichfacilitatesthepaymenttocomplete
thetransactioniscalledForeignExchange.
•Soforeignexchangeisthemoneyinonecountryfor
moneyorcreditofgoodsorservicesinanothercountry.
•Foreignexchangeincludes:Foreigncurrency,Foreign
chequesandforeigndrafts.
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4. Exchange Rate Determination
•Exchangerateisthepricepaidinthehome
currencyforaunitofforeigncurrency.
•Exchangeratecanbequotedintwoways:Direct
Quote,IndirectQuote.
•Exchangerateinafreemarketisdeterminedby
thedemandforandsupplyofforeigncurrencyof
aparticularmarket.
•Theequilibriumexchangerateistherateatwhich
demandforforeignexchangeandsupplyofforeign
exchangeareequal.
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5. 5
Exchange Rate Drivers
International
Trade
Speculation
Balance of
Payment
Intervention by
Central Bank
Economic
Fundamentals
Political
Stability
Interest rate
Parity
Inflation rate
Self fulfilling
prophesy
© CA. Prithvi R Parhi, M Com, FCA,DISA(ICAI)
5:59 PM © CA Dr Prithvi R Parhi

6. Demand & Supply
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7. Demand for Foreign Exchange
1.Importofgoodsandservices
2.InvestmentinForeignCountries(FDIOutward)
3.PaymentmadebyIndianGovttootherforeign
Govt(interest,loanetc)
4.Othertypeofoutflowofforeigncapitallike
givingdonationsetc
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8. Supply of Foreign Exchange
1.Country’sexportsofgoodsandservicestoforeign
countries
2.InflowofForeignCapital
3.Paymentmadebytheforeigngovernmentsto
Indiangovernmentsforsettlingtheirtransactions
4.Othertypeofinflowofforeigncapitallike
RemittancesbyNRI,Donationsreceived
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9. Exchange Rate Regimes
1.CommoditySpecieStandard
2.GoldStandard
3.TheBrettonWoodsSystemofExchangeRates
4.ExchangeRateRegimesSince1973
a.FloatingRateSystem
b.PeggingofCurrency
c.CrawlingPeg
d.Target-zoneArrangements
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10. Commodity Specie Standard
•Initiallytheexchangeratesweredetermined
onthebasisofthevalueofmetalcontainedin
thecoinsoftwocountries.
•Thissystemwasreferredasthecommodity
speciestandard.
•Withtheintroductionofpapercurrencythis
systemceasedtoexist.
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11. Gold Standard
•GoldStandardwasprevalentbetween1870s
and1914,whichwassuspendedduringthe
greatworldwar.
•Howeveritwasreadopted,butwasfinally
abandonedby1930s.
•GoldStandardwasinitiallyadoptedbyBritain.
Later,Germany,Japan,USAandother
countriesadoptedGoldStandard.
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12. Gold Standard
•InthissystemCentralBankwasmaintaining
officialparitybetweenitscurrencyandgold
andassuchneededanadequatestockofgold
reserves.
•Banknoteswereexchangedforgoldon
demand.
•Thepriceofgoldwasofficiallysetatwhichit
wasboughtandsold.
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13. Gold Standard
•Goldstandardallowedfreeflowofgold
amongcountriesandforautomatic
adjustmentinexchangerateandinbalanceof
payments.
•InthiscaseDeficitinbalanceoftradeledto
outflowofgoldandviceversa.
•Thefixedsupplyofgoldledtothedemiseof
goldstandard.
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14. The Bretton woods system of
Exchange Rates
•ThecollapseofgoldstandardledtotheconductoftheBretton
WoodsconferenceinJuly1944andtheestablishmentofIMFin1945
andevolutionofanewsystemofexchangerate,whichisknownas
Brettonwoodssystemofexchangerate.
•BrettonWoodssystemrepresentedafixedparitysystemwith
adjustablepegs.
•Underthissystemeachcountrywastofixtheparvalueofits
currencyintermofgoldorUSdollar.
•Themonetaryauthoritieswereallowedtomakeadjustmenttothe
extend+/-1%offixedparvalue.
•Thissystemcouldbringaboutstabilityinexchangerate,itcouldnot
sustainforlongtime.
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15. Exchange Rate Regimes Since 1973
•InthewakeofcollapseofBrettonwoodssystemof
exchangeratethecommitteeappointedbyIMFsuggested
fouroptionsforexchangerate.
•ThesesuggestionswereacceptedbyIMFand
incorporatedinits2
nd
amendmenttotheArticleof
agreement.
•Theseoptionsare:
1.Floatingratesystem
2.PeggingofCurrency
3.CrowlingPeg
4.Target-ZoneArrangement
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16. Exchange Rate Regimes Since 1973
1.FloatingRateSystem:
•Marketforcesdeterminetheexchangerateof
currenciesunderfloatingratesystem.
2.PeggingofCurrencies:
•Heredevelopingcountriespegsitscurrencieseitherto
astrongcurrencyortoacurrencyofacountrywith
whichithasalargeshareoftrade.
•Peggingsystemprovideforfixedexchangerate
betweentwocurrencies.However,theexchangerate
floatwithrespecttoothercurrencies.
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17. Major Fixed Currencies (Pegged to USD)
Country Region Currency Code
Bahrain Middle East Dollar BHD
Belize Central America Dollar BZ$
Cuba Central America Convertible Peso CUC
Djibouti Africa Franc DJF
Eritrea Africa Nakfa ERN
Hong Kong Asia Dollar HKD
Jordan Middle East Dinar JOD
Lebanon Middle East Pound LBP
Oman Middle East Rial OMR
Panama Central America Balboa PAB
Qatar Middle East Riyal QAR
Saudi Arabia Middle East Riyal SAR
United Arab EmiratesMiddle East Dirham AEDCA DR Prithvi Ranjan Parhi 17

18. Exchange Rate Regimes Since 1973
3. Crawling Peg:
•Itisahybridoffixedrateandfloatingrate.
•Here,theexchangerateofacurrencywith
whichitispeggedisstableintheshortrun,but
itchangesgraduallyoveraperiodoftimein
ordertoreflectthechangesinthemarket.
•Thissystemhastheadvantagesofstabilityand
flexibility.
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19. Exchange Rate Regimes Since 1973
4. Target-Zone Arrangement:
•Underthissystemtheexchangeratesarefixed
withrespecttothecurrenciesofthecountries
ofaparticularzoneandtheexchangeratefloat
withrespecttocountriesoutsidethezone.
•Example:EasternCaribbeanCurrencyUnion,
CentralAfricanEconomicandMonetary
communityandWesternAfricanEconomicand
MonetaryUnion.
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20. Fixed/Pegged Exchange Rate
•Afixedexchangerate,sometimescalledapegged
exchangerate,isatypeofexchangerateregime
whereacurrency'svalueisfixedagainsteitherthe
valueofanothersinglecurrency,toabasketof
othercurrencies,ortoanothermeasureofvalue,
suchasgold.
•Inafixedexchange-ratesystem,acountry’scentral
banktypicallyusesanopenmarketmechanism
andiscommittedatalltimestobuyand/orsellits
currencyatafixedpriceinordertomaintainits
peggedratio.
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21. Fixed/Pegged Exchange Rate (Advantages)
1.PromotesInternationalTrade:
Fixedorstableexchangeratesensurecertaintyabouttheforeign
paymentsandinspireconfidenceamongtheimportersand
exporters.Thishelpstopromoteinternationaltrade.
2.NecessaryforSmallNations:
Fixedexchangeratesareevenmoreessentialforthesmaller
nationslikeDenmark,Belgium,inwhoseeconomiesforeigntrade
playsadominantrole.Fluctuatingexchangerateswillseriously
affecttheprocessofeconomicgrowthintheseeconomies.
3.PromotesInternationalInvestment:
Fixedexchangeratespromoteinternationalinvestments.Ifthe
exchangeratesarefluctuating,thelendersandinvestorswillnot
bepreparedtolendforlong-terminvestments.
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22. Fixed/Pegged Exchange Rate(Advantages)
4.RemovesSpeculation:
Fixedexchangerateseliminatethespeculative
activitiesintheinternationaltransactions.Thereisno
possibilityofpanicflightofcapitalfromonecountry
toanotherinthesystemoffixedexchangerates.
6.NecessaryforDevelopingCountries:
Fixedexchangesratesarenecessaryanddesirablefor
thedevelopingcountriesforcarryingoutplanned
developmentefforts.Fluctuatingratesdisturbthe
smoothprocessofeconomicdevelopmentand
restricttheinflowofforeigncapital.
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23. Fixed/Pegged Exchange Rate(Advantages)
7.SuitableforCurrencyArea:
Afixedorstableexchangeratesystemismostsuitabletoaworldofcurrency
areas,suchasthesterlingarea.Iftheexchangeratesofthecountriesinthe
commoncurrencyareaareflexible,thefluctuationsintheleadingcountry,like
England(whosecurrencydominates),willalsodisturbtheexchangeratesof
thewholearea.
8.EconomicStabilization:
Fixedforeignexchangerateensuresinternaleconomicstabilizationandchecks
unwarrantedchangesinthepriceswithintheeconomy.Inasystemofflexible
exchangerates,theliquiditypreferenceishighbecausethebusinessmenwill
liketoenjoywindfallgainsfromthefluctuatingexchangerates.Thistendsto
Increasepriceandhoardingactivitiesincountry.
9.NotPermanentlyFixed:
Underthefixedexchangeratesystem,theexchangeratedoesnotremainfixed
orispermanentlyfrozen.Rathertherateischangedattheappropriatetimeto
correctthefundamentaldisequilibriuminthebalanceofpayments.
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24. Fixed/Pegged Exchange Rate(Advantages)
10. Other Arguments:
Besides,thefixedexchangeratesystemisalsobeneficial
onaccountofthefollowingreasons.
i.Itensuresorderlygrowthofworld'smoneyandcapital
marketsandregularizestheinternationalcapital
movements.
ii.Itensuressmoothfunctioningoftheinternational
monetarysystem.Thatiswhy,IMFhasadoptedpeggedor
fixedexchangeratesystem.
iii.Itencouragesmultilateraltradethroughregional
cooperationofdifferentcountries.
iv.Inmoderntimeswheneconomictransactionsandrelations
amongnationshavebecometoovastandcomplex,itis
moreusefultofollowafixedexchangeratesystem.
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25. Fixed/Pegged Exchange Rate(Disadvantages)
1. Outmoded System:
Fixedexchangeratesystemworkedsuccessfullyunderthe
favorableconditionsofgoldstandardduring19thcentury
when
a)thecountriespermittedthebalanceofpaymentstoinfluencethe
domesticeconomicpolicy;
b)therewascoordinationofmonetarypoliciesofthetrading
countries;
c)thecentralbanksprimarilyaimedatmaintainingtheexternal
valueofthecurrencyintheirrespectivecountries;and
d)thepricesweremoreflexible.
Sincealltheseconditionsareabsenttoday,thesmooth
functioningofthefixedexchangeratesystemisnotpossible.
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26. Fixed/Pegged Exchange Rate(Disadvantages)
2.DiscourageForeignInvestment:
Fixedexchangeratesarenotpermanentlyfixedorrigid.Therefore,such
asystemdiscourageslong-termforeigninvestmentwhichisconsidered
availableunderthereallyfixedexchangeratesystem.
3.MonetaryDependence:
Underthefixedexchangeratesystem,acountryisdeprivedofits
monetaryindependence.Itrequiresacountrytopursueapolicyof
monetaryexpansionorcontractioninordertomaintainstabilityinits
rateofexchange.
4.Cost-PriceRelationshipnotReflected:
Thefixedexchangeratesystemdoesnotreflectthetruecost-price
relationshipbetweenthecurrenciesofthecountries.Notwocountries
followthesameeconomicpolicies.Thereforethecost-price
relationshipbetweenthemgoonchanging.Iftheexchangerateisto
reflectthechangingcost-pricerelationshipbetweenthecountries,it
mustbeflexible.
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27. Fixed/Pegged Exchange Rate(Disadvantages)
5.NotaGenuinelyFixedSystem:
Thesystemoffixedexchangeratesprovidesneitherthe
expectationofpermanentlystableratesasfoundinthegold
standardsystem,northecontinuousandsensitiveadjustment
ofafreelyfluctuatingexchangerate.
6.DifficultiesofIMFSystem:
Thesystemoffixedorpeggedexchangerates,asfollowedby
theInternationalMonetaryFund(IMF),isinrealityasystemof
managedflexibility.
Itinvolvescertaindifficulties,suchasdecidingasto
a)whentochangetheexternalvalueofthecurrency,
b)whatshouldbeacceptablecriteriafordevaluation;and
c)howmuchdevaluationisneededtoreestablishequilibriuminthe
balanceofpaymentsofthedevaluingcountry.
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28. Fixed/Pegged Exchange Rate(Disadvantages)
7.Inflationary Nature
Acommonelementwithallfixedorpeggedforeign
exchangeregimesistheneedtomaintainthefixed
exchangerate.
Thisrequireslargeamountsofreservesasthe
country'sgovernmentorcentralbankisconstantly
buyingorsellingthedomesticcurrency.
Theproblemwithhugecurrencyreservesisthatthe
massiveamountoffundsorcapitalthatisbeing
createdcancreateunwantedeconomicsideeffect–
namelyhigherinflation.
Themorecurrencyreservesthereare,thewiderthe
monetarysupply–causingpricestorise.
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29. Floating/Flexible Exchange Rate
•Undertheflexibleexchangeratesystem,exchangerate
betweendifferentcurrencies,likethepricesof
commoditiesarefreelydeterminedbymarketforces,that
is,bydemandandsupplyforces.
•Withthechangeineconomicconditionsunderlying
demandandsupply,theexchangeratewillautomatically
changewithoutanyinterventionbytheGovernment.
•Thatiswhyitiscalledflexibleorvariableexchangerate
system.
•ThisisalsocalledFreeFloatofcurrency.
•Example:USDollar,Euro,JapaneseYen
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30. Floating/Flexible Exchange Rate(Advantages)
1.Noneedforinternationalmanagementofexchange
rates:Unlikefixedexchangeratesbasedonametallic
standard,floatingexchangeratesdon’trequirean
internationalmanagersuchastheInternational
MonetaryFundtolookovercurrentaccount
imbalances.Underthefloatingsystem,ifacountryhas
largecurrentaccountdeficits,itscurrencydepreciates.
2.Noneedforfrequentcentralbankintervention:Central
banksfrequentlymustinterveneinforeignexchange
marketsunderthefixedexchangerateregimetoprotect
thegoldparity,butsuchisnotthecaseunderthe
floatingregime.Herethere’snoparitytouphold.
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31. Floating/Flexible Exchange Rate(Advantages)
3.Noneedforelaboratecapitalflow
restrictions:
Itisdifficulttokeeptheparityintactinafixed
exchangerateregimewhileportfolioflowsare
movinginandoutofthecountry.Inafloating
exchangerateregime,themacroeconomic
fundamentalsofcountriesaffecttheexchange
rateininternationalmarkets,which,inturn,
affectportfolioflowsbetweencountries.
Therefore,floatingexchangerateregimes
enhancemarketefficiency.
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32. Floating/Flexible Exchange Rate(Advantages)
4.Greaterinsulationfromothercountries’
economicproblems:Underafixedexchangerate
regime,countriesexporttheirmacroeconomic
problemstoothercountries.Supposethatthe
inflationrateintheU.S.isrisingrelativetothatof
theEuro-zone.
Underafixedexchangerateregime,thisscenario
leadstoanincreasedU.S.demandforEuropean
goods,whichthenincreasestheEuro-zone’sprice
level.Underafloatingexchangeratesystem,
however,countriesaremoreinsulatedfromother
countries’macroeconomicproblems.ArisingU.S.
inflationinsteaddepreciatesthedollar,curbing
theU.S.demandforEuropeangoods.
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33. Floating/Flexible Exchange Rate(Advantages)
5.Correctionofbalanceofpaymentsdeficits-
When,thereisdeficitinthebalanceof
payments,theexternalvalueofacountry's
currencyfalls.Asaresult,exportsare
encouraged,andimportsarediscouraged
thereby,establishingequilibriuminthebalance
ofpayment.
6.EliminatesCostofFOREXreserves-Thissystem
eliminatestheexpenditureofmaintenanceof
officialforeignexchangereserve.
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34. Floating/Flexible Exchange Rate(Disadvantages)
1.Unstableconditions:
Flexibleexchangeratescreateconditionsofinstability
anduncertaintywhich,inturn,tendtoreducethe
volumeofinternationaltradeandforeigninvestment.
Long-termforeigninvestmentsaregreatlyreduced
becauseofhigherrisksinvolved.
2.AdverseEffectonEconomicStructure:
Thesystemofflexibleexchangerateshasserious
repercussionontheeconomicstructureoftheeconomy.
Fluctuatingexchangeratescausechangesinthepriceof
importedandexportedgoodswhich,inturn,destabilize
theeconomyofthecountry.
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35. Floating/Flexible Exchange Rate(Disadvantages)
3.UnnecessaryCapitalMovements:
Thesystemoffluctuatingexchangeratesleadsto
unnecessaryinternationalcapitalmovements.By
encouragingspeculativeactivities,suchasystemcauses
large-scalecapitaloutflowsandinflows,thus,seriously
disturbingtheeconomyofthecountry.
4.DepressionEffectsofCapitalMovements:
Speculativecapitalmovementscausedbyfluctuatingex-
changeratesmayleadtotheproblemofextremelyhigh
liquiditypreference.Inasituationofhighliquidity
preference,peopletendtohoardcurrency,interestrates
rise,investmentfallsandthereislarge-scale
unemploymentintheeconomy.
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36. Managed Float/Dirty Float
•Itisafloatingcurrencyexchangeratesystemwhichisnot
controlledentirelybythemarketforcesofdemandand
supplybutatleastpartiallycontrolledbygovernment
interventionthatlimitsdepreciationorappreciationofthe
currencywithinarange.
•Hence,'DirtyFloat'isasystemoffloatingexchangerates
inwhichthegovernmentorthecountry'scentralbank
occasionallyintervenestochangethedirectionofthe
valueofthecountry'scurrency.
•Example:In2013,82countriesandregionsusedthe
system,or43%,accordingtoasurveyof191countriesby
theInternationalMonetaryFund.
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37. Convertibility of a currency
•Currency convertibility is the ease with which a country's
currencycan be converted into gold or another currency.
Convertibility is extremely important for international
commerce. When a currency is inconvertible, it poses a risk
and barrier to trade with foreigners who have no need for
the domestic currency.
•Government restrictions can often result in a currency with
a low convertibility. For example, a government with low
reserves of hard foreign currency often restrict currency
convertibility because the government would not be in a
position to intervene in the foreign exchange market (i.e.
revalue, devalue) to support their own currency if and
when necessary.
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38. Convertibility of Rupee
•Currency convertibility is of two types:
1.Current Account Convertibility
2.Capital Account Convertibility
•Current account convertibility allows free inflows
and outflows for all purposes other than for
capital purposes.
•Capital purpose means dealing the investments in
foreign currency and obtaining loans in foreign
currency,acquiring any plant and machinery from
abroad by making payments in foreign exchange.
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39. Convertibility of Rupee(Indian
Experience)
•After the BoPcrisis of 1990-91 and change in the central Government,
the LERMS was introduced as a first measure towards making foreign
exchange a free commodity.
•Thus, when LERMs was introduced, there were two exchange ratesin
India: Official Rate for select items of exports and imports Market Rate
for all others.
•The Government said that now onwards, anyone who deals in current
account means international trade of goods and services will be able to
convert them to Indian Rupees as follows: 40 %of the receipts at
Official rate 60%of the receipts at Market Rate.
•This means that only part of the current account receipts were made
convertible at market rates and that is why it was called Partial
Convertibility of Rupee on Current Account.
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40. ------Convertibility of Rupee(Indian
Experience)
•Encouraged with the success of the LERMS,
the government introduced the full
convertibility of Rupee in Trade account
(means only merchandise trade no service
trade)from March 1993 onwards.
•With this the dual exchange rate system got
automatically abolished and LERMS was now
based upon the open market exchange.
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41. --------Convertibility of Rupee(Indian
Experience)
•In August 1994, the Government of India declared full
convertibility of Rupee on Current account.(Trade and
invisibles)
•Capital account convertibility (CAC) or a floating
exchange rate means the freedom to convert local
financial assets into foreign financial assets and vice
versa at market determined rates of exchange.
•The Committee on Capital Account Convertibility (CAC)
or TaraporeCommittee was constituted by the Reserve
Bank of India for suggesting a roadmap on full
convertibility of Rupee on Capital Account.
•The committee submitted its report in May 1997.
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42. --------Convertibility of Rupee(Indian
Experience)
•However, some partial convertibility of Rupee on Capital
Accountwas introduced later. Today we have Partial
convertibility of Rupee on Capital Account.
•Reserve Bank of India appointed the second Tarapore
committee to set out the framework for fuller Capital
Account Convertibility.
•The report of this committee was made public by RBI on 1st
September 2006.
•In this report, the committee suggested 3 phases of
adopting the full convertibility of rupee in capital account.
–First Phase in 2006-7
–Second phase in 2007-09
–Third Phase by 2011.
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43. --------Convertibility of Rupee(Indian
Experience)
Following were some important recommendations of this
committee:
•The ceilingfor External Commercial Borrowings (ECB)
should be raised for automatic approval.
•NRI should be allowed to invest in capital marketsNRI
deposits should be given tax benefits.
•Improvement of the Banking regulation.
•FII (Foreign Institutional Investors) should be prohibited
from investing fresh money raised to participatory notes.
•Existing PN holders should be given an exit route to phase
out completely the PN notes.
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44. Are We moving towards fuller capital
account convertibility?
•Though there are certain risks associated with full capital
account convertibility, we cannot avoid it for longer period
as it may become counter-productive.
•But how early are we moving to full capital account
convertibility depend on various pre-conditionslike low and
sustained current account deficit, fiscal-consolidation,
controlled inflation, low level of NPAs, resilient financial
markets, prudent supervision of financial institutionsetc.
•Already India is making progress on these fronts.
•Today we have Partial convertibility of Rupee on Capital
Accountand slowly moving towards fuller capital account
convertibility.
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45. THANK YOU
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46. CA DR Prithvi Ranjan Parhi 46

47. Thank You
47CA DR Prithvi Ranjan Parhi