BUSINESS SYSTEMS BANGALORE MAY REQUIRE UPDATE

0802

POTATOS, ONIONS & FOREIGN EXCHANGE

A LAYMAN'S GUIDE TO FOREX
(By S.KRISHNAMURTHY, B.Com., FCA, VISITING FACULTY : IIM-B)

INTRODUCTION

NOTE: Through out this paper, the subject is discussed from the angle of a BUYER of Potatos, Onions or Foreign Exchange. It is also assumed that you buy these for your own use and not for re-sale (unless the law compels you to sell). NARRATIVE TIT BITS 1. Any item or goods purchased or sold has a value. When we buy or sell, we use the word price to indicate the same. Salt as Currency We call money as a medium of exchange. By this we mean that we This price is always mentioned in relation to the item, will give certain amount of money in exchange of goods, property, quantity, quality etc. For example: services we buy. This money QNTY ITEM PRICE represents the value or price of our purchase. This money when it is in 1 Kg Potato Rs.10 the form of paper we call it 1 Meter Cloth Rs.50 currency. If it is metal we call it coin. By passing a law through our 1 No. Pencil Rs.5 Constitution, we have authorised our 1 Litre Petrol Rs.20 Government to produce this currency & coin in standard Even for the same product or item we talk of different denominations of Rs.500, Rs.100, Rs.50 etc. The value (or prices for different volumes or quality. For Eg.. denomination) of the money is printed QLTY Nellore Rice Rs.15 per Kg. or embossed on the currency or the coin. REF Basmati Rice Rs.50 per Kg. Kerala Banana Madurai Banana QNTY REF 1 Kg. Silver 1 gm. Silver Rs.40 per Doz. Rs.20 per Doz. Rs.7860 Rs.7.95 These currencies & coins give value or price in exchange of other goods, services or property.

Earlier to this concept of paper or coin money, people used other goods as money in exchange of goods they 1 Kg. Onion Rs.25.00 wanted. For example instead of giving 1 tonne Onion Rs.24000 a currency you can buy 1 kg potato by giving 5 kg tomato as money. This 2. Purchase or sale of goods, take place in markets such as was called Barter. mandies, fair price shops, provision stores, wholesale markets, super markets etc. People choose the type of During Roman empire (B.C.) Salt used market depending on their requirements of quantity, to be the medium of exchange (or quality, friendships, ideas, price etc. Sometime people even money). Roman Soldiers used to be specially travel to far off places to specially choose and paid specific quantity of salt every bargain for items of their choice. (Eg. Visit to Kanchipuram month as payment for their services. to buy silk sarees ).

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NARRATIVE TIT BITS 3. Depending upon season, demand, taste etc. some items are This is how he word Salary came scarce in certain places, that you may have to go in search into existence. This salt was used by of the same. In many instances Government or local the soldiers to buy their rice, wheat, helmet, bows, arrows etc. In other authorities put restrictions on purchase or sale of items in words Salt was money, then. the market. For eg. You have no liquor shops in Gujarat. But in Goa there are plenty. Hence in Gujarat you may Gradually gold (because of its unique chemical & physical properties) have to pay Rs.100 for a bottle of beer whereas the same became money all over the world. It may be available at Rs.10 in Goa. was assigned a value for eg.- 1 gm of 4. Depending on the custom, tradition, practice, culture, gold for 100 kgs of rice or 50 kgs of wheat etc. Physical handling of gold season etc. different communities, different regions became a problem. Hence specialise in buying/ selling specific items. For Eg.. in Goa governments started printing of paper not only liquor is available everywhere, consuming liquor currency by keeping equal value of is not considered to be a taboo. Similarly you will get tea gold in safe custody with them. USA followed this system till 1971. For everywhere in North East India but Curd is difficult to get ; every ounce of gold they had, they you wont get pork in Islamic areas or beef in Hindu areas. used to print $ 35 in paper currencies. Hence even if supply is available, there may be no demand This meant that if you had $ 35 notes in hand, you could give this to US (or it may even be prohibited). Govt. and get 1 ounce of Gold. This 5. Now, apply the same example for Foreign currencies. They was discontinued from 15.8.1971 by are, for all practical purposes, foreign items or foreign USA. goods. This is because these are not produced in your Now a days stocking of gold by country. Hence you have to buy these at a price from Governments is only a portion of the persons who have these for sale. For Example: value of currencies printed. Other QNTY ITEM PRICE wealth (assets) such as receivables are also taken into account to print 1 U $ (U.S. Dollar) Rs.42.50 currencies. 1000 (Japanese Yen) Rs.400 1 1 C (British Pound) (EURO) Each country has its own currency as a medium of exchange for purchase Rs.48.10 or sale within the country. Hence currency of another country is like for different volumes or goods which you have to purchase using your currency. Rs.42.00 per $ Thus for an Indian in India, U$, DM, Rs.42.50 per $ etc. are goods like Potato, Onion etc. Rs.43.00 per $ You have to pay Indian rupee to purchase these. Thus what we call as Rs.42.00 per $ Foreign exchange rate is nothing but Rs.41.90 per $ the price of a foreign currency in Rs.41.80 per $ Indian Rupee. Rs.72.60

These also have different prices quality - For Eg.. QLTY REF Currency Note U $ Tr. Cheque U $ Demand Draft U $ QNTY REF Less than $ 1000 $ 1000 - $ 1,000,000 $ 1,000,000 +

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NARRATIVE

TIT BITS

6. For the foreign exchange market also we have mandies, You have a $ 100 note. You want to provision stores, specialist shops, super markets, retail sell it to the Bank. They may give you shops etc.. They are known by names such as Money only Rs.42.00 per $. But if you have a Changers, Authorised Dealers, Banks, Brokers, etc.. Some $ 100 travellers cheque, they will give of them specialise in specific currencies, some in all you Rs.42.50 per $. Why ? Keeping currency note is more risky. It may currencies; some big; some small. Here also people go to tear. It may be a counterfeit. If it is their favourite shops to buy or sell different currencies. lost, recovery is impossible. Whereas For eg.. when people want to buy say $ 100 million, they a travellers cheque of $ 100 means, go to Bombay or Delhi where SBI or other bankers offer this amount is already in the bank good prices; Bank of Muniswamy may not have U $ to sell which issued the travellers cheque. but may have Bangladesh Takas (for which there may be no buyers). During drought season, potatos are in short supply. Too many people want 7. From the above it will be seen that, like any other goods, potatoes. But only those who can pay there is a price for forex also. These prices are referred more will be able to buy. So potato to as Exchange Rate. Like different goods have different prices increase. prices, different currencies have different rates. Prices of goods change according to demand and supply. Similarly Similarly we want to buy crude oil. prices of foreign exchange also change according to demand and supply. In an absolutely restriction-free market, the prices are purely based on demand and supply (availability) of the goods. But these prices get artificially altered by legal restrictions such as Minimum Price or Maximum Price or administered price etc. imposed by Government authorities. For eg. Certain drugs have been prescribed maximum prices by the Govt. under Drug Price Control Order. In 1960s we had a Scooter Control Order So, what do we do ? We sell garments under which scooter owners were prohibited from selling to USA for U$. We get U$. We sell it their scooter for 5 years from the date of purchase. There to our Bank for Indian rupees. The was a maximum price also fixed for scooter manufacturers. Bank sells the U$ to the oil importer Similarly Department of Economic Affairs of the Ministry for Indian rupees. The oil importer pay U$ and buy crude oil. If the demand of Finance of the Govt. of India is the authority to for U$ is high then the price of U$ is determine policy on buying, acquiring, using and selling also high. If the price of crude oil forex. This policy is administered through Exchange goes down, the demand for $ is down. Control Orders by the RBI. Accordingly RBI has put Then the price of $ goes down (unless various restrictions from time to time about purchasing, you require $ for some other imports) selling, dealing in forex. Thus price of forex gets artificially altered to certain extent. We do not have sufficient quantity. So we have to buy from Middle east. The oil seller wants a price of U$ 12.00 per barrel. So we have to get U$ first. How to get U$ ? U$ is the currency of USA. They do not sell U$ for Indian rupee as Indian rupee has no use in USA.

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SUMMARY Foreign Exchange means foreign currencies or equivalents (like cheque, DD etc. payable in any other currency other than our national currency) Exchange Rate means the price of a currency. The price (exchange rate) of a currency will depend upon the demand & supply. Like any other goods, foreign exchange also has wholesale market, retail market, brokers, dealers, agents etc.. Like vegetable vendors, wholesale shops, departmental stores etc. require corporation licence, registration under Shops & Establishment Acts etc., the buyers/ sellers of foreign exchange also require permission for their business from RBI etc. Like there are Govt. restrictions in buying, storing, selling of certain specified essential goods, all Govts. impose restrictions in buying, stocking, selling forex, etc., if they feel they are essential goods. Like different shops specialise in different goods, different foreign exchange also has specialised shops or dealers.

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II. RESTRICTIONS IN SELLING OR BUYING FOREIGN EXCHANGE NARRATIVE 1. Goods like Rice, Wheat, Potato, Onion etc., constitute staple diet for human beings. When they are available in plenty, normally Government authorities do not interfere with the market. They simply take steps to protect the common man from being exploited by traders who, by creating artificial scarcity, try to increase prices. Sometimes shortage due to drought, floods etc. happen. To protect the poor people from facing starvation and high prices what do the Government authorities do ? They impose legal restrictions (eg. Essential Commodities Act). They compulsorily acquire the grains or produce at a price fixed by them; then they distribute the same to the poor and needy through ration card/ fair price shops at a low price fixed by them. We call this the PDS. Many a time the Govt. actually incurs a loss by this, which we call as subsidy The Government authorities, in fact, even keep huge stocks by buying them from the producers at a fixed price (called procurement price). They use these stocks to distribute to the poor and the needy at a low price during times of shortage. 2. Have you come across any instance of Government compelling a cashew nut grower or a mango producer or a TV manufacturer to sell it to them only at a low fixed price ? No. ! Why ? Because these are not essentials. Hence Government does not interfere with these goods. Thus for these non-essential goods the price is not interfered with. Those who want, have to buy them in the market at prevailing market price. The price will depend on the demand for the product and availability (or supply) of the same. 3. Now let us examine the market for foreign exchange. There are more than 100 foreign currencies in the world. Out of them only a few are in large demand. Why ? Because we require these currencies to buy our requirements from the countries of those currencies. Which are the countries from whom we have to buy our requirements ? What are our requirements ? In which currency we have to buy them ? The answer obviously will be TIT BITS Under Public Distribution System (PDS), let us assume the Govt. procures 100,000 tonnes of rice from the Farmer @ Rs.5000 per tonne. They make it available to the ration card holders @ Rs.4500 per tonne. Thus the Govt. incurs a loss of Rs.500 per tonne. How does the Govt. make up this loss ? By increased taxes or transfer of profits from sale of other goods. Even after this, the Govt. is not able to recover the loss. This loss

becomes part of the deficit on revenue account (ie. Revenue or income being less than expenditure).

We require, say U$ 1000 crores to import our requirements. How do we get U$ 1000 Crores ? By exporting our goods we get, say only U$ 800 Crores. What do we do to get the

balance of U$ 200 Crores ? We beg or borrow. This difference is called

trade deficit. When we borrow, we have to repay with interest. This

means we have to earn more U$ through exports. This may not be

possible in a short period of time. Hence we borrow with a longer repayment period. We try our best for low interest rates.

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NARRATIVE

TIT BITS

(a) We depend on those countries who have the goods we A substantial portion of the purchases need (eg. Oil, technology, machine tools, metals etc.) from the advanced countries by the (b) We have to buy our requirements from them by paying underdeveloped countries consist of them in the currencies they want. Thus a situation arises that we have to earn or buy or arms, weapons & luxuries. If the acquire those currencies to enable us to pay for our underdeveloped countries stop buying purchases in those currencies 4. Like India is abundant in several products such as certain ores, granite spices etc.. there are other countries who have abundant oil, technology, arms, fertilisers etc.. The not acceptable to the advanced countries who are highly advanced industrially naturally countries. Hence what they resort to is have advantage over those countries who are not like this: developed. Thus we require currencies of those advanced Advanced Country : Do you want fertiliser? countries to buy our requirements. Not only India. Needy Country : Yes Hundreds of other countries are also depending on these I will sell small group of countries who are industrially advanced. Advanced Country : Hence all these less fortunate countries have to somehow them to you only if you buy 100 battle acquire the currencies of those few advanced countries to tanks also from me at U$ 10 million buy their requirements. each. 5. From the above you can see that the currencies of a few countries are in heavy demand in other countries who Thus you can see the dilemma of an underdeveloped country. Now they these, then the prices of the currencies of the advanced countries will come down substantially. This is politically

require these currencies to buy their requirements. For this have to find means of acquiring extra reason, these currencies are called Hard Currencies. As foreign exchange to buy the tanks also. of now a few such currencies are U $, DM, , , Sw. Fr., Fr.Fr. Etc (about 20 currencies). Even among them, like Rice, Wheat, Potato & Onion, the currencies in large demand would be U $, DM, , , etc. The need for these In real life, we use words

contradictorily. For Eg. If I die, you

currencies by the underdeveloped countries are critical. bury me under the earth but tell others Hence they even try to acquire these currencies from even that I have gone up. We say cargo other countries. For eg. India requires U $ so much that for despatch by ships and say when we sell sarees to Sri Lanka, we want U $ from them shipment for despatch by motor and not Sri Lankan Currency. Thus you can see that these transport. Similarly when we say hard currencies are used even for trade between countries free currency, it means very whose currencies are different. Since these currencies are freely used by other countries for their trade transactions, costly. these hard currencies are also called free foreign exchange or free foreign currency.

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NARRATIVE 6. These few fortunate countries who are industrially advanced and whose currencies are in demand by others, have no restriction regarding conversion of their currency into another. Thus they are called freely convertible currencies. HEREAFTER WHEN WE USE THE WORD FOREX OR FOREIGN EXCHANGE WE MEAN ONLY HARD OR FREELY CONVERTIBLE CURRENCIES. 7. Naturally, those countries which require these hard currencies have restrictions in their countries regarding acquiring, possessing & use. Such restrictions are to conserve these hard currencies to meet their requirements for essential imports. Hence Exchange Control. This Exchange Control is very similar to PDS of grains, kerosene etc. The history of our PDS on foreign exchange is as follows: a) Monopoly control over foreign exchange : Under this, by law, any forex coming into India had to be surrendered (sold) to the RBI only, at a rate fixed by RBI. Any one wanting forex had to buy it from RBI only, again at a rate fixed by them. In other words, there was a total rationing. The Banks held the forex as safe keepers on behalf of RBI. In other words, Rupee was convertible into forex only at the rate fixed by RBI. Any forex coming into or going out of India had to be only through banks specially permitted by RBI (called Authorised Dealers). Possession of forex by anyone without the RBIs permission was a punishable offence. Thus the forex prices were fixed by RBI only & artificial. (Consequently there was very little incentive for any business to earn forex; many who did earn, kept it secret, leading to a huge blackmarket in forex) b) The above stated regime was called Fixed Rate system. This lead to a situation of scarcity of forex to meet our requirements. We required the same in huge volumes very badly to purchase our requirements such as oil, arms, fertilizers etc. (We had managed so far till 1991 mostly out of borrowed forex, grants, aids etc. rather than earning them by selling goods/services).

TIT BITS
What are the sources of forex for a country?

They are * Export earnings on goods/services * Remittances of citizens working abroad * Loans * Grants / aid * Earnings on investments abroad * Receipt of repayment of loans given * Receipt on tourism/travel etc.
What are the outflows of forex of a country ?

4 4 4 4 4 4 4

Imports of goods/services
Repatriation by foreign workers here

Loans Grants / aid Return on investment by foreigner Repayment of loans & interest Tourism/Travel etc. abroad

These inflow & out flows have to be matched properly so that sufficient forex is available to us to meet our requirements. This policy decision is taken by Dept. of Economic Affairs (DEA) of Min. of Finance. RBI is entrusted the job of administering the same through Exchange Control Regulations. Even advanced countries have some sort of restriction on forex. These are basically to protect their own industries being taken over by foreigners. i.e., though their currencies are freely convertible, the use to which they can be put in their country is restricted. For eg. your having with you does not mean Britain will permit you to buy land in UK. These are called Investment restrictions by foreigners. Similarly a Japanese can sell & buy U$ without restriction as they are freely convertible currencies. But he may not be able to use it to buy General Motor Company in USA. Hence free convertibility is to be differentiated free use of convertible currency in the country of that currency.

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NARRATIVE c) To see that foreign exchange flow into India increase to meet our requirements the Govt. had to do the following: i) To give incentives for people to earn forex & bring them into our country ii) To give incentives to people abroad to invest in India by bringing in foreign exchange iii) To give incentives to Indians abroad to send their forex earnings to India. d) Partial Monopoly Regime: In 1991, Dr. Manmohan Singh de-monopolised control over forex by RBI partially. e) In what was called Liberalised Exchange Rate Management Systems (LERMS), RBI reduced their monopoly control over foreign exchange to 40%. In other words, 40% of forex coming to India, had to be surrendered (sold) to RBI at a rate fixed by them. The balance of 60 % was permitted to be sold at the market rates (ie. Price of forex determined according to demand and supply in the market) by the banks, to those who required forex to pay for their (permitted) imports, expenses etc. The 40% portion compulsorily acquired by RBI at a fixed rate (naturally much lower than the market price) was made available at a low fixed rate to importers of oil, fertiliser & pharmaceuticals. This was also used for repayment of borrowed forex and interest by the Govt. This regime was known as dual rate system. The following example illustrate the working of this dual rate system. i) An exporter of garments gets U$ 10,000 for his exports. This U$ 10,000 comes to India through authorised banking channel anyway. ii) Out of this U$ 10,000, RBI will acquire U$ 4,000 @ Rs.25.00 per U$ as fixed by RBI. iii) The balance U$ 6,000 will be purchased by the bank from the exporter at market determined rates say Rs.35.00. iv) Thus the exporter will get Rs.100,000 (for the 40% portion surrendered to RBI) + Rs.210,000 (for the 60% portion purchased by the Bank at market rate), totalling to Rs.3,10,000 to the exporter.

TIT BITS The forex your reserves (Reserves commitments for mean the amount available to meet immediate imports, loan repayments, interest etc.) at one point of time was so low that it was sufficient only to meet 2 week requirements of imports. We had to pledge our gold in England to borrow temporarily to meet our repayment dues on date. Subsequently we retrieved our gold back after our forex reserve position improved. In early 1973, when OPEC at the instance of Iran quadrupled the oil prices, the RBI was compelled to float the exchange rates. What it really meant was that even the fixed rates by RBI will undergo changes in relation to the exchange rates between and other currencies. (RBI used to take as the principal forex otherwise known as reference currency, to fix the rates for other currencies). For example let us say RBI had fixed Rs.20 for one . Now you wanted DM. What will be the price of the DM to you ? The Bank will find out how much 1 can get in the foreign market. Supposing it fetches 2 DM, then the price of DM will be Rs.10 to you. For instance, earlier RBI had fixed Rs.1.896 for 1 SFr. Now this rate was no more valid. You had to see how many SFr a can get in international market to know the price of SFr. Nov. 73. It became Rs.2.65 in

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NARRATIVE Under our exchange control, no one other than Authorised persons (ie. Permitted by RBI) can buy or sell forex. Hence when the exporter gets U$ 10,000 for his export, he cannot keep it with him. He has to sell it to the authorised dealer, (normally his bank through whom he received the money). Under the dual rate system, the bank purchased U$ 4000 at RBI rate (and held it on behalf of RBI) and U$ 6000 at the market rate.

TIT BITS In 1991 the reference currency was changed to U$. In other words, today if you want DM 10,000, how do the bankers quote? They first find out

how many U$ it will cost to buy DM 10,000 abroad. Let us say it will come

to U$ 6000. Now, the market price of v) What did the RBI do with the $ 4000 acquired by U$ in India, is say Rs.240,000. them @ Rs.25.00. This was sold (through Banks) to oil/fertiliser/pharmaceutical importers @ say Therefore the banker will quote Rs.24 Rs.26.00 (fixed by RBI). as the price of DM. For example : Under Public Distribution System, the Govt. compulsorily procures say 40% of rice from the grower @ Rs.5.00 per kg. This is distributed to the poor through ration cards @ Rs.5.50 per kg, at 10 Kg per person per month. Other people will have to buy During USSR regime we had a special their requirements of rice from the market where the balance 60% of rice would be sold at market- deal with them. They used to sell their determined price, may be Rs.10 per kg or more. goods to us for Indian rupees and use Similarly under the above dual rate forex pricing, the same to buy their requirement in oil/fertiliser/pharmaceutical requirement of forex was India. But our purchases from them given by RBI at Rs.26 per U$. For other importers, they had to buy forex from the Banks at the market- (mainly defence items) were more determined prices, may be Rs.35 or more per U$. than their purchases from us (mainly f) The above dual rate system gave some incentive to the coffee, tea, tobacco etc.) that we owed exporter. At least for 60% of his forex earning, he got them around Rs.20,000 crores at the market-price. time of dismemberment of USSR. g) The RBI (and the Govt. of India) also took steps in Subsequently the erstwhile USSR liberalising other restrictions on foreign investments in India. Earlier no foreigner was permitted to own more countries have insisted that our than 40% in industries in India. Moreover even Indians purchases from them have to be paid had to apply for permission/ licences etc. to start any industry. All these were liberalised to a large extent for only in hard currency. selectively by amendment to Industries (Development Special schemes are in place for & Regulation) Act.. This enabled foreigners to invest forex in India to start industries either by lending for liquidating this balance of Rs.20,000 interest or owning shares (on which they will get crores due to them. This scheme is too dividends). However this liberalisation was done gradually with restrictions that they cannot withdraw complicated to discuss in this paper. their forex investments before a specific number of years.

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NARRATIVE

TIT BITS

h) The earners of foreign exchange (ie. Exporters of goods RBI giving up monopoly over forex and services) were extended special income tax benefits does not mean, anyone can buy or sell on the profits earned out of exports. Similarly various other incentives such as special benefits for starting forex. This still has to be done only by Export Oriented Units, Special Import Licences, those licensed by RBI. Customs duty free import facility for export production etc. were announced/liberalised. i) Similarly special facilities and concessions were What it meant was that any one who is extended to Indians abroad (called Non-Resident permitted to buy or sell forex can do Indians - NRI) to send their forex earnings to India so at the market determined rates. In (called repatriation). India forex market consists of only These steps helped in increasing the forex in-flow to a large extent. But these were not enough. Still our those authorised to buy/sell, deal in requirement for forex was much more than what we forex. were getting. Other countries like China, Taiwan, Korea etc. were giving more concessions to attract forex. Moreover with the dismemberment of USSR into In order to see that these authorised several countries, they were also looking for acquiring the forex to meet their requirements. Hence the forex from the advanced countries were flowing more to those countries than to India. Thus a situation arose (Foreign foreign currency. k) Full Market Rate Regime: In 1992, RBI completely gave up their even partial monopoly over the forex. Exchange Dealers where we had to take further steps to attract in-flow of Association of India) Rules are in vogue. These rules besides giving dealers do not form cartels, hoard forex and exploit people, FEDAI

j)

guidelines as to pricing of forex,

From then on all forex prices are determined only by lays down the guidelines regarding the market based on demand and supply. For their own charging of interest, commission, bank requirements of forex, RBI also buys from the market charges etc. at the market prices. This meant even oil, fertiliser, pharmaceutical industries who were getting their forex from RBI at a very low fixed rates, had to buy their requirements at market prices. To sum up, the forex prices today are left to the market forces. If more forex comes in than what is required the forex prices will be down. If forex requirement is more than what is coming in, the forex prices will be up. The RBI giving up monopoly over forex and forex prices had given a tremendous boost to in-flow of forex, due to simultaneous liberalisation of other Govt. controls in Industry etc.

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l)

TIT BITS Forex prices being determined by the market is called What happens when restrictions on forex is removed totally overnight ? full convertibility. It does not mean free convertibility. This distinction is important. Full Let us take the example of Indonesia convertibility means the prices of forex is determined which made their currency freely by the market. Free convertibility means your being convertible in order to attract forex inflow. Because the Indonesian able to buy or sell forex for whatever purposes you currency became freely convertible, want without any restrictions. Indian Rupee is still not Indonesian businessmen borrowed freely convertible. There are still restrictions. For huge amounts of forex from abroad. example if you earn U$ 10,000 out of your exports, you These borrowals were short-term borrowals i.e., to be repaid to the cannot keep it abroad or with yourself or sell it to lender within one year of borrowal. anyone you want. You have to sell the same only to the There were no restrictions about how authorised dealer. But you will get equivalent in to use the forex borrowed. The Indian rupees at the market rate which will depend on Indonesian borrower used this forex to buy land, building, factories etc. in demand/supply position of forex at that time. Similarly Indonesia. When the time for you cannot go to the bank and buy U$10 for buying a repayment came (at the end of one New York lottery ticket. You can buy forex only for year), the Indonesian borrowers have specified genuine requirements (specified in exchange no money. Remember he has to repay in the currency he borrowed. Hence control) such as import of raw materials, machinery, when repayment time had come, there foreign travel, medical expenses, foreign studies etc. was a huge demand for the forex (even here certain restrictions are applicable. For whereas there is no matching inflow of example you cannot ask for $ 100,000 for your travel forex. This matching inflow of forex can be only in 2 methods abroad).

NARRATIVE

m) Even this full convertibility (ie. Forex being bought a) By producing goods and exporting or sold at market rates) is restricted to what is called the same to earn forex. Current Account transactions. This means forex can b) By borrowing again. be bought/sold at market prices only for the purposes of The first one i.e., (a) is not possible import/export, travel, interest/dividend payments etc. because production is yet to and not for investments (Capital Account) abroad. commence and export market is not For example you cannot buy forex to buy shares abroad there for the goods. or give loans outside India. You cannot buy land in The second one i.e., (b) is not London by buying in India and using the same for possible because the lender abroad is purchase of land at London. Similarly you cannot buy not prepared to lend again unless he is sure his loans will be repaid on time forex to pay another resident in India. (& with interest in forex).

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NARRATIVE SUMMARY Today forex prices (exchange rates) are determined by the market without any Govt. restrictions.

TIT BITS Consequently forex price in Indonesia shot up to such high that the Indonesian borrower could not buy forex for repayment.

Result : Bankruptcy, insolvency, winding up etc. When this happened in Buying or selling forex is still restricted only for authorised Indonesia, there was a chain reaction. The Japanese lender (bank) to purposes only. Indonesia could not recover his money. Consequently he could not repay his customers who had lent him Dealing in forex can be only by those authorised by RBI. money. So Japanese Bank collapses. This phenomena called borrowing Indian rupee is fully convertible that too only on Current short & investing long (borrowing short term funds and investing in long Account transactions term assets) leads inevitability to such crisis in the absence of any control mechanism. This usually leads to a Indian rupee is not yet freely convertible as the freedom debt trap meaning you have to borrow more just for repaying earlier to buy or sell is still restricted. borrowals with interest. How to get out of it ? Restrictions are still in place for foreign investments in This is where organisations like World Bank/ IMF come in. They lend money India as well as Indian investments abroad. They are to overcome such situations by lending money for a reasonably long period of slowly being relaxed. time at a low rate of interest. This period gives you sufficient time to use the borrowed money to earn forex before repayment time. However, to ensure that the borrower will have sufficient forex at the time of repayment, WB/IMF certainly put a lot of conditions which will affect the internal policies of the borrowing country. They do not want this forex to be used up by the borrowing country for wasteful purposes. They put conditions regarding reduction of fiscal deficit, inflation rate, control over industries etc. This do create political unrest & turmoil etc.

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III. FOREIGN EXCHANGE RATE RISK MANAGEMENT NARRATIVE 1. INTRODUCTION: To start with, let us study the risks involved in receivables of money in Indian Rupees through an example: Example: You have to receive Rs.1,000,000 from your customer 30 days from today. The following are the risks involved: (1) Whether you will get any money at all on the 30 day (Recovery Risk or Credit Risk) (2) Opportunities you may lose within the next 30 days.
th

TIT BITS In 1950s & 1960s, bread was not at all in demand in South India because no one had developed taste for it. It used to be prescribed by doctors as a diet for sick people. Whenever we fell sick we used to be given only bread and milk (and sometimes biscuits too !) ! Milk chocolates used to be only for rich people. Look at the market now. Every village has a bakery. There is

May be if this amount of Rs.1,000,000 was with you abundance of milk chocolates. Due to now, you could have saved Rs.10,000 interest you are change in the standard of living, paying your bank for borrowals; or may be you could awareness etc.. there is a lot of have purchased shares in a blue-chip company; or may demand for these; and supplies are be you could have a plot of land allotted to you or also abundant. bought a house; or may be.(opportunity Risk). (3) Due to inflation, prices are going up by 10% p.a. So Similarly the Hawai Chappals : what you could have purchased today for Rs.1,000,000, What today everyone calls bathroom will cost you Rs.1,010,000 after 30 days. Conversely, slippers used to be a premium item in the value of Rs.1,000,000 received 30 days later is 1950s & 60s. Only super-rich people equal to only Rs.924,243 ( 1,000,000 100/110 1/12 ) could afford it. One of the must buy today (Value Risk). on a foreign tour to western countries, These above are financial risk any one undergoes for was this chappal. It used to be a gift amounts to be recovered. These risks are applicable article on birthdays. Can you think of whether the amount you have to receive is in our own the same now ? Look, what supply, currency or foreign currency. demand and liberalisation of markets If what you have to receive is foreign currency, additional risks you undergo are: Todays car market is a good example. (a) Rate Risk & (b) Regulatory Risk. Due to supply exceeding the demand, the prices of cars fall. have done !

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NARRATIVE Remember when you have to receive foreign exchange it is foreign goods as far as you are concerned. You have to sell these in India to recover your money in Indian Currency. Hence the additional risks are: (a) What is the price in rupees you will get for the forex (Rate Risk) (b) What is the legal provisions of your country on forex transactions (Regulatory Risk). We have already seen that Exchange Rate means the price of a foreign currency. If prices of Potato, Onion, Rice, Wheat etc. change frequently, why not the prices of forex? Still it baffles us quite a bit ! Why ? This is because we are not directly buying or selling forex. Instead we use them as money to pay for our foreign purchases, travel etc. The confusion on forex prices arises in us because we do not deal with them directly but get affected by it. (The jargon used by the forex dealers such as volatality, forward rates, premia, discount, cross-currency rates. oversold, over bought, cover operation, squaring, call rate. bid-rate, bills rate, TT rate, exposure, position etc. add to the confusion). For example, an increase in the electricity power tariff affect hotels. They in-turn increase the price of Chapathy, Coffee, Idly etc. You are able to connect the increase in the price of Coffee to increase in the price of electric power. Similarly your petrol prices may go up because the price of U$ has gone up. What is the connection ? The price of Petrol may remain at U$ 20 per barrel. But the price of U$ may go up from Rs.40.00 to Rs.50.00. Hence automatically the price of petrol to you will increase to Rs.1000 from Rs.900 per barrel. Is this increase due to increase of price by the petrol seller ? No ! It is due to increase in the price of U$, which is the currency the petrol seller abroad wants.

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NARRATIVE The question now would be : why does the price of forex go up or down ? Why does the price of Potato, Onion, Tomato etc. go up or down ? The answer is : demand and supply. What causes the change in demand & supply of vegetables ? Rain, drought, floods, harvest, seasons, tastes, transportation, stocks, storage etc. etc. Same rules apply for forex also. A decade back our requirement for forex was lesser due to import controls, less quantity of oil imports etc. Further, we did not need forex for a large portion of our defence related imports. We had a special arrangement with USSR and other communist countries like East Germany, Poland, Romania, Bulgaria, Checkoslovakia etc. They used to supply our requirements against payment in rupees. They used these rupees to buy their requirements of Coffee, Tea, Tobacco etc. from us. Those days are now gone. Now they also want only forex for our purchases from them. Hence the demand for forex in India has increased. Since we do not have matching inflows (through exports, earnings etc.) of forex, the price of forex is high. Supposing we become self sufficient in our oil and stop importing arms & weapons: Then what will happen to the price of forex in India ? It will go down due to lack of demand. 2. INFLATION AND FOREX RATES: The world consists of more than 150 countries. Each of them have geographical boundaries; each have different system of government, different ideologies, culture, religion etc. Because of these geographical borders, each country insulates itself from outside influences by various barriers and restrictions ostensibly to protect their own people. These independent political entities are called governments, countries etc. They have different trade policies, tax structure etc. Naturally each country will have something in plenty and something else scarce. The prices of the goods will accordingly, in each country, be constantly changing depending on demand and supply.

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How does inflation rate affect the exchange rates ? See the example: Assumptions a. There is a total free market for onions globally. b. In 1990, the price of onion was U$ 100 per tonne in USA and Rs.3000 per tonne in India. c. Average annual rate of inflation in USA was 3% and in India 8%. What will be the price of onions per tonne in USA & in India in 1999 ?

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NARRATIVE Each country evaluates the total commercial value of goods Year and services in that country from time to time. Such calculation will show the general trend of prices i.e., 1990 whether the average prices are going up or down based on

TIT BITS Price per tonne of Onion in USA U$ 100 in India Rs.3000

ie. price of U$ will be Rs.30.00

total volume of all goods and services. When there is an 1999 Increase due increase in the prices as a whole compared to the same to inflation volume in an earlier period, such increase is calculated in (9 years) 27 % percentage terms. This is called inflation. price U$ 127 IN OTHERWORDS INFLATION RATE INDICATES U$ rate =

72 % Rs.5,160

5160 = Rs.40.63 127

THE AVERAGE INCREASE IN PRICES OF ALL From the above you can see that in a GOODS & SERVICES ARISING DUE TO DEMAND totally free market forex prices will EXCEEDING THE SUPPLIES OF ALL THE GOODS & change with reference to differential SERVICES PUT TOGETHER, OVER A SPECIFIC PERIOD OF TIME. inflation rates between the two countries compared.

Why do we feel odd about the inflation rates announced by Government ? Study the illustration below: PRODUCT PRICES
Months Cashew/Tonne Potato/Tonne Onion/Tonne Mango/Tonne Apples/Tonne Total

Rs. June July Difference % 100,000 100,000 Nil

Rs. 10,000 12,500 + 2,500 25%

Rs. 10,000 12,500 + 2,500 25%

Rs. 10,000 15,000 + 5,000 50%

Rs. 20,000 15,000 - 5,000 - 20%

Rs. 1,50,000 1,55,000 + 5,000 3.33%

When the Government says inflation is 3.33 %, they have computed the average of all products. As a consumer you are looking only at Potato & Onion. Thus you feel agitated about the Government statistics (of 3.33 % inflation) when prices of your needs have gone up by 25 %. In a free market, when the rate of inflation between 2 countries are different, the difference will

automatically affect the forex price of the currencies compared.

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NARRATIVE 3. RISK & EXPOSURE : We do worry about the price of Potato & Onion not only for todays requirement but also next month. In short we have the risk of uncertainty of the price at a future period of time. Similar is the case with forex. If you are thinking of importing anything, you may know the price of the product in forex but not the price of forex itself. For example you may know a CD costs you U$ 10 but you do not know what is the price of U$ 10 in Indian rupees next month when you have to pay for the CD. This uncertainty-risk becomes a fructified-risk once you order the CD. That is, once you have committed yourself you are now exposed to the risk. The risk has come alive. You are bound to pay U$ 10 for the CD ordered and you do not know how much this U$ 10 will cost you. This fructified risk is called exposure when you have a commitment to pay a specified amount of forex but you do not know how much this forex will cost you in Indian rupees. Every day we take risks in our commitments. For example we book our railway or air-tickets weeks in advance. Even if you have already paid for them (and have confirmed reservation) you have to still pay for any increase in the fare on the date of journey. In this type of risk there is no method available to be absolutely sure of the amount you have to pay. In regard to forex (and also commodities) there are several methods available to 'cover' this "exposure" (risk). In other words there are mechanisms available by which you can be sure of the price of forex on a future date. These are called "Hedging" techniques. "Hedging" means "protection" from an identified risk. By 'hedging' you 'cover' yourself from an 'exposure' by becoming absolutely certain of the amount you have to pay in your currency.

TIT BITS "Exposure" and customs duty : As per our Customs Act, the rate of duty payable on any import is as on the day of arrival of the goods ("entry inwards") or on the day you file your "Bill of Entry" with the customs authorities whichever is later. If the imported goods are bonded in a warehouse, then the rate of duty is as on the date of removal from the warehouse. Hence when you place an order for import, you are exposed to the risk of uncertainty, of "rates of duty of customs".

Not only the uncertainty of rates of duty but even the rate of exchange to calculate the imported goods value. Under Customs Law, the exchange rates (for customs purposes only) are notified from time to time. Only such rates as on the date of your Bill of Entry can be adopted for Customs Valuation of imports. Here also there is no method available to protect yourself from the risk of exchange rate

fluctuation, besides risk of change in Let us take an example: In January, you have ordered for a Mercedes car from rate of duty. Germany. You have agreed to pay DM 20,000 for the same in April when the car will be shipped and bill will come to you. This commitment is a binding contract.

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NARRATIVE Since there is a commitment on your side to pay DM 20,000 in April, you are exposed to risk of price of DM for Indian rupees. You do not know whether DM will cost in April for Rs.30 or 40 or 25. So you have an exposure. Is it of any use, your knowing today's price of DM. Say Rs.28? Now let us examine what are the methods of protection (hedging) from this exposure ie., you want to be sure of how much Indian rupees you have to shell out for this DM 20,000. a. Method 1: You know today's price of DM is Rs.28. So you may buy the DM 20,000 today at todays price, keep the DM 20,000 safe and pay the German in April. This means you have to pay Indian rupees today @ todays price say Rs.28 per DM. You will be out of pocket today to the tune of Rs.5,60,000/-. If the interest rate for Indian rupee is 12% p.a., you are incurring an opportunity loss of Rs.16,800 which you could have got by investing the Indian rupee in the Indian market. Thus the elimination of the forex exposure in this method will cost you Rs.5,76,800/-. Moreover, what about safety of the DM 20,000 ? Our forex law does not permit you to keep the forex with you. Even if you want to pay the German today, there are restrictions (and the risk of German party swallowing the money and not sending you the car). Most important of all: Liquidity ! Can you afford to be out of pocket for Rs.5,60,000 today ? b. Method 2: Assuming that interest rate in Germany is 4%, buy DM 19802 today at today's price and keep it in a bank in Germany for 3 months. Thus in April you will get DM 20,000 to pay for the car. This means you will have to shell out Rs.5,54,456 (19,802 of interest @ 12% p.a. in Indian rupees for this will be Rs.16,634. Thus the total cost would be Rs.571,090/-. Again the problems are: (i)You are out of pocket today for Rs.554,456 and (ii) Our law does not permit you to keep forex deposits abroad.

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NARRATIVE c. Method 3: Enter into a "forward contract" today with your bank (authorised dealer). He is also going to do the same as above but out of his funds. He is going to charge you Rs.571,090 (or one DM = 28.5545). The advantage is that (i) you are not out of pocket (ii) you are sure of your liability in April regarding DM 20,000 ie., Rs.571,090. Probably the banker may add a few paise for his services and quote to you DM @ Rs.28.56 ie., Rs.571,200. (In actual practice, the banker is not going to 'buy' the forex today and keep it in FD abroad. Instead he will enter into a similar transaction like yours, with his 'big brother'. Or he will seek out an exporter from whom he will get DM 20,000 in April to meet your requirement. d. Method 4: Enter into an "Option Contract" today with your bank. In this type of contract, you negotiate with the bank for a certain price of DM 20,000 for April delivery to you (called "Strike Price"). In this type of "Option Contract", the understanding is : if you want, the banker has to deliver in April DM 20,000 at the "Strike Price" agreed to; If you do not want, the banker cannot insist on your buying the DM in April at the Strike Price. Let us see the advantage in this through illustration: I) You have got a "strike price" of Rs.30.00 per DM for April. II) If in April, the "Spot Price" of DM is only Rs.29.00, you need not honour the "option contract" at Rs.30 per DM. You can buy forex at Rs.29.00 per DM & remit the money to German party. III) If in April, the "Spot Price" of DM is only Rs.31.00, then you can demand DM 20,000 from the banker at the "strike price" of Rs.30 per DM and thus protect yourself (and save Rs.20,000) FOR THIS TYPE OF CONTRACT, THE BANKER TAKES A RISK SPECIALLY IF 'SPOT RATE' IN APRIL IS LESS THAN RS.30 PER DM. IN SUCH A CASE YOU ARE NOT GOING TO HONOUR THE CONTRACT AND HE HAS TO FIND ANOTHER BUYER TO WHOM HE MAY HAVE TO SELL IT AT LESS THAN 'STRIKE PRICE' OF RS. 30 PER DM. Hence for this type of contract, the banker will charge you "up front premium" (cash down). This premium is like the insurance premium and is not refundable. This means this "premium" will be your cost of the contract whether you honour the same or not. This is referred to as the option price.

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