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SVKMS

NMIMS SCHOOL OF LAW

A PROJECT SUBMITTED ON;


RBI and Foreign Exchange Management
IN COMPLIANCE TO PARTIAL FULFILLMENT OF THE MARKING
SCHEME, FOR TRIMESTER II OF 2014-2015, IN THE SUBJECT OF
ECONOMICS II
SUBMITTED TO FACULTY:
Ms. BHAKTI KULKARNI

SUBMITTED BY:
Neel Narsinghani
BBA LLB (HONS) ROLL NO A059

RECEIVED BY: ____________________________


ON DATE: __________ TIME: _________

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INDEX
Sr.No

Topics

Page.
No

Chapter
1.

Research Methodology
Relevance of Topic
Scope of Study
Objective of Study
Hypothesis
Limitation of Research

04-05

Chapter
2.

Introduction
Origin and Evolution
Origin and evolution in India
Contemporary position
Contemporary position in India
Role Of RBI in Foreign Exchange Management

06-10

Chapter
3.

Macro Economics Analysis


Analysis in Macroeconomics
Theories
Exchange rate determination
Diagrams

11-16

Chapter
4.

Relationship between Economics and Law


Interdisciplinary Linkage
Constitutional Provisions

17-22

Chapter
5.

Comparative Study
India and US
Between Different aspects of economics

23-27

Chapter
6.

Summary

28-29

Chapter
7.

Suggestions

30-31

Chapter
8.

Bibliography

32

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Table of Abbreviations used


Sr.No
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Abbreviation
Govt.
FY
GOI
IT
GDP
Prof.
US
SC
UK
SGD
AUD
FERA
FEMA
LERMS
MFER

Full Form
Government
Financial Year
Government of India
Income Tax
Gross Domestic Product
Professor
United States
Supreme Court
United Kingdom
Singapore Dollar
Australian Dollar
Foreign exchange regulation Act
Foreign Exchange Management Act
Liberalized exchange rate management system
Managed Flexible Exchange Rate

Table of Statutes Referred


Statute
Constitution of India
FERA
FEMA
Reserve Bank Of India Act

Year
1950
1973
1999
1934

CHAPTER 1
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Research Methodology:
Relevance of the topic:
The topic being Foreign exchange management and RBI is highly relevant in
todays world is related to svral aspcts of conomics and law, this at th sam tim
maks it a grat topic to rsarch on. This system of exchange management has been
gaining importance from the last one century as international trading is on the rise and
each economy has realised that it can no longer be self-reliant. Due to this, this topic
has started gaining importance, without which a national will be impaired from its
ability to trade in the international market. As it plays with the value of the currency in
the international market, it has to be given prime importance, because it is the value of
a currency in the international market that affects the whole of the economy within the
country.

Scope of the study:


The study is focusing to reveal the insights of the Foreign Exchange Management.
This looking so simple task is actually a hericulan and one of the most complex tasks
carried out by the Reserve Bank of India. The study attempts to give the utmost
insight needed to simplify the understanding of this management. It also compares the
management done by the RBI than that of the Foreign banks, and how the US$ dollar
is managed in quite a different manner than that of rupee.

Objective of the Study:


The objective of the study is to research on the topic of Foreign Exchange
management by RBI in detail, and globally in brief. Although, the main objective of
the study to gain personal knowledge on topic but there are other objectives too. With
the rising importance of trading in the international market, it has become one the
main object of the study to focus on the trading aspect that is related to foreign
exchange management.

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Research Question/Hypothesis:

Why is it the need of the hour to study foreign exchange management?


What different aspects of economy are affected by foreign exchange

management?
Why is it considered so complex?
Does US$ have an edging advantage over the other of having a globally

accepted currency?
How does the RBI manage this process?

LIMITATIONS:
Thr ar svral limitations of this projct too bcaus I am not abl to covr th
ntir topic and dpth study of all th aras. Som portions of th Foreign Exchange
Management ar not covrd undr this study du to th lack of undrstanding of th
topic. Th projct fails to conduct a primary rsarch thorough xamination,
intrviws and survys du to lack of tim. Th rsarch of th projct limits to books
and intrnt contnt.

Chapter 2

Introduction

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Foreign exchange is the The exchange of currency from one country for currency
from another country.1 Or it may also be defined as System of trading in
and converting the currency of one country into that of another.2

Origin and Evolution:


Before the system of money, barter system was prevalent. In the barter system, the
commodities were exchanged between people to fulfil the needs of the entire
population. But with the passage of time this system of trading faced many challenges,
for eg. The need of everyone could not be satisfied with the rise in population. The
system of printed money had to come into existence because of the drawbacks of the
barter system. With the emergence of the new exchange system, the problems of the
old barter system were solved but with the passing time, it also had to face a few
challenges.
With the formation of new countries, each one of these started developing their own
currency to trade in. In the initial stage, this did not cause any problem, for trading
within the country the printed money proved very useful. Difficulties arose when there
was a question of exports and imports. Each country with its own currency was
trading within its boundaries, but the question was, how the payment will be done
when there are exports and imports. This question arose because each country had a
different currency and did not recognise other currency. So the currency of one
country was totally worthless in the other. This made trading between the countries
difficult as there was no proper medium of exchanging the money. Finally, each
country had to maintain other countries currency reserves so as to continue trading
between the two.

Origin and evolution in India:


1 http://en.wiktionary.org/foreign_exchange
2 http://www.businessdictionary.com/definition/foreign-exchange-Forex-orFX.html
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Under the Bretton woods system India declared the par value of rupee in terms of gold
as equivalent of 0.268601 rams of fine gold. Historically, rupee was linked to rupee
sterling. In terms of pound sterling, the parity was Rs 1= 1 shilling and 6 pence.3
In September 1949, the pound sterling was devalued and there was a corresponding
devaluation of the rupee. The gold content of the rupee was reduced to 0.186621
grams. In June 1966 India devalued rupee by 37.5 per cent and the parity rate of the
rupee was fixed at US$ 0.133333 equivalent to a gold parity of 0.118489 grams.(NoteThere was free convertibility of US dollars into gold at the official rate of US$ 35 per
ounce. In 1971, the fixed parity system, or what was better known as the Bretton wood
parity system broke down, the major currencies started floating. The US suspended
the convertibility of US dollar into gold. Then it was decided to peg the rupee to dollar
at Rs 7.50. The RBI however retained pound sterling as the currency for intervention. 4
The rate of pound sterling was determined on the basis of the rate of US dollar to
pound sterling in the London market. In September 1975, Rupee was delinked from
the pound sterling and linked with a basket of currencies. The value of rupee was
determined by the value of currencies that constituted the basket.
Contemporary position:
The subject of foreign exchange reserves has received renewed interest in recent times
in the context of increasing globalisation, acceleration of capital flows and integration
of financial markets. Each nation has its own official currency, which is normally
issued by the central bank of the country.
The two basic questions that arise out of this are:
How is the value of rupee, that is, the rate of exchange determined?
Is the rupee convertible?

The answer to the first question is fully determined by market forces. TO answer the
second question, the concept of convertibility should be understood. Convertibility
3 Pg 171; Foreign Exchange Markets;Dun & Bradstreet
4 Pg 61; Foreign Exchange Simplified;B.Srinivasan
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means the conversion of a currency by his holder into any currency of his choice at
market determined rates.5 The rupee today is convertible on all current account
transactions, though therer are a few restrictions the capital account. The classification
of a transaction into current account or capital account is based on the classification
the balance of payment. Current account transactions are those that relate to the trade
in goods and services. Capital account transactions are those which bring about a
change in the assets and liabilities position of a country, such as external debts,
investments etc. India with its huge forex reserves is progressively moving towards
making the rupee convertible on capital market too.
The Indian Contemporary position:
In 1973, FERA was amended and it came in force on January 1 st, 1974. It gave wide
powers to RBI to administer exchange control mechanism properly. With effect from
March 1992, the US dollar was adopted as the intervention currency is place of
sterling and rupee was partially floated.

This System was known as liberalized

exchange rate management system (LERMS). The 1993-94 Budget made Indian
Rupee fully convertible on trade account. LERMS was withdrawn. Developing
countries allowed market forces to determine the exchange rate. Under flexible
exchange rate system, if demand for foreign currency is more than that of its supply,
foreign currency appreciates and domestic currency depreciates and vice versa. To
minimise the disadvantages of flexible exchange rate, most of the developing
countries including India have adopted the concept of managed Flexible Exchange
Rate (MFER).
Under MFER, the Central bank intervenes to bring stability in exchange rate. RBIs
intervention involves purchase of foreign currency from market or release (sale) of
foreign currency in the market, to bring stability in exchange rates.

ROLE OF RBI IN FOREIGN EXCHANGE MARKET

5 Pg 150;Foreign Exchange simplified;B Srinivasan.


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The role of RBI in the foreign exchange market is revealed by the provisions of
FERA (1973):
Administrative Authority
The RBI is the administrative authority for exchange control in India. The
RBI has been given powers to issue licences to those who are involved in
foreign exchange transactions

Authorised Dealers
The RBI has appointed a number of authorised dealers. They are permitted to
carry out ail transactions involving foreign exchange. The above provision is
laid down in Section 3 of FERA.

Issue Of Directions
The 'Exchange Control Manual' contains all directions and procedures given
by RBI to authorised dealers from time to time.

Fixation Of Exchange Rates :The RBI has the responsibility of fixing the exchange value of home currency
in terms of other currencies. This rate is known as official rate of exchange. All
authorised dealers and money lenders are required to follow this rate strictly in
all their foreign exchange transactions.

Foreign Investments :Non-residents can make investments in India only after obtaining the
necessary permission from Central Government or RBI. Great investment
opportunities are provided to non-resident Indians.

Foreign Travel :Indian residents can get foreign exchange released from RBI up to a specified
amount for travelling abroad through proper application.
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Import Trade:The RBI regulates import trade. Imports are permitted only against proper
licenses. The items of imports that can be imported freely are specified under
Open General Licence.
Export Trade:The RBI controls export trade. Export of gold and jewellery are allowed only
with special permission from RBI.
Gold. Silver. Currency Notes Etc.:In recent years, the limits fixed for bringing gold, silver, currency notes etc.
has been relaxed considerably.
Submission Of Returns:All foreign exchange transactions made by authorised dealers must be reported
to RBI. This enables the RBI to have a close watch on foreign exchange
dealings in India. Thus, from above points we can say that RBI is the apex
bank that intervens, supervises, controls the foreign exchange markets in order
to create an stable and active exchange market.

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CHAPTER 3

MACRO ECONOMICS ASPECT


Analysis in Macroeconomics:
Foreign Exchange, which is a study of macroeconomics, holds high importance even
in the Microeconomic aspects. Foreign exchange is affected by all the important
factors of

Macroeconomic study, such as GDP, GNP etc, thus becomes a very

important subject to study because of its effects at the Micro level. There are no two
opinions about its importance as a Macroeconomic study, but at the micro level too, it
is very important for its effect on the People. For eg-Travellers.
Understanding the role of banks:
Banks play a vital role. They perform many functions,. But the most important one is
that they are intermediaries through whom documents are exchanged for money
between exporters and importers. They are also the extended arms of the RBI and the
administration of FEMA. Every commercial bank deals in foreign exchange since it is
an activity with good potential for profits. But broadly we could classify the functions
into:
a)
b)
c)
d)

Finance of exports
Finance of imports
Misc. services like travellers cheques, currency encashment, etc.
Dealings, Rates of exchange etc.

To facilitate dealings in foreign exchange, a bank in India maintains account with


banks abroad. Similarly, some foreign banks may maintain the bank account in India.
In Banking terminology, these are known as Nostro account and Vostro account.6
Nostro account:- Nostro account means our account with you. For example, BOI
maintains an account with Natwest bank London. Obliviously, this account will be
maintained in pound sterling. When corresponding with the Natwest bank, BOI will
refer to its account with Natwest bank as nostro account, meaning our account with
you.
6 http://www.slideshare.net/anujzeal4u/rbi-intervention-in-foreignexchange-market
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Vostro account:- The account pended by a foreign bank in Indian rupee with an
Indian bank would be referred in all the correspondence by the Indian bank as Vostro
account, meaning your account with us. For eg- Bank of Middle East, sharjah
maintains a rupee account with Syndicate bank, Mumbai. Syndicate bank in all its
correspondence

with bank of middle east would refer to this account as vostro

account.
While analysing the Macro-economic point, the question arises of how does a
trade in currencies?
Any trading has two aspects: purchase and sale. So, going by this rule, the bank would
either purchase the commodity (Foreign currency) or sell the commodity (Foreign
currency). Banks would thus be paying Indian rupees for purchase of currency and
would accept Indian rupees and deliver foreign currency in a sale transaction. What
must be kept in mind is that the transaction classification, that is, a purchase or sale is
always referred to as banks point of view and the item referred to is the foreign
currency.
Purchase transaction means bank purchases/acquires foreign cuurency and pays the
home currency (Indian Rupees).
Sale transaction means bank sells/parts with foreign currency and accepts the home
currency (Indian rupees).
The Following chart best depicts the purchase and sale of transaction:

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Page 13 of 33

Following can the examples of the purchase and sale transaction:

The bank issues a demand draft on London for 5000 on behalf of XYZ

Sale transaction.
A telephonic transfer from

enterprise for US$ 25000- purchase transaction.


A traveller enchases a traveller cheque for US$ 100 and currency notes of

US$ 200- sale transaction.


A customer comes with demand draft of Jap 200000 to the bank for

Unilever Ltd. London in favour of Pilmur

encashment.

Theories:
Foreign Exchange management and markets are solely based on exchange rates. In
Finance, an exchange rate between two currencies is the rate at which one currency
will exchanged for another. It is also regarded as the value of one countries currency
in terms of another currency. While discussing international trade and foreign
exchange, two types of exchange rates are used:

Real Exchange rate


Nominal Exchange rate

Real exchange rate describes how many of a good or service in one country can be
traded for one of that good or service in another country. For example, a real exchange
rate might state how many European bottles of wine can be purchased for one US
bottle of wine. The real exchange rate abstracts away these issues, and it can be
thought of as comparing the cost of equivalent goods across countries. The real
exchange rate is the relative price of the goods of two countries. That is the real
exchange rate tells us the rate at which we can trade the goods of one country for the
goods of another. This real exchange rate is sometimes called the Terms Of Trade. The
Formula to calculate the real exchange rate is7
Real Exchange rate= (Nominal Exchange rate x domestic price) / (foreign price)

7 http://www.businessdictionary.com/definition/foreign-exchange-Forex-orFX.html
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Nominal exchange rate is simply the price of one currency in terms of the number of
units of some other currency. It is nominal because it measures only the numerical
exchange value, and does not say anything about other aspects sch as the purchasing
power of that currency. An increase in the value of domestic currency against other
currency is called an appreciation and a decrease in value is called depreciation.
Usually, in practical world, to find the current exchange rate of a currency, it is
generally expressed in Nominal Terms. To calculate the Nominal Exchange rate,
simply measure, how much of one currency will be necessary to acquire one unit of
another. Formula:
Nominal Exchange Rate= (Real Exchange rate x foreign price) / (Domestic price level)

Exchange Rate Determination:


The Price of any commodity is dependent on its supply and on its demand. In the
Foreign exchange market, the commodity is the foreign currency, i.e. the US dollar,
Japanese yen, euro, Swiss francs, pound sterling, and a host of other currencies. The
price of these currencies is called the exchange rate. The demand for, and supply of
these currencies would determine the rate of exchange. Now One of the basic question
that arises out of this is:
Who creates the demand and who Supplies?
The importer of goods and services, people wanting to remit money abroad for
whatever purpose, persons intending to travel abroad and a host of other people create
a demand for currency which could be US dollars, pound sterling, etc. They need
these currencies since they have to make payment to the overseas suppliers of goods
and services. To keep it simple, it could be stated as if you are an importer you operate
on the demand side and if you are an exporter; you are on the supply side.
But, Demand and supply are not the only factors affecting exchange rate; there are a
few others too.
For Example
a) Balance of Payments
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It is a record of the value of all the


transactions between residents of a
country with outsiders. In other words
it represents the demand for and supply
of

foreign

exchange

which

will

determine the value of the currency.


Exports represents the supply side;
while imports create demand for the
currency.
b) Inflation
This means rise in the prices of the domestic commodities. With increase un price the
exports maybe affected as it will cease to be competitive. To give an example, if both
India and US experience 7% inflation, the rate of exchange will not change. If on the
other hand India has 15% inflation and US has 5% inflation, then obviously the Indian
rupee will depreciate by 10%.
c) Money Supply:
An increase in the money supply in the country increases the supply of currency in the
foreign market and its value declines.
d) Political factors
Political stability induces confidence in the investors and encourages capital inflow
into the country. This would strengthen the currency and it would appreciate. In
likewise fashion where the political situation is volatile there the value of currency
will decline.

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Diagrams:

Below is the example of Foreign exchange reserves of India in US$ dollars(Million)

Date

30th
Sept
2011

31st Oct 30th


2011
Nov
2011

31st Dec 31st Jan 29th Feb 31st


2011
2012
2012
March
2012

Foreign
Exchange
Reserves

311,428

316,210

296,470

307,976

292,670

295,325

294,149

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CHAPTER-4

REALTIONSHIP BETWEEN ECONOMICS AND LAW


Interdisciplinary Linkage:
Economics and Sociology
According to Thomas, Economics is a branch of comprehensive science of
sociology. The fact that society is influenced by economic factors while environment
processes are largely determined by the social environments clearly proves that
relation between sociology and economics is very intimate. Economic Sociology is the
study of cause and effect of various economic phenomena.
Coming to the topic of the foreign exchange management, it is quite a way related to
the society at large. The activities carried out during the process of this management
ultimately have an impact on the general public. This management affects the value of
rupee in the Global market. Thus, due to this the value of rupee appreciates or
depreciates. This appreciation or depreciation ultimately affects the citizen or the
people of the country and thus has an impact on the society.
Economics and Political Science
Political Science and Economics are social sciences. Political science is the study of
politics in theory and practice, while economics is the study of how resources are
produced, assigned, and circulated. Political science is the science of governance.
Foreign exchange management is important for all the governments to that have to
work at the centre. It is through proper foreign exchange management that they will
have the enough foreign reserves to pay for the imported goods and services that
suffice the needs of the people in the country. Without this, the country has to be selfreliant, that in todays world is a herculious task. So, it is the government that has to
take utmost care while formulation the norms for such a task that effects on all the
sections of the economy.

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Present Legal framework:

The subject of Foreign Exchange Management is quite related to Law. All the
happenings needed to carry out foreign exchange management are backed by law.
The head of such management in any country is its central bank, that itself is a
legal body. For eg In the case of India, it is the RBI (Reserve Bank Of India), that
itself is recognised by Law. The Functions carried out by this Bank are related to
Foreign exchange management are codified properly and have various laws
governing it.

Foreign Exchange Management being very complicated process requires various


laws to govern the complete process. The laws govern day to day activities of the
management of currencies. Various statues governing such trading of currency
have become an integral part of any economy in the world. Foreign exchange
management is quiet a lengthy subject which comprises of many stages right from
acquiring foreign exchange to Selling it off, and there have to be laws governing
each aspect. As there are different problems that each country has to face regarding
the management, the remedies, i.e. the laws, also have to be home grown. There
cannot be a single set of laws that can be applicable on all the countries. Thus such
framing of laws even though makes the process more complex, but at the same
time helps towards making the system effective. With Laws falling into place, it is
only the system and method of the trading that has to take place effectively so as to
make profits during the deal.

Without Law governing all these happenings, there is no way that such a complex
management could have worked effectively and bring about a positive change in
the economy. But, it is not only the laws that have to be implemented to get results,
laws only come into force only when the guidelines are not adhered to. But for
gaining efficiency I the process, it is the management that will make the difference.

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As explained above, Laws are guiding each and every process of foreign exchange
management. In India, the RBI that is the central bank undertakes this management.
All this management has to be according the predetermined codes, rules, and
regulations. Such rules are codified into FEMA (Foreign exchange management Act).
Following are the details about the Foreign exchange management Act of India:
FEMA 1999, the acronym for Foreign Exchange Management Act 1999, was notified
by the government of India8, Ministry of Finance vie notification No. GSR (371)(E)
dated May 1, 2000, and has been in force since June 1,2000. This act replaced Foreign
Exchange Regulation Act (FERA) 1973. FEMA consists of 49 sections spread over
seven chapters9

Section 46 confers power to the government to make rules to carry out the

provisions of the act and broadly defines the area in which it may make rules.
Section 5 provides that the central Govt. may in the public interest and in
consultation with the RBI impose such reasonable restrictions for current
account transactions. So you could say that section 5 is an inclusive portion of

section 46.
Section 6 confers power to RBI to regulate, prohibit, restrict through
regulations and broadly defines its area of operation.

Administration of the Act

Foreign Exchange
Management Act (FEMA)
1999
Government of India

Reserve Bank of India

(Note- This study has mainly focused on the Current account transactions and not the
capital account ones.)
8 http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/VMBPW121212.pdf
9 Pg 279;Foreign Exchange simplified;B Srinivasan.
Page 20 of 33

Current Account Transactions and Its Rules


What is meant by current account transactions?
Current account transaction means a transaction other than a capital account
transaction and includes

Payments, due in connection with foreign trade, other current business, services,

and short-term banking and credit facilities in the ordinary course of business.
Payments due as interest on loan and as net income from investments.
Remittances for living expenses of parents ,spouse and children residing abroad
and.
Expenses in connection with foreign travel, education, and medical care of parents,
spouse and children.

Who is an authorised person under FEMA?


Authorised person means an authorised dealer, a moneychanger, offshore banking
unit or any other person for time being authorised in writing by RBI to deal in foreign
exchange10. And you as a person would have to deal only with the authorised person
and no one else when you

Deal or transfer any foreign exchange or foreign exchange or foreign security.


Make any payment to or to the credit of any person outside India, in other

words remitting money out of India.


Receive any money or payment by order in any manner from abroad.

What are the rules regarding account transactions?


In terms of the provisions of FEMA any person may sell or draw foreign exchange to
or from an authorised dealer if such sale or drawal is a current account transaction.
Which means there are hardly any restrictions.

But there are a few restrictions mentioned as under:


10 http://www.bis.org/publ/bppdf/bispap73l.pdf
Page 21 of 33

Those prohibited by the FEMA Act-transactions listed in Schedule I.


Transactions which require the prior permission of the govt- transactions

listed in the schedule II.


Transactions which require the prior approval of the RBI-transactions
listed in schedule III.

Schedule I (prohibited transactions)


There are certain restrictions, drawal of exchange for the following transaction is
prohibited

Travel to Nepal or Bhutan.


Transactions with a person resident in Nepal or Bhutan.
Remittance of income from racing/riding, etc, or any other hobby.
Remittance for purchase of lottery tickets, banned/proscribed magazines,

football, pools, sweepstakes, etc.


Payment of commission on exports made towards equity investment in joint

ventures/wholly owned subsidiaries abroad of Indian companies.


Remittance of dividend by any company to which the requirement of dividend

balancing is applicable.
Payment of commission on exports under Rupee State Credit Route.
Payment related to call back services of telephones.
Remittance of interest income on funds held in Non-Resident Special Rupee
Scheme.

Schedule II (Prior Permission of the govt.)11


No person shall draw foreign exchange for a transaction included in the schedule II
without prior approval of the govt. of India; provided that this rule shall not apply
where the payment is made out of funds held in Resident Foreign Currency(RFC)
account of the remitter.
Schedule III (Prior Approval of Reserve Bank)
No person shall draw foreign exchange for a transaction included in the schedule III
without prior approval of the RBI; provided that this rule shall not apply where the

11 http://www.rbi.org.in/scripts/statistics.aspx
Page 22 of 33

payment is made out of funds held in RFC (Resident Foreign Currency) account of the
remitter.12
Another question that may arise in the minds of reader is that why are drawal of
exchange for travel and transactions with Nepal/Bhutan prohibited?
This is because for exchange control purposes, rupee accounts maintained in India

By citizens of India, Nepal, and Bhutan.


Residents in Nepal and Bhutan.
Indian, Nepalese, and Bhutanese firms, companies or other organisations.
Banks functioning in these countries.
are regarded as resident accounts and rupee transfers to such accounts, for imports
into India (or for any other purpose), may be made freely, without reference to the
RBI. Hence sale of foreign exchange for current account transactions with persons
residents in Nepal and/or Bhutan, or against import into these countries made by
residents in India is prohibited.

12 http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14350#int
Page 23 of 33

CHAPTER-5

Comparative study:
Comparison between India and the US:
The role of Rupee as a currency and how the exchange is done in the international
market has been explained above. Rupee, like every other currency has to face the
challenges as faced by every other currency. Rupee, like every other currency, has to
see the appreciation and depreciation based on the economic conditions of the
country. This section will be primarily analysing the Merits and Demerits of having a
Global Currency US$
It is usually believed that America is having an edge over the other due to the
advantage of having a global currency. So, this section will compare that if there are
any such advantages to America.
In the following we will recall the determinants of an international currency. From
these
relationships we derive a simple graphical model which highlights some of the
benefits for an economy with a currency with reserve currency status. This model
exhibits the relationship between the foreign exchange market as well the capital
market. The supply of US dollars on the foreign exchange market has a positive
upward slop with an increasing exchange rate (dollars become more expensive
relative to other currencies) more dollars will be supplied to the market. The US
dollar supply curve can be shifted by a change in liquidity for instance increasing
the amount of US Treasuries (or other dollar assets) by the Federal Reserve. For the
purpose of this model, liquidity remains the only variable of the US dollar supply
curve. The US dollar asset demand curve has a negative downward slope: When the
exchange rate rises, the demand for US dollar assets declines. Liquidity and network
effects increase the international demand of US dollars by private and public actors,
due to its international currency status. The variable initiating a shift in the US dollar
demand curve is therefore liquidity, which would not be the case for currency
without international currency status. If the variable liquidity is altered, the US
supply as well as the US demand curve is shifted.
America, never had the problem of acquiring foreign exchange, as there is the
currency universally accepted. Heres what that means

Page 24 of 33

Lets say youre from England and you want to buy oil from Russia. You cant just
pay for your oil in British Pounds, because the oil is priced in dollars as are all
commodities.
So you have to buy dollars first, and then buy your oil.
This is partly why a gallon of gas in England is $7.75, more than double the average
price of gas here in the states.
And so, the value of the Pound is of great importance to the British government. In
order to maintain the value of its currency, the British must produce at least as much
as they consume from around the world otherwise the value of its currency will
begin to fall, causing prices to rise and its standard of living to decline.
But in America, they able to consume as much as they want without worrying about
acquiring the money to pay for it, because their dollars are accepted everywhere
around the world. In short, for decades now, they havent had to produce anything or
export anything to get all the dollars they needed to buy all the goods our country
wants.
In the end, if all you need is dollars to buy things, then just make more dollars. And
if you live in the country where dollars are produced, then youre on easy street.
It is widely believed that the dollar is overvalued.It is difficult to be precise about
what proportion of this overvaluation is due to the reserve currency status of the
dollar. According to the statistical estimates in an EPI Briefing Paper by Robert
Blecker, the rise in the dollar exchange rate up to 2002 caused the following negative
effects on the US economy:
A loss of three-quarters of a million U.S. manufacturing jobs;
A decline in profits on U.S. manufacturing operations of about $100 billion per
year;
A reduction in capital expenditures at U.S. manufacturing plants of over $40 billion
at an annual rate.
This is a clear advantage of the reserve currency issuer. But the large accumulation
in recent
years of foreign-held US debt has created a potentially significant responsibility that
could increasingly limit US policy autonomy. An argument could be made that the
reserve currency status is increasingly creating larger costs to the US economy by
forcing the United States to run significant current account deficits and accumulate
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debt. This is similar to Triffins Dilemma, first identified in the 1960s. Triffins
Dilemma is the idea that because the reserve currency issuer must provide liquidity
to the global system by issuing debt denominated in its currency, at some point the
pressure to provide additional debt will endanger the sustainability of the reserve
currency issuer. This could possibly place the system under great strain and cause it
to fall apart.
Cost and benefit in crisis years
What has been stated thus far about costs and benefits relates to normal economic
conditions. We will now consider how the distribution of costs and benefits changes
in an economic downturn. The net benefit as a result of reserve currency status is $40
billion to $70 billion in a normal year (0.3 to 0.5 percent of GDP).These figures
reduce in a bad economic conditions to the range of a net cost of $5 billion to a net
benefit of $25 billion (0 to 0.2 percent of GDP) annually. This decline in the size of
the net benefit occurs due to substantial inflows of foreign capital into the American
economy during a crisis year. There is a subsequent rise in foreign purchases of US
Treasuries which significantly increases the capital cost advantage in early 2009.
However, this larger benefit was outdone by a sharp appreciation of the dollar, which
had negative consequences on the competitiveness for the exporting industry as well
as companies in competition with imported goods and services. In the US Dollar
Index for the past decade, the dollar appreciated considerably during the financial
crisis, which had a highly negative effect on companys competitive position. The
incurred cost for trade increased from $30 billion to $60 billion in a normal year to
between $85 billion and $115 billion during the financial crisis in 2009 (a negative
impact on GDP of 0.5%).This exhibits some of the problems that a reserve currency
issuer faces in global economic downturns. The overall benefit of reserve currency
status diminishes to negligible levels.
Comparison between different aspects of economics:
Foreign exchange is a concept that is related to the majority of economic activities.
In this study it will be compared with the trading aspect of macroeconomics, i.e.
Imports and Exports.
These economics concepts form a circle of relations, i.e. both the topics are affected
by each other. There is effect of foreign exchange on the exports and imports of the
country, and on the other hand, the exports and imports also have impacts on the
Foreign exchange in the country. This is will be explained in detail in the following:
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Exports: Exports are usually believed to be good for an economy, which to some
extent is quite true. They are good till the extent the residents of the country do not
face the lack of goods due to over-exporting. Coming to the effects of exporting on
foreign exchange, they are usually positive. With the rise in exports we get to earn
more foreign exchange. This helps us to pay for the imports we do. Now coming to
what is the effect of foreign exchange on exports- A country can only trade when it
has reserves of the currency it wants to trade in. Thus is the country with which one
wants to trade is not having enough reserves of the currency that has to be
exchanged, then the trading cannot take place.
Imports- Imports, in general are not believed to be a good sign of an economy. It has
negative effects on the economy and the currency. With the rising imports, we have
to pay more to the other countries. For this we require more foreign exchange to pay
for. This is the reason, each economy lays high duties on the imports, so that due the
high duties on imports, there can be less of imports. There are two possibilities that
may happen in the case of imports:
i)
The currency to be traded in is a foreign currency
ii)
The currency to be traded in is the local currency
Well, both of these have negative impacts. When the currency to be traded in is the
foreign currency, we will have to acquire more of that currency, and this process we
have to sell our exchange that we had earned through the exports. In this process, the
demand of that currency rises and it appreciates in comparison to ours. The second
possibility, when the currency of exchange is our currency, then we will have to shell
out our currency to get the desired services, In this process, we create additional
supply of our currency in the global market and the value of our currency depreciates.

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CHAPTER-6

CONCLUSION
Summarization of the chapters:
The Reserve Bank, as the custodian of the countrys foreign exchange reserves, is
vested with the responsibility of managing their investment. The legal provisions
governing management of foreign exchange reserves are laid down in the Reserve
Bank of India Act, 1934.
The Reserve Banks reserves management function has in recent years grown both in
terms of importance and sophistication for two main reasons. First, the share of
foreign currency assets in the balance sheet of the Reserve Bank has substantially
increased. Second, with the increased volatility in exchange and interest rates in the
global market, the task of preserving the value of reserves and obtaining a reasonable
return on them has become challenging.
The basic parameters of the Reserve Banks policies for foreign exchange reserves
management are safety, liquidity and returns. Within this framework, the Reserve
Bank focuses on:
a) Maintaining markets confidence in monetary and exchange rate policies.
b) Enhancing the Reserve Banks intervention capacity to stabilise foreign exchange
markets.
c) Limiting external vulnerability by maintaining foreign currency liquidity to absorb
shocks during times of crisis, including national disasters or emergencies.
d) Providing confidence to the markets that external obligations can always be met,
thus reducing the costs at which foreign exchange resources are available to market
participants. e) Adding to the comfort of market participants by demonstrating the
backing of domestic currency by external assets.
The Reserve Banks approach to foreign exchange reserves management has also
undergone a change. Until the balance of payments crisis of 1991, Indias approach to
foreign exchange reserves was essentially aimed at maintaining an appropriate import
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cover. The approach underwent a paradigm shift following the recommendations of


the High Level Committee on Balance of Payments chaired by Dr. C. Rangarajan
(1993). The committee stressed the need to maintain sufficient reserves to meet all
external payment obligations, ensure a reasonable level of confidence in the
international community about Indias capacity to honour its obligations, and counter
speculative tendencies in the market. After the introduction of system of marketdetermined exchange rates in 1993, the objective of smoothening out the volatility in
the exchange rates assumed importance.
Indias exchange rate policy has evolved in tandem with the domestic as well as
international developments. The Reserve Banks exchange rate policy focuses on
ensuring orderly conditions in the foreign exchange market. For the purpose, it closely
monitors the developments in the financial markets at home and abroad. When
necessary, it intervenes in the market by buying or selling foreign currencies. The
market operations are undertaken either directly or through public sector banks.
In addition to the traditional instruments like forward and swap contracts, the Reserve
Bank has facilitated increased availability of derivative instruments in the foreign
exchange market. It has allowed trading in Rupee-foreign currency swaps, foreign
currency-Rupee options, cross-currency options, interest rate swaps and currency
swaps, forward rate agreements and currency futures.
Foreign exchange being such a complex process for involving too many economics
concepts requires too much of expertise to deal with. But, at the same time, it has
become a subject of prime importance in todays times. In this era of globalization,
trading is a very important factor that no economy can ignore. No economy is so selfreliant that it does not needs to export or import something from the other. This is
where the need of foreign exchanges arises. And, in times when trading is of such
prime importance, no economy can ignore this fact of requiring assistance by the best
formulators to make plans for a flourishing economy. This plan of flourishing
economy cannot be achieved without the proper management of foreign exchange. It
is because of this that a country can have a good currency and satisfy the needs of the
people that it itself is unable to do, by the process of importing. Proper foreign
reserves help a country to recover from various economic problems and thus hold very
high importance.
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CHAPTER-7

Suggestions/Recommendations
The policy formulation process is not difficult on the surface. It is the thorny issues
and debates that emerge that tend to scuttle development and implementation of a
sound foreign exchange management policy. The basic development process can
be summarized as follows:
A. Examine current practices and past experience with regard to foreign
exchange management.
B. Define and evaluate exposures, both actual and projected. Evaluate
effectiveness of past hedging actions if feasible.
C. Formulate policy guidelines:
1. Establish priorities for managing exposures.
2. State corporate objectives clearly.
3. Ensure compatibility with other corporate goals and philosophies.
4. Obtain senior management mandate.
D. Develop operational structure:
1. Decide on degree of centralization.
2. Evaluate reporting systems and implement needed changes.
3. Specify approved hedging techniques.
4. Specify key decision makers/authorized traders.
5. Develop performance evaluation standards.
6. Establish transaction reporting requirements and procedures.
7. Provide for management review of outstanding contracts and
activity.
D. Establish a procedure for regular reviews of foreign exchange policies and
guidelines. A good policy provides positive framework for action, with
room for appropriate modifications and changes over time.

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F. Utilize policy review, goal setting, and policy implementation to encourage


the integration of foreign exchange management into the broader corporate
decision-making process. This will lead to more informed decision-making
and result in fewer surprises in the future.
G. The Study of Foreign Exchange Management unlike many other Social
Sciences is not a theoretical one. It is one of the most practical ones from
beginning to end.
H. Wee, the most important goal should be to keep it as transparent and as less
complicated as possible, as it already has enough layers of functions to make it
a complex one.
I. When the process is kept as transparent as possible, even a layman can
understand the topic with great ease.
H. RBI publishes each and every report on rbi.gov.in. People should be made
aware about it, so that they themselves can view the latest statistics and the
current standing of the country in terms of other counties.
In the proper context, a foreign exchange management policy serves several
important functions in addition to the critical control function.
An effective policy also helps in assessing treasury performance, providing a
framework for analysis, and involving the foreign exchange function in broader
corporate decision-making. These benefits can be just as important as the control
issues addressed by a formalized policy.

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BIBLIOGRAPHY
Books Referred:
Foreign Exchange Markets-Dun & Bradstreet
Foreign Exchange Simplified-B. Srinivasan
Forex Markets: Exchange Rate Dynamcs- G R K Murty

Websites Referred:
http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12251
http://rbidocs.rbi.org.in/rdocs/Content/PDFs/FUNCWWE080910.p
df
http://dor.gov.in/fem
http://www.slideshare.net/anujzeal4u/rbi-intervention-in-foreignexchange-market
http://business.gov.in/doing_business/fema.php
http://www.investopedia.com/terms/f/foreign-exchange.asp
http://www.businessdictionary.com/definition/foreign-exchange

Forex-or-FX.html
http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14350#int

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